The ageing of populations around the globe is causing an acceleration in the shift to Defined Contribution pensions.
We all know, because we’re often reminded, that we are living longer. A greying society is not just a trend in the UK, however; it is a global phenomenon. According to the UN’s medium population projections, the number of people aged over 65 will rise from just over 600 million today to close to 2.5 billion by 2100.
Furthermore, over the next century, the growth in the number of older people is expected to far outpace the rise of the working age population, as the chart below demonstrates. The UK is on a similar path.
Source: World Economic Forum
Dramatic increases in life expectancy have a profound implication for politics and the welfare state; moreover we see many of the models designed to manage those systems start to come under pressure, or even unravel.
Workplace pensions are a case in point. Defined benefit (DB or ‘final salary’) schemes promise participants a highly predictable income in retirement, based on a formula linked to earnings and length of service. If you have a DB pension, your employer is responsible for funding the scheme and for ensuring there’s enough money to pay your pension income at the time you retire.
But the DB model has mainly relied on a broad base of young members to support fewer retired members. As the ratio of old to young gets bigger, not only does DB become more difficult to administer, it presents a significant financial risk to companies, governments, and other institutions.
Defined contribution (DC) pensions, on the other hand, require you to build a ‘pension pot’, with you and your employer putting money into your chosen investments. Unlike a final salary scheme, there are no income promises; the value of your pension pot is determined by the performance of your investments. Consequently, most of the risk is placed on your shoulders rather than those of your employer.
Final salary schemes have long been giving way to DC-type plans as companies transfer pension liabilities off their balance sheet. In the UK, many final salary schemes have closed, and there has been growing participation in DC schemes brought about by ‘auto-enrolment’.
But the same phenomenon can be seen around the globe, as regulatory changes serve to accelerate the rate at which retirement markets converge towards DC.
Japan, for example, has one of the fastest-ageing populations in the world. It has a long history of DB pension plans, but the government is legislating to expand coverage of its DC scheme nationwide.
In the US, the move from DB to DC has been happening for several decades. In 1980, of those private sector workers who were in a workplace pension scheme, 60% were only covered by a DB scheme. But by 2006 that had fallen to just 6%2. Stricter funding requirements imposed by government have often been used to defend the closure of many schemes.
So how does the move from DB to DC affect people in the UK? Put simply, the government now expects much more from individuals in terms of having the expertise to manage their own retirement planning affairs.
You are expected to translate the value of your pension into income terms and make appropriate investment decisions; you must ensure you have saved enough to maintain your lifestyle over an unknown period, and you must understand costs in retirement to avoid an income shortfall.
Admittedly, a minority of people enjoy making such decisions, but the reality is that most of us don’t know how to manage all of the risks described above. New rules introduced last year, which give people the freedom to do what they like with a pension from age 55 onwards, only serve to increase the possibility of them making a mistake.
Building a pension pot and drawing an income from it requires you to manage a combination of risks, and demands a different mindset. In the past, individuals retiring with a final salary pension or annuity have generally only needed financial advice at the point of retirement. Going forward, those retiring with a DC pension will need to take financial advice not just up to that milestone, but throughout their retirement.
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1 World Economic Forum, 2 October 2015
2 Handbook of Aging and the Social Sciences, 2011