New analysis by asset manager Fidelity International, reveals that the cost to UK employers of providing a Defined Benefit (DB) pension scheme has soared over the last ten years.

The Fidelity analysis shows that the cost of providing a year’s benefits for the typical 40-year-old worker in a DB scheme has risen from 9.2 per cent of salary in 1995 to 23.8 per cent in 2005.

Employers’ overall costs ^[1] have jumped by 80 per cent over this period.

If pensions are viewed as deferred pay, then members of DB schemes have seen their total remuneration rise by an average of 6.4 per cent each year since 1995, roughly twice the level of inflation. This compares with an annual total pay increase of 4.6 per cent for members of Defined Contribution (DC) schemes.

Assuming that earnings increased in line with the national average, cumulative wage inflation in the period 1995 to 2005 for the members of DB schemes has been 86 per cent, compared with 57 per cent for DC scheme members.₂

Many employers have been slow to appreciate what impact the combination of both improved longevity but predominately the sharp fall in index-linked gilt real yields – particularly between 1997 and 2000 - has had on the cost of DB benefits.  As a result, some employers have over-promised on benefits.

Simon Fraser, President, UK and Europe, Fidelity International comments, “These figures allow for an interesting comparison.  Employees are often unaware of the real value of a DB pension.  These individuals have done very well over the last 10 years, with the average 40 year old experiencing an average 6.4 per cent annual increase in his remuneration compared to only 4.6 per cent per annum for his defined contribution counterpart. 

“However, the effect on UK plc is as important.  The real cost of employing this 40 year old has crept up on employers who have seen a dramatic 80 per cent increase in their wage bill.  With the underlying cost rising by 6.0 per cent per annum since 1995 many employers have perhaps been unaware quite how generous they have been to their DB scheme members.

“Many employers have sought to reduce this cost burden by offering defined contribution pension schemes to new recruits. Our analysis shows that employers could offer generous contribution levels to DC members – say 15 per cent of salary for the 40-year-old – and still save themselves money. Moreover, by doing this employers would also help to tackle the UK’s looming crisis in retirement savings.

“Employers can also make their pension arrangements more efficient by reviewing their asset allocation strategy. The headlong rush into government bonds over recent years has arguably exacerbated the considerable pension burden shouldered by employers with DB schemes.”

Fidelity International Limited (“FIL”) and its subsidiary companies serve the major markets of the world by providing investment products and services to individuals and institutional investors outside the US. The FIL Organisation manages a total of £159 billion of assets^[3].

Financial Assumptions

• Earnings are in line with National Average Earnings.
• Future earnings growth for the purpose of calculating the value of accrued pension is assumed to be 1.5 per cent higher than retail price inflation.
• The pre-retirement discount rate is assumed to be the real yield on the 30 year Index-Linked Gilt at 5 April in the appropriate year, plus a 3 per cent equity risk premium.
• The post-retirement discount rate is assumed to be the real yield on the 30 year Index-Linked Gilt at 5 April in the appropriate year.

Demographic Assumptions

• Pre-retirement mortality is assumed to be in line with the mortality tables AM80 for the period up to and including 1999 and AM92 for all subsequent periods.
• Post-retirement mortality is assumed to be in line with the mortality tables PMA80(c=2010) for the period up to and including 1999 and PMA92(c=2020) for all subsequent periods.
• Spouse benefits of 50 per cent of members pensions in retirement are assumed

Other Assumptions

• Individuals are assumed to accrue a fully index-linked pension of 1/60th of final salary payable from age 65 for each year of service.
• All pensions are assumed to be non contributory.
• Pension costs are calculated using the Projected Unit Credit method.
• In calculating the benefits earned by the member, employee contracted-in National Insurance contributions and Income Tax payments are deducted; the value of pension accrual is added, but other benefits in kind are ignored.
• Indirect taxes and benefits related to factors such as age, marital status, disability and dependent children are ignored.
• In calculating the cost of employment borne by the employer, employer contracted-in National Insurance contributions are added; the value of pension accrual is also added, but other benefits in kind are ignored.
• All earnings are assumed to be pensionable.
• Any pension costs arising from deficits relating to accrued benefits are ignored - the only pension costs considered.