Pensions in Peril

The pension expectations of millions of workers are in peril. Companies are cutting back on the amount they pay into pension schemes and ending the guarantees they used to make about the pensions that will be paid. The problems have been brewing for some years. But recent changes have created a crisis which has thrown into doubt the incomes which millions of people were expecting to receive when they retired.

Not all pensions are in peril. The schemes affected are final salary schemes that promise staff a proportion of their pay in retirement. Most at risk are schemes run by private companies, but even some public sector pensions are threatened. Schemes where the pension paid is NOT guaranteed are NOT affected – though as we have seen in Saga Magazine recently, they face their own problems of providing people with a decent pension. The different sorts of pension are explained in the box.

The crisis does not generally affect people who have already retired, their pensions are protected and are unlikely to be at risk in the future. But people still at work who are expecting a pension related to their final salary may find that the promises they have been made are not kept.

If you are in a final salary scheme, your employer will pay a percentage of your salary into a separate pension fund. In most cases you will pay in as well. Typically your employer will pay in just over 9% of your pay (nearly 12% in public sector schemes) with you contributing just over 7% (or nearly 9% in the public sector). Public sector contributions are higher because the age you can draw the pension is usually lower and other benefits may be better too.

The fund is managed by independent trustees who will include directors of the company and usually staff representatives. The fund is entirely separate from the company and is invested to maximise the return on the money so that the pensions that have been promised can be paid. However, if the fund is not sufficient to pay the pensions then the company has to find the money needed. In other words, your employer has to stand behind the promises it has made to you about the pensions that will be paid. Today a growing number of companies fear that they will have to step in to prop up ailing pension funds which have been damaged by five things.

• Tax change In 1997 the new Labour government stopped pension funds reclaiming the tax that had already been deducted from the dividends on the shares held in the fund. That costs them an estimated £5 billion a year.

• Shares fall The stock market fell by 25% in from January 2000 to December 2001 so pension funds have shrunk.

• Life lengthens We are all living longer so pensions have to be paid for many more years.

• Contribution holidays When the stock market was booming pension funds grew strongly and many employers decided they could safely stop paying into the scheme or reduce their contributions. Nearly £20 billion was taken out over 13 years, damaging the ability of fund to pay the promised pensions.

As a result of these factors, companies with final salary schemes predict that their average contribution will have to rise from 9.2% of each employee’s salary to 15.5%. In the United States of America pension obligations are already driving companies to the wall. The photographic company Polaroid and one of America’s oldest companies Bethlehem Steel both filed for bankruptcy protection in 2001, partly blaming the cost of employee pension and benefit promises.

In the UK two other changes have made things worse. After Robert Maxwell died in 1991 it was discovered that he had stolen £440 million from Mirror Group pension funds. To prevent such crimes in future, the Government passed a law to ensure funds always had enough to pay out their immediate pensions. More and more funds are now failing this minimum funding requirement and companies are being asked to make contributions.

And now there is another difficulty looming. Accountants have decided that the obligations a company has to its pension fund must be shown clearly in its accounts. Under the dry name of FRS17 this accountancy rule will knock a hole in the finances of many major companies.

The result is that final salary pension schemes are being seen as a luxury that more and more companies feel they cannot afford. The chairman of the National Association of Pension Funds, a lawyer called Peter Thompson, said recently that two thirds of them were at risk. Other analysts expect them to have all but disappeared, at least from the private sector, within ten years. And as they close, their members will be left with broken pension promises.

There are three stages to the end of a final salary pension scheme.

• Stage 1 The first step is to close the fund to new members of staff. Existing staff carry on paying in and keep the promise of a pension related to their pay. But new members of staff cannot join, though they are normally offered the alternative of a different sort of company scheme. That almost always results in both them and the employer paying in less – on average the amount going in falls by a third. One in six final salary schemes in the private sector and one in ten in the public sector are now closed to new entrants. British telecom, Britain’s biggest pension fund, recently took that step.

• Stage 2 The next step is to close the final salary scheme to all staff – including those already in it. That may follow a few years after stage 1 when there are more staff outside the scheme than in it. Many smaller companies have already taken this step and early in 2002 accountants Ernst & Young closed its 1500 member scheme and the food retailer Iceland is expected to follow suit shortly for more than 4000 staff in its scheme. When that happens the fund continues but people in the scheme get their benefits ‘frozen’. The closer you are to retirement, the less you will lose. But for everyone, the pension will be less than was promised.

• Stage 3 The final step is to wind up the scheme – that can happen either at the choice of the company or following bankruptcy. By law, the pension fund has to be used first to guarantee all the pensions already in payment. Nowadays, all pension funds should have enough to do that. Once those pensions have been secured, any remaining money is transferred into an ordinary pension fund with no guarantees for the non-retired members. They are likely to get very little. Employees of Ravenhead Glass, which used to make almost every beer glass in Britain, found this out to their cost when the company called in the receivers last year.

Unfortunately there is not much that employees can do. If you are in a final salary pension scheme it is worth lobbying your trustees – at least one of whom must be an employee like you – to see what their plans are. But companies can always pull the plug if they feel they cannot afford the contributions. All we can do in practice is to make sure we are saving money elsewhere, outside the company scheme, to provide for our old age. And many of us are going to have to work longer.

· Final salary schemes – promise you a pension which is a certain percentage of your salary in the last years of employment. With most schemes you get a sixtieth of your pay for each year you have paid into the scheme. So after 30 years in the scheme you get 30/60ths or half your salary. In addition you will get up to three times your salary as a cash free lump-sum. The scheme may also offer life insurance, a pension for your widow or widower, and inflation proofing of up to 5% a year for the pension itself. Nowadays these schemes are often called ‘defined benefit’ schemes because the amount of the pension, the benefit, is guaranteed or defined.

· Money purchase schemes – are completely different. They simply save up all the contributions made into your pension into your own pension fund which is invested, usually mainly in shares. When you retire some of the fund can be taken as a tax-free lump-sum if you want and the rest has to be used to buy a pension for life. The amount you get will depend on how well the fund has performed, current interest rates and your age – there are no guarantees. These schemes are nowadays known as ‘defined contribution’ schemes because it is the amount you pay in which is fixed, not the pension you get at the end.

· Other pension schemes – are all basically money purchase schemes. You can top up your pension by paying additional voluntary contributions into a separate pension fund. You can pay into a stakeholder pension – which is just a money purchase scheme with low charges. Or perhaps into a personal pension plan (before July 1988 they were called retirement annuity contracts). The big difference with these schemes is that your employer – if you have one – often pays nothing in. So all the contributions have to come from you. That makes it much harder to save a big enough fund to get a decent pension when you retire.

April 2002

e-mail Paul Lewis on paul@paullewis.co.uk