Final Salary Scheme Closures
In a recent survey nearly a third of employers indicated that they intend to freeze their final salary schemes to existing members and over 80% had already closed the schemes to new members. In addition, the Pension Protection Fund (PPF) recently indicated that collectively the UK’s final salary schemes have a shortfall against the amount needed to provide members benefits of £179.3Billion.
What is this article about?
This piece looks at the reality of the protection provided by the Pension Protection Fund. If you want to be spared my verbiage and cut to the Conclusions
Final salary schemes have traditionally been described as guaranteed on the grounds that the benefits provided by them are ‘guaranteed’ by the employer. In any case, if the employer went bust, benefits would be protected by the PPF. Correct?
Well, not quite. Whilst those who had already retired and reached their scheme’s normal pension age when their employer went bust will receive 100%of their entitlement, others will receive 90% of a their entitlement subject to maximum pension of £28,742.68. This equates to the maximum pension an individual earning £43,115 would receive after 40 years service assuming that their entitlement builds up at 1/60th per year of service (which is commonly the case with this type of scheme). Individuals with a greater pension entitlement than this will have their benefits reduced to £28,742.68.
Many readers who are not lucky enough to be on high earnings or who don’t have a large pension entitlement may conclude that they are pretty well protected by the scheme since it provides 90% of their pension entitlement. Unfortunately, especially for those with some time to go, before they are due to retire, there are a couple of other catches with the ‘protection.’ One of these is that the option of early retirement is lost. PPF Benefits are only payable at the original scheme’s normal retirement age, typically 65. Forget heading to Spain at age 55!
The other catch, which is more subtle but, in the long run highly damaging to the level of benefits actually paid out, relates to the level at which the pension entitlement increases in the time before retirement. Since the Social Security Act 1990 came into effect all benefits must be increased between leaving service and retirement by RPI, subject to a 5% pa cap. This means that deferred pensions are substantially inflation proofed. However if the scheme comes under the auspices of the PPF the rate at which deferred pensions increase is capped at 2.5% per annum.
In common with many financial calculations, the effect of a 1-2% reduction to pension increases in deferment may be difficult to see. However, this is perhaps best illustrated by the rate of return (commonly called the ‘Critical Yield’) required to match final salary scheme benefits given up in the event of a transfer. Without going into the full details of final salary pension transfers, returns of 6-7%pa are usually required to match scheme benefits in the event of a transfer. However, in a number of cases I have recently looked at, returns of around 3-4% are required to match PPF benefits. This means that the PPF benefits, which need to be targetted, are substantially lower than the original entitlement. In addition, whilst it may be borderline to transfer for the purpose of beating original benefits, even for relatively risk averse individuals the chances are fairly good that PPF benefits would be exceeded.
It would be remiss of me not to point out there there is a great deal more to final salary pension scheme transfers than this and it is essential that professional advice from an appropriately qualified pension specialist be sought before making any changes to pension benefits.
The Pension Protection Fund provides limited protection at best in the event that an employer with a final salary pension scheme goes bust. Benefits are capped and higher earning employees could stand to lose a substantial amount. Early retirement is not available and benefit increases, before and after payment, are subject to a low cap. PPF benefits are funded by way of levies from other pension funds and if there is a shortfall benefits could be reduced.
Anyone with final salary benefits should arrange for these to be reviewed by a specialist pension consultant, especially if they are fearful of the financial strength of their ex-employer. Once an employer goes bust it is too late.