Final salary pension schemes must take more risk to avoid shortfalls

5 December 2017

Defined benefit pension schemes are being accused of investing their assets too cautiously.

Following the publication today of the Pension Protection Fund’s Purple Book – its annual update on the health of the UK’s defined benefit pension schemes – financial provider Hargreaves Lansdown is warning that conservative investment strategies will lower returns and force employers to increase their contributions.

The Purple Book reports that defined benefit schemes’ investments in shares – the key driver to growth – has reduced from 61% in 2006 to just 29% in 2017.

This means the schemes’ assets may not achieve the level of growth that is required to pay the pensions they have committed to and employers will have to pay more into the scheme to ensure they can meet their liabilities.

In turn, this could impact the amount employers pay into auto-enrolment pensions.

With many employers already struggling with the rising costs of their pension, this pressure could put the business at risk and increase the chance of the scheme falling into the hands of the Pension Protection Fund.

The Pension Protection Fund (PPF) – which is funded by a levy on the pension schemes it covers – pays compensation to members if their employer or the pension scheme fails. For more on the PPF, read our guide to How safe is your gold plated final salary pension?

Nathan Long, senior pensions analyst at Hargreaves Lansdown warns: “Of all investors in the UK, final salary schemes should be able to take the most patient, long-term view of asset allocation and investment risk, yet they have become increasingly short-term and conservative in their strategy. Not necessarily because they think this will produce the best returns but because it reduces the uncertainty risk. The whole system is out of kilter.

“Lower investment returns mean higher contributions are required to make up the shortfall, so employers are having to pour more and more money into defined benefit pensions. This comes at the expense of the auto-enrolment generation who desperately need higher levels of contribution directed into their modern-day pensions, the reality is legacy pensions could be stifling the future retirements of today’s workers.”

However, Andy McKinnon, chief financial officer of the PPF says reducing the level of equities in pension funds is minimising risk. He says: “Companies are taking further measures to reduce risk, both by closing their schemes to future accrual and shifting their asset allocation away from equities and into bonds.”

Only 12% of final salary schemes now open to new members

The Purple Book also revealed that more defined benefit schemes are being curbed in as employers strive to reduce costs. Only 12% of schemes are now open to new members, down slightly on last year when this figure stood at 13%, but down more significantly from 43% in 2006 when the Purple Book began.

The number of schemes closed to future accruals rose from 35% in 2016 to 39% in 2017.

The report was, however, able to share some positive news. Over the last 12 months the collective deficit of UK defined benefit pension schemes – that is the difference between their assets and their liabilities – fell from £221.7 billion in 2016 to £161.8 billion in 2017.

Commenting on the Purple Book figures, Mr McKinnon adds: “It has been another testing year for defined benefit pensions, with a succession of events casting a spotlight on the sector. For schemes and their sponsors, fulfilling past promises, made in a very different environment, has become much more expensive and much more challenging.

“While the landscape remains tough, we are seeing signs of progress. Scheme funding, while volatile, continues to show signs of improvement.”

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