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The death of final salary Pension schemes? A Good background article

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Guest Liam

Original link : The death of final salary schemes? - Investors Chronicle

 

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The UK pensions landscape has for years been characterised by a 'great divide'. On the one hand sit employees of large companies or the public sector with gold-plated defined benefit (DB) schemes, from which they will receive a guaranteed retirement income linked to final salary. On the other hand employees in inferior defined contribution (DC) pension schemes have no guarantees; their retirement income is dependent on the fortunes of financial markets.

 

In the private sector at least, many more will soon be exposed to that fate. Already, many private sector DB pension schemes have closed to new entrants, and the most recent downturn is only expected to hasten the decline of those that remain. Companies say factors such as increasing longevity and tighter regulation are making it difficult for them to keep future liabilities under control.

The National Association of Pensions Funds predicts that 52 per cent of DB pension schemes currently open to new members could yet close due to the financial crisis. This is equivalent to the closure of 1,000 UK private sector schemes. According to the NAPF's findings, over the last five months, the likelihood that employers will make changes to their scheme has increased significantly.

Get out now?

Should members view the uncertainty around the future of final salary schemes as a signal to transfer out? The answer is that getting out is unlikely to make much financial sense.

The winding up of DB schemes could mean a big loss in a DB saver's potential pension benefits, as well as a transfer of investment risk from the employer to the individual. Mike Morrison, head of pensions development at Axa Winterthur Wealth Management, explains: "These individuals will presumably have to take out a DC alternative, and have to work out a level of contribution and a risk profile to project forward to the level of benefit that they would like to get at retirement. All of which could be ruined by a fall in the markets just prior to retirement."

Besides, when a DB schemes close - either to new members or to existing members - the law requires the employer to make sure there is enough in the kitty to pay the pension benefits accrued to date. If the employer goes bust, the Pension Protection Fund (PPF) picks up the tab.

Pension safety net

The PPF will provide two levels of compensation. For someone who has reached their scheme's normal pension age or, irrespective of age, is either already in receipt of survivors' pension or a pension on the grounds of ill health, 100 per cent compensation will be paid. For anyone below the scheme's normal pension age, the fund will pay a 90 per cent level of compensation of the pension accrued before the scheme entered the PPF assessment period.

Robin Ellison, former chairman of the NAPF and a senior partner at lawyers Pinsent Masons, says that it is possible that the 90 per cent protection could be reduced if the economic crisis leads to large numbers of schemes relying on the PPF. However he believes that people who are in DB schemes still have much better overall protection than anything else they can invest in.

If an employer has been declared insolvent and the pension scheme has subsequently passed through the PPF assessment period, which usually lasts for between two and three years, the PPF will value the scheme in a completely different manner to that of a traditional pension fund. The part of compensation that is derived from pensionable service on or after 6 April 1997 will be increased by the PPF each year in line with the Retail Price Index capped at 2.5 per cent, which could result in a lower rate of increase than the original scheme would have provided.

Compensation paid is subject to an overall cap, which, as of April last year, equates to £27,770.72 at age 65. The cap will be adjusted according to the age at which compensation comes into payment. Current compensation cap factors can be found on the PPF's website.

Endangered species

Given that employers running DB schemes are under increasing financial pressure to close these schemes and provide alternative pension arrangements, will there be a massive exodus from DB schemes? Tom McPhail, head of pensions research at Hargreaves Lansdown, says for now there is enough money, but most schemes are in deficit. "The aggregate deficit is circa £190bn, with only around 10 per cent of schemes in surplus - so the longer the downturn goes on, the more likely it is that employers will look to negotiate reductions in benefit structures such as removing inflation proofing and increasing member contributions."

According to Mr Ellison, the real question is the degree of risk in a DB scheme, which while it is not nil, is still relatively low. "Also even if there is a failure, it is virtually unheard for there to be a total collapse. Most people would get 70p in the pound or 80p in the pound, even if the PPF did not exist."

Those lucky enough to be in a DB scheme may want to think twice before waving goodbye to these benefits. Mr Ellison says: "Unless they are keen on investment decision making, and are prepared to take a loss on the level of their pension, they should reflect very hard on transferring out of DB. They are sacrificing an employer guarantee plus a PPF support system in exchange for having the freedom of investment."

The alternatives

Jamie Clark, occupational pensions marketing manager at Scottish Life, says trustees and employers have several options if a scheme is closed to new entrants, future accrual or both. If closed to new entrants, but not future accrual, members could be asked to start paying, or pay more, for their benefits. If the scheme is being closed to future accrual and new entrants, members may be offered a DC scheme instead, which effectively shifts the risk to the members by removing the cost to the employer of the guarantee of a defined level of income in retirement.

"DC schemes are reliant on two main things - the contributions paid, in total, by employer and employee and the investment returns achieved," explains Mr Clark. "Some schemes may simply not have enough contributions going in or they may not have suitable investment choices which will mean that there may not be enough to provide the level of income that would have been available at retirement under the DB scheme."

Alternatively, members may be incentivised by way of a cash sum or an increased transfer value from the employer to transfer out of a scheme where the funds held are insufficient to provide a full transfer value of their benefits. The risk here is that the top-up to the transfer payment, or cash offered, could be far less than the actual value of the benefit being given up.

While shifting from DB to a DC typically means greater costs and the lost of a guaranteed level of income at retirement, there are some circumstances where switching might make sense. Flexibility could be one motivation for switching over, according to Ashish Kapur, head of European Institutional Solutions for SEI, a global provider of pension fund solutions. For example if an individual is a smoker and their company pension does not offer a smoker's annuity at retirement, they might then wish to opt for a private pension which does have this option. This could result in a higher retirment income.

Alternatively, if an individual has the desire to choose and control investments going into their pension fund, they might choose to switch from a DB scheme to a self-invested personal pension (Sipp). Mr Ellison, however, advises that this should only be considered by individuals who have other income, are relaxed about accepting investment risk and have a pension pots of around £150,000 or more.

There is, however, no blanket answer that applies to all schemes, as Mr Kapur explains: "Each final salary scheme is in a different situation and the decision to transfer out or not should be based on the reasons why the scheme is closing. If the employer is in trouble, then removing your money might be a consideration. However, if an employer is purely setting up a DC scheme to better manage future risk but is still willing to make the same level of contributions, then chances are that the scheme will still be reasonably well funded. Just because a DB scheme is closing down, does not necessarily mean bad news - you need to take it from an employer by employer perspective."

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They got rid of defined benefits here for all new employees where my husband worked. A few years ago they asked my oh if he would transfer to market or stay defined. We stayed with defined and so pleased we did.


Petals

:ssign15:taking no prisoners :wink:

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Guest Liam

Petals

 

I bet the company showed your husband some lovely brochures on the new scheme!..they would love to close the old schemes and pass the risk to the employees!

 

I have always discouraged people from leaving Defined Benefit schemes here in Australia. With UK based funds you have to take more into consideration. Tax on growth, future exchange rates, the fact that you can leave Superannaution in Australia to your children etc.. Lots to think about and people should get advcice on their own particular circumstances.

 

Liam

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My husband is no dummy when he finally got is final payment they short changed him and he took them to the super tribunal and they had actuary work it all out and the difference to my husband's calculations in the end between the actuary and him was $2.00. We received another $15000 which is not to be sneezed at. Wonder how many people take the time to work it all out and check.


Petals

:ssign15:taking no prisoners :wink:

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Guest thedenster

Hi Liam

 

Can you offer me any advice on pension funds? I am 33 and work for Ford Motor Company, my Final Salary Pension scheme is run by prudential and I have been contributing for almost 15 years.

 

My wife also has a Final Salary Scheme run by the prudential, she is a nhs nurse and has about 10 yrs worth of contributions. She is 32 years old.

 

We are moving to Perth in May 2009 and I haven't a clue what to do with both our funds.

 

Many Thanks

 

Jonathan

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Guest Liam

Jonathan, I have sent you a Private Message with some details.

 

regards

 

Liam

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Guest Bonniebuster

We have just received a report from a finacial advisor regarding moving our final salary pensions and to be honest it may as well be written in double dutch!! Also how do we check out that the information he has told us is right?

Apologies if I sound distrustful but this is our future and really need to get it right and only get one go at it!!

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