Defined Benefit Pensions and the benefits of rising interest rates

Posted: 25 / 05 / 2023

Article by: Jon Fisher, Head of Wealth

In recent years, defined benefit pension schemes have been struggling to meet their financial obligations, primarily due to low-interest rates, increasing life expectancy, and volatile financial markets.

However, an increase in interest rates may offer a glimmer of hope for these pension schemes, as it can result in a surplus, which presents an opportunity for trustees who wish to wind up the scheme.

Defined benefit pension schemes promise to pay a fixed amount to retirees for the rest of their lives, based on their final salary and years of service. The promise of a secure income in retirement has made these schemes attractive to employees and has been a popular employee benefit for decades. However, as the cost of providing these pensions has increased, many employers have chosen to close their defined benefit schemes to new members or to freeze them altogether.

One of the challenges facing defined benefit pension schemes is that they must make assumptions about future interest rates when calculating their liabilities. In recent years, interest rates have been at historic lows, which has made it more difficult for these schemes to meet their financial obligations. When interest rates are low, pension funds must set aside more money to ensure they have enough to pay pensions to retirees. Conversely, when interest rates increase, the liabilities of the pension scheme decrease, leading to a surplus.

When a defined benefit pension scheme has a surplus, it means that it has more assets than it needs to meet its obligations. This surplus can present an opportunity for trustees who wish to wind up the scheme. Winding up a pension scheme involves distributing the assets of the scheme to its members. If a scheme has a surplus, this can mean that members receive a larger payment than they would have otherwise.

However, winding up a defined benefit pension scheme is not a straightforward process, and there are several factors that trustees must consider before making any decisions. For example, trustees must ensure that all members of the scheme are treated fairly, and that the scheme’s assets are distributed equitably. Trustees must also ensure that they follow all legal and regulatory requirements and that they communicate clearly with all stakeholders throughout the process.

One option for trustees looking to wind up a defined benefit pension scheme is to buy out the scheme’s liabilities with an insurance company. This involves transferring the scheme’s assets to an insurance company, which then takes on the responsibility of paying pensions to the scheme’s members. This can be an attractive option for trustees, as it allows them to distribute the scheme’s assets quickly and efficiently. It also provides greater security for the scheme’s members, as they are protected by the financial strength of the insurance company.

Another option for trustees is to transfer the scheme’s assets to a defined contribution scheme. A defined contribution scheme is a pension scheme where the benefits are based on the amount of money contributed by the employer and employee, as well as any investment growth. Transferring the assets of a defined benefit scheme to a defined contribution scheme can be a complex process, but it can provide greater flexibility for members and can be an attractive option for younger members of the scheme who may prefer a more flexible retirement savings plan.

CONCLUSION

An increase in interest rates can provide a much-needed lifeline for defined benefit pension schemes.

A surplus resulting from an increase in interest rates can present an opportunity for trustees who wish to wind up the scheme, but this is a complex process that requires careful consideration and planning. Trustees must ensure that they follow all legal and regulatory requirements, and that they communicate clearly with all stakeholders throughout the process.

Ultimately, the goal should be to ensure that the interests of all members of the scheme are protected and that they receive the best possible outcome.