How safe is your 'gold plated' final salary pension?

7 June 2016

If your employer goes bust it may not just be your job that is at stake. If your company offers a final salary pension, your retirement income could be at risk too.

This has been highlighted by ongoing problems at Tata Steel and by the collapse of BHS. At the time of writing, the sale of Tata Steel is being derailed by the problem of its £15 billion pension scheme, while investigators are trying to work out just what happened at BHS to threaten the retirement incomes of some 20,000 current and former employees.

Employers offering final salary pensions to their staff shoulder the risk of continuing to pay the member’s pension as long as they live, and that of a surviving spouse or civil partner.


But gone are the days when final salary schemes can be described as gold-plated. While other pension investors might worry about stock market performance or whether or not they are paying enough in, members of final salary schemes will worry whether there will be enough left in the pot to pay them an income.

The cost of meeting final salary pension promises has continued to spiral as life expectancy increases, and the low-interest rate environment makes the pensions more expensive to pay.

The situation is so serious, that at the end of May, MPs on the Work and Pensions Committee launched an inquiry into the state of final salary pensions.

Tom McPhail, head of pensions at Hargreaves Lansdown, says: “It’s no longer possible to turn a blind eye to the yawning reality gap that has opened up between the past promises made by employers through their pension schemes, and the funds available today to make good on those promises.”


What is the Pension Protection Fund?

The Pension Protection Fund (PPF) protects the pensions and provides a safety net for people who are members of a company final salary (or other defined benefit) scheme. Currently, this includes some 6,000 schemes, with 11 million members.

It does not, however, protect members of public sector schemes that are backed by the government (for example the Police, Local Authority or NHS schemes) because they are not subject to the same risks.

Since it launched in April 2005, more than 800 schemes have transferred into the PPF, with more than 220,000 people relying on it to pay their pension.

Contrary to popular belief, the PPF is not funded by the taxpayer, rather it’s an insurance policy funded by a levy on the 6,000 schemes it protects. Should a company collapse, the PPF can take on its pension and make payments to its members. As a creditor, it can also take on the remaining assets of schemes transferring into the PPF and can recover assets from the insolvent firm itself.

First, it needs to conduct a thorough assessment of the scheme’s assets and work out whether a better outcome can be achieved – a process that can take a year or more, according to Kate Smith, head of pensions at Aegon. “It may be that the scheme is still able to pay a benefit above what can be paid by the PPF, ” she explains. Likewise, the scheme won’t be eligible if a buyer is found for the company.

During the assessment period, if you have reached pension age and are receiving an income, your pension payments will continue as normal.

In some instances the PPF may even be involved in the restructuring of a company before it goes bust – if it means the company can be saved. In 2014, for example, it took on the pension liabilities of the airline Monarch in return for a 10% stake in the company and a payment of £37.5 million. That intervention saved some 2,500 jobs and without it the airline would have almost certainly gone bust.

But while the so-called ‘pension lifeboat’ has rescued hundreds of thousands of workers’ pensions, the limitations of the fund mean it can’t always match the benefits that should have paid by the original scheme.

How much protection does the PPF provide?

The PPF only pays 100% compensation if you have reached your scheme’s normal retirement age when it takes over. Those who are yet to reach this age – including those who retired early – will only be entitled to 90%, subject to a cap. This year the cap is just over £37,400 for a 65-year-old. However, it drops rapidly for younger workers. The cap for a 50-year-old, for example is just over £26,000, while a 40-year- old would be limited to around £22,500.

The PPF says this cap only affects 0.5% of claims; nonetheless reports after the deal with Monarch (see page x) suggested the combination of high earnings and age-related caps meant some pilots lost more than half their anticipated pension.

Retirement provider Aegon’s Kate Smith also warns that all PPF claimants will get less inflation protection. “Annual increases to payments will be restricted. Only payments from pensionable service built up after 5 April 1997 will be increased in line with inflation [Consumer Prices Index] up to 2.5% a year. Payments built up before this date won’t be increased.”

How secure is the “pension lifeboat”?

As BHS and Tata Steel continue to dominate headlines the spotlight has, understandably, turned to the PPF itself and whether or not a rush of claims could sink the lifeboat.

Of the 6,000 schemes covered by the PPF in April 2016, more than 4,800 were ‘in deficit’.  This means they do not currently have enough money to cover the cost of the pensions they have committed to paying. The figures make for frightening reading.

According to Hargreaves Lansdown, these schemes have a total liability of £2,099.2 billion, but the total assets of those schemes are just £1,298.3 billion. This means there’s only enough money in the combined pots to pay 62% of what’s required.

However, Conall Reilly, pensions specialist from wealth management adviser, Johnston Campbell says these numbers can be blown out of proportion. “Scheme deficits are getting bigger and bigger, but this can be a bit of a red herring.

“The deficit is literally what would be needed to buy an insurance policy to cover that liability today. Instead, the focus needs to be how able is the company to meet its liabilities in future.”

As soon as a scheme goes into deficit, the firm is required by the regulator to put in place a recovery plan designed to bring it back into surplus. However, setting up a successful plan is not easy. Very much will depend on the financial strength of the company and the size of its deficit.

For some schemes there is a tricky balance to strike – if the demands of the recovery plan are too severe, for example, that in itself could bring down the company. “It’s pensions versus jobs,” says Ms Smith.

Fear of losing what money they do have to pay employees’ pensions in volatile markets is also adding to firms’ woes. Jamie Smith-Thompson, managing director at Portafina, says: “There are more schemes struggling.” This has led to schemes reducing their level of exposure to the stock market to lower their risk. This could increase pressure on the PPF: “If they sell off their investments where is the necessary growth going to come from?” says Mr Smith-Thompson.

But Mr Reilly does not think there’s immediate need for panic. “It’s always the case that when we have a high-profile company going into the PPF that people worry it will be the one that breaks its back.”

The PPF is in a robust position. In its 2015 annual report it had total assets worth £23 billion with £3.6 billion in reserves. This means the fund is in surplus and has 115% of the money currently required to fulfil its promises.

Gary Smith, a financial planner at Tilney, says he’s “not overly concerned” about the health of the PPF.

This is because, even if there is an increase in the number of schemes that transfer into the PPF, it does not have to start paying out to all its new claimants on day one, only when they reach their scheme’s normal retirement age. “When you look at the likes of BHS, there will be members of the scheme that are still in their 40s or 50s,” he says.

As such, the PPF has time on its side. “It can then plan to bring the funding position up to cope with its pension liabilities,” he adds.


What could the PPF do to improve its financial position?

In the current tax year member schemes will pay a combined £615 million levy to the PPF and the PPF says it has the scope to increase that sum substantially – by close to £1 billion if necessary.

However, Mr Smith-Thompson is not convinced this funding model will be sustainable. “If a scheme is in deficit, it will be paying a higher levy – that is only going to compound the problem,” he says. “There will come a point where trustees will just want to quit their losses.”

Ms Smith agrees: “There will be fewer and fewer schemes paying the levy and more going into the scheme.”

As an absolute last resort the PPF says it could apply to Parliament for permission to reduce the level of payouts.

At the end of May, ministers were seeking to restructure Tata Steel’s UK pension scheme and switch its inflation benchmark from the retail price index (RPI) to the consumer price index (CPI). This seemingly innocuous move could cut the company’s future pension liabilities by billions of pounds, but would see members incomes increase at a slower rate.

“I think the government will have to intervene at some point with taxpayer support,” says Mr Smith-Thompson.

How well is your final salary scheme doing?

You need to know what is going on with your scheme and be prepared to ask tricky questions.

Ms Smith says: “Look at how well funded the scheme is and at the strength of the employer. You might be concerned, for example, if the recovery plan is for more than 20 years,” she adds.

This information should be in your employer’s annual report, says Ms Smith, but she concedes: “It can be quite difficult to find unless your schemes’ trustees are really on to their communication.”

The average length of a recovery plan is around the 10-year mark, according to the PPF, but the BHS plan was a whopping 23 years.

While larger companies might have the means to raise the necessary finances not all firms will have this option. “Employers may not be able to afford their pension contributions,” says Mr Smith. “It’s always more of a problem for smaller companies,“ he adds, “as the costs as a proportion of turnover are going to be higher.”

Should you leave a final salary scheme?

If your scheme is in hot water, quitting your losses and transferring out might seem an obvious solution. Here, your scheme pays you a lump sum in return for giving up your guaranteed income. It’s then your responsibility to use that money to provide an alternative income in retirement.

Mr Smith says there may be value in stopping payments if your anticipated pension income is likely to breach the PPF cap. “If your scheme is in difficulties, you could be pouring water into a bucket with a hole. You could opt out of the scheme and pay further contributions into another scheme.”

To help you decide, it’s worth getting advice from an independent financial adviser (IFA) who specialises in pension transfers.

Ms Smith adds: “The value of your transfer would be reflected by the solvency of the scheme. However, your employer may top it up to encourage you to leave. Employers do this as a de-risking strategy.”

At the opposite end of the scale, if lots of people are transferring out of the scheme trustees may have to sell off assets and reduce transfer values.

Even if you’re offered an enhanced transfer value, quitting the scheme may not be the best option if you may struggle to replicate the benefits – even if it ended up in the PPF.

Mr Reilly says: “All guarantees will be off. With the PPF you are at least guaranteed 90% of your income [subject to the cap].”

Mr Smith says that having your pension paid by the PPF need not necessarily be a bad thing. “Take somebody with a £10,000 a year guaranteed income. That might have a transfer value of £80,000 which at age 60 may only get you £3,000 or £4,000 a year.”

But while the benefits of the PPF cannot be underestimated, they aren’t very flexible, and Mr Smith-Thompson says it’s this that might encourage some members to transfer. If you are in ill health, for example, you may be better off with a lump sum rather than an income.

A brief history of final salary protection

Today, members of final salary schemes have far greater protection than they did in 1991 when Robert Maxwell went over the side of his boat taking his staff’s final salary pensions with him. The media tycoon’s death triggered the collapse of his publishing empire and the revelation that he had misappropriated £440 million from the Mirror Group pension fund.

Within a year, the government had arranged for 32,000 pension scheme members to be compensated. The scandal led to tougher regulation of pension funds.

However, from 2002-2004 a succession of companies collapsed, leaving around 125,000 final salary scheme members with next to no pension.

This led to the creation in 2005 of the Pension Protection Fund, which provides a safety net for members of final salary and other defined benefit schemes.