According to consulting firm JLT the total private sector final salary pension scheme deficit has increased to an all-time high of £390bn. This is a potential issue for those with a deferred final salary pension or in an ongoing scheme.
Final salary pension scheme deficit is also a real issue for the public sector. The National Audit Office recently reported the UK government’s public sector pension liability increased to £1,493bn, rising by approximately 30% in 5 years. It is often difficult to grasp the impact of such large numbers but to put it into perspective £1.5bn is roughly four times the total value of UK exports in 2015.
A pension scheme deficit increases the risk the terms of a pension schemes will be re-negotiated at some stage or, worst case, fail. In this post we discuss the issues driving the deficit, discuss the Pension Protection Fund (PPF) and its rules.
Why Have Final Salary Pension Scheme Deficits Increased?
Final salary pension scheme deficit has actually been an increasing problem for a number of years. The BHS pension scheme failure, the ongoing issues with the British Steel pension fund and the impact of Brexit have all, within just a few months, significantly raised the profile of the issue.
Very low UK interest rates over a number of years and demographic factors including rising life expectancies are two major factors behind the rise in deficits. The level of employer contributions in the past, tax changes and an increasing administrative burden have also had an impact. In the short term Brexit has caused uncertainty, volatility in stock markets and, crucially, driven down the yield on Gilts to record lows.
What The Deficit Means For Those With A Final Salary Pension
It is important to note a final salary pension scheme deficit does not automatically mean the scheme will not pay out benefits in full or (worst case) fail. For those in the private sector, the employer may make up the deficit by increasing contributions. Alternatively, interest rates and the yields on Gilts could improve.
For those in public sector schemes ultimately the government (and taxpayer) stands behind those schemes but if the burden on the taxpayer and the public purse becomes too great it is probable a political debate will be forced at some point.
If deficits cannot be made up then difficult discussions may be required on changing inflation measures (RPI to CPI), increasing retirement ages, increasing contributions or moving to career average rather than final salary pensions.There is also an ongoing debate surrounding CDC type pensions.
It is true most employers will stand behind their final salary pension schemes and not exploit any loopholes that may appear but it is possible others will not. There is a long history of some businesses using creative means to reduce their exposure to a pension deficit. The Pensions Institute recently published a report entitled “Milking and Dumping – The devices businesses use to exploit surpluses and shed deficits in their pension schemes” that covers this issue.
In the worst case if a pension fund fails there is the Pension Protection Fund lifeboat (PPF)
What is the PPF?
If the worst happens and your scheme falls into the PPF what can you expect to receive?
The Pension Protection Fund was set up in 2005 to pay compensation to members of eligible final salary pension (defined benefit) schemes, when an employer becomes insolvent and/or where there are insufficient assets in the pension scheme to cover its commitments. To be a member of the PPF a business must pay an ongoing levy to fund the scheme.
When a pension scheme applies to the PPF an assessment period begins. During the assessment period (which can take up to 2 years) pensions are paid at PPF specified levels (see below). While most businesses running defined benefit schemes are members some are not. You can read more on eligible funds on the pension protection fund website. It is important to note that once a PPF assessment period is entered or a PPF funding scheme is in place it is highly unlikely any pension scheme transfers will be allowed.
Pension Protection Fund (PPF) Rules
If already in retirement when the PPF takes over a fund then the position is relatively straightforward as those scheme members already in receipt of benefits will generally receive 100% of the amount they were receiving before the employer became insolvent. The same applies if early retirement on health grounds can be proven to the satisfaction of the Pension Protection Fund.
Payments rise in line with inflation each year (to a maximum of 2.5%) but only for the portion of your pension fund that accrued from 5 April 1997 onwards. Payments relating to pensionable service before this date will not increase.
Members of pension schemes who have not yet retired will receive up to 90% of their entitlement on reaching their normal pension age. The pension entitlement is calculated based on the salary of the pension scheme member at the point the pension fund applied for PPF protection.
The level of the pension payment is subject to a cap that currently limits the annual pension payment to a maximum of approximately £36,000 regardless of final salary. This cap is age related and is recalculated each year, it is designed to ensure that those who paid into the pension scheme for longer receive more. For those who have earned high average salaries over their working life or (depending on the scheme rules) are nearing retirement on a high salary these caps can have a significant impact.
The Final Salary Pension Transfer Option
Entitlement to a yearly pension from a final salary pension scheme may be swapped for a cash (transfer) sum. This sum must, in the first instance, be invested in a registered personal pension scheme. An individual may then drawdown on the sum invested to fund their lifestyle in retirement. Drawdown may be in the form of lump sums and/or income withdrawals.
There are both advantages and risks involved in a final salary pension transfer that must be considered carefully based on individual circumstances. For pension fund values exceeding £30,000, there is a legal requirement to take Independent Financial Advice but it is a good idea to take appropriate advice before transferring a pension of any value.
A final salary pension scheme deficit will not be a major concern for most but it is important to be aware of the potential issues. If a problem is identified it is important to source all relevant information in good time to be in the best position to make decisions on the way forward.
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The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances.