Why young Irish people have much worse pensions than their parents

PROGRESS IS NOT linear in most areas, but one that is meant to be an exception is working conditions.

Employment practices are meant to improve over time. People get paid more, quality of life goes up, all that good stuff. 

Workers now should be better off versus those of 20 or 30 years ago, particularly with increases in productivity coupled with rising corporate profits.

But there is one area in which many workers are far worse off compared to their parents – their pension.

Back in the day, many workers could join ‘defined benefit’ (DB) schemes.

This is a system which guarantees a specific income once a worker hits retirement age, normally based on salary and years of service.

The big thing to note here is that the final payment – a set monthly income for life upon retirement – is funded by the employer.

These pensions have been largely replaced by ‘defined contribution’ (DC) schemes. These are where employees contribute to their own retirement, often with matching payments from the employer. The final retirement payments depend on the final value of their investments.

Importantly, it shifts the investment risk from the employer (DB) to the worker (DC).

DC payouts are also typically lower than those from DB, meaning that the employee receives less money in retirement.

Securing DB pensions was a major labour win for workers, providing retirees with a good level of stable income.

However, DB pensions are vanishing. While there used to be over 2,500 DB schemes in Ireland in the early 1990s, that number has since dropped to just 450 or so.

To get an idea of how generous DB pensions often were compared to DC, we just need to look at the standard formula DB schemes typically operated under.

This would often multiply each year of service by 1/60th or 1/80th of your final salary.

For example, say we have an employee who works in a company for 40 years and has a final salary of €60,000.

This corresponds to a retirement payment of 1/60 × 60,000 × 40 = €40,000 per year. This payment is for the rest of the retired employee’s life.

Compare this to a typical DC worker. Financial analysts normally advise workers to save about 10 times their final salary. This is considered a stretch goal.

For someone who finishes on €60,000, this would mean a pension pot of €600,000.

Assuming a withdrawal rate of about 4.5% per year, again fairly typical, the DC pension would pay out about €27,000 annually – well below the DB pension.

And with the DB pension, the worker faces no risk that the money will run out one day if they live for longer than expected.

This raises an obvious question: if DB pensions were always more expensive, why did companies ever offer them?

Initially, DB pensions became popular as a benefit to attract workers. These types of plans were most strongly associated with the civil service and bodies connected to the state, such as semi-state businesses.

After becoming embedded in the public sector, DB systems later expanded into private-sector employers, such as major banks and manufacturing firms.

This was supported by favourable tax treatment. Pensions were one of the most tax-efficient forms of compensation, as employer contributions reduced taxable profits.

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DB schemes were not unique in this – any pension system could have got similar benefits. But DB was the default at the time, so thousands were established.

The trend was also spurred by the fact that many jobs were ‘for life’ positions at the time. DB pensions were viewed as long-term investments which bought loyalty.

However, there was a major shift around the late 1990s and early 2000s. Employers either closed DB schemes to new entrants, or moved to cut them entirely. 

There were a few reasons for this. One is obvious: cost. DB schemes cost businesses more money, for a longer time period.

While this had been true for years, changes to accountancy rules around the early to mid-2000s meant that companies had to make much larger provisions for DB pensions on their books than previously. In many cases, this led to visible deficits on the company books, which spooked employers.

Falling interest rates also had a major impact. 

Using mortgages rates as a proxy, we can see that these rose from over 10% in the early 90s to around 6% later in the decade. They hovered around this level until the financial crash, when rates fell sharply again, reaching 0% by the mid-2010s.

This sharp drop in interest rates made DB pensions much more expensive and volatile to fund. This pushed many employers to freeze schemes to new entrants, or close them entirely.

The reason why falling interest rates makes DB pensions more expensive is because interest rates are used to work out the expected return on safe investments used in pension funding calculations.

Lower rates broadly mean lower expected returns. So the company needs to set more money aside to fund DB pensions.

Rising life expectancies also played a part. In the mid-1960s, men aged 65 could expect to live for a further 12.4 years, while that number was 14.7 for women.

By the early 2000s, those figures had increased to 15.4 and 18.7 respectively – meaning that companies would have to pay higher rates for longer.

And of course, after the financial crisis of 2008 and the subsequent recession, Irish companies went into cost-cutting mode. DB schemes were an obvious target.

Companies linked to the state normally just closed DB programmes to new entrants. For example, the ESB did so after its DB liabilities exploded to almost €2 billion. 

Private employers tended to move faster. For example, the likes of INM (Independent News and Media) moved to entirely shut their DB scheme in one go, lowering the retirement income for former staff members.

Over time, the result was a sharp decline in the number of DB schemes. As of 2020, the Pensions Authority estimated that there were fewer than 600 of these in Ireland. More recent figures put that number around 450. That is out of an estimated 86,000 or so pension schemes across the country.

However, these several hundred public sector DB schemes have higher liabilities than all the private ones combined.

This is likely due to the fact that just one of the schemes can have thousands of members, such as for teachers.

They are also some of the few DB schemes which are still open to new entrants, although under revised conditions since 2013. 

Retirement payouts are now calculated on an average of career earnings, rather than final salary, which means they will be lower for new entrants than existing members pre-2013.

Ireland is not unique in this. The trend is similar internationally. 

In the UK in 1997, an estimated 37% of private sector employees had a DB pension. By 2021, this was down to 7%. While Ireland does not track data the same way, the results are likely similar.

DB pensions are largely a thing of the past for private sector workers, with today’s employees having much less generous provisions compared to previous decades.

While DB schemes live on in the public sector, final payouts have dropped compared with the past.

For both public and private employees, the same fact holds true – workers now are typically getting a worse deal compared to their parents’ generation.

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