I wrote yesterday about confusion about what a defined benefit promise is today. This surrounds the concept of the “DB pot”, a concept that is utter fiction. There is no DB pot.

A defined benefit scheme, whether final salary, career average or even cash balance is just one big pot sufficient to pay out promises made to participants (members) and topped up when needs be by a sponsor, typically an employer, occasionally the PPF. This is also the same for Royal Mail’s CDC scheme.

The cost of meeting the promise is measured by actuaries by taking guesses on the performance of the assets in the scheme and the likely amounts needing to be paid out in retirement (the liabilities). If you add all the promises to members together and discount them by an assumed rate of growth on the assets, you get to a valuation of the scheme’s assets and liabilities and this gives rise to a surplus or a deficit (scheme’s are rarely in equilibrium).

Since 1988, trustees of these schemes have had to provide members with  their individual valuations as “cash-equivalent transfer values” or CETVs. These are what have given people the idea of a “DB pot”.

But the CETV is nothing like a pension pot you have in a DC pension. Though DB schemes need to keep some cash in their fund to pay CETVs on demand, they do not organize the administration of the pension scheme around them.  The idea is that a CETV is paid only in exceptional circumstances rather than as an alternative to a pension. However, during the last decade, CETVs became very popular to a point where for many people they were more valuable than the pension promise itself.

This was never the intention of those who set the rules (the DWP) , enforced the rules (TPR) or managed the scheme (trustees and their administrators). The popularity of CETVs was a result of the bizarre way that CETVs are calculated, using a method that raised the transfer value every time that the gilt rate fell and raised it again every time that life expectancy rose. Though gilt yields have fallen and life expectancy has fallen recently, for most of this century life expectancy has been rising and gilt yields have been as low as they can go. This has meant CETVs have been HUGE.

Since inflation and interest rates started rising in late 2021, CETVs have been falling. For example, a man working for Scottish Power told Money Marketing that his CETV had fallen by £600,000 from £1.4m to £800,000. But this does not mean his pension has fallen. The £800,000 figure is what an actuary reckons is needed to pay his pension now that interest rates have risen. It’s the same pension as before (it’s actually nominally bigger because  it’s had some cost of living rises added in).

The trouble is, the member has stopped thinking of his pension as a pension and become obsessed with something that doesn’t exist – his DB pot.

Here we have the whole problem we have got ourselves into with DB pensions , encapsulated into CETV madness. The CETV can be created in a variety of ways. There is a section of TPR guidance that explains the discretion available to trustees and their actuaries in doing this. The basic rule is that CETVs should follow the method of valuations used by the Scheme as a whole. For more than a quarter of a century Schemes have been using very conservative ways of valuing scheme liabilities which has meant that members have had very secure pensions. This conservatism is referred to as “prudence”.

But prudence has some unintended consequences. one of those is that it requires employers to plough corporate money into pensions (as opposed to paying people more or investing in R and D) and it means that CETVs get higher and higher. The most extreme consequence of high pots was the debacle that followed the British Steel Pension Scheme changing the way it calculated CETVs in early 2017. This coincided with a major restructuring of the Scheme that made steelworkers choose whether they wanted their pension paid by the lifeboat Pension Protection Fund or by a new iteration of the BSPS scheme.

We all know what happened next.

What goes up, must come down.

People who did not take the high transfer values on offer till 2022 are now feeling they missed out. There will be many former members of pension schemes who took their CETVs and are now sitting on large DC pots as a result. But they have no private pension anymore.

Organizing the mass migration of DB members out of DB schemes and into private pensions was what many IFAs did for much of this century. They were encouraged to do it by sponsors who enhanced CETVs to get members to take them and these employers were encouraged to do this by their corporate advisers who could see advantages to the corporate balance sheet of paying off scheme members. All of this went on, under the eyes or the Pension Regulator who considered such activities “scheme de-risking”.  There was complicity throughout , advisers could be paid through a quasi-commission arrangement called contingent charging (no win no fee) and it wasn’t till the BSPS fiasco , that the FCA got involved.

Suddenly, in late 2017 and 2018, the FCA sprung into action , determining that over half the steelworkers who were taking CETVs were badly advised and belatedly trying to put a stop to what had already become a flood of applications. The consequences of this abrupt intervention are still being felt today, 1400 steelworkers , still to receive compensation, are set to receive between £50m and £70m compensation, many IFAs are now out of business and more facing ruin. The problem is not confined to BSPS, mini-BSPS problems are alive with many other DB schemes.

This ongoing fiasco is down to CETV madness, where a cash alternative to a pension promise was seen as more attractive than the prospect of a wage to life.

What went up , has now come down. The CETV bubble has burst , but it should never have been inflated in the first place.

The fiction of the DB pot

Robert Cochrane made the point on a recent podcast that people get pots but don’t get pensions. It is not intuitive that it costs over £100,000 to pay a £5,000 pa pension.

Offering a CETV looks to a member like the pension scheme has got a DB pot sitting on a shelf – like a life insurance pay-out.

But there is no pot, no shelf and the value of the pot is only guaranteed for a few weeks. The next value could be higher or lower and many schemes do not allow people to get more than one valuation a year.

More sophisticated schemes offer online valuations which can change every day. Members can quickly become obsessed with CETVs – which goes unnoticed when CETVs are going up but can lead to mental health issues, when they go down. The member who saw his CETV fall by £600,000 claims he can no longer work but has been forced into early retirement out of worry. Ironically, the retirement income he will get will (as mentioned above) be the same as he had when his “DB pot” was £600,000 higher.

If you are in an unfunded DB pension (not NHS, teachers and other public sector schemes), then you don’t get a CETV, this provides sanity. Here a pension is always a pension, never a pot.

The use of the word “madness” is grounded in reality. The promotion of CETVs, the exploitation of people’s bias towards cash in hand  and the failure to apply common sense in the valuation process, has led to over 100,000 DB pensions becoming DC pots. The long term outcome of this will be ongoing grief  from those whose DC pots go wrong and ongoing grief for people complaining they’re stuck with a pension they’d rather not have.

Which of course is CETV madness.