The Pension Protection Fund (PPF), which provides a cushion for members of final salary pensions when their employer goes under, recently published its first annual report detailing how many pension scheme members it had provided protection for in its first full year of operations and how the organisation has managed its funding.

One of the most significant disclosures was the shortfall in levies. This caused some experts to warn that the fund may have to increase levies on companies running final salary pensions to meet the £1bn in probable and possible claims the fund is facing.

What is the Pension Protection Fund?

The PPF was designed to help cover pension shortfalls of insolvent employers. It is funded by insurance premiums which are paid by employers. The PPF then invests these levies to fund the pension promises of insolvent employers.

At the time the fund was set up, in April 2005, a series of high-profile pension schemes had collapsed. In some cases members were left with only 10 per cent or less of their benefits, prompting the government to set up a compensation scheme to protect people’s pensions.

The PPF provides a lifeboat for people who have defined benefit or final salary pension schemes with a sponsoring company that becomes insolvent and has underfunded the pension scheme.

What compensation does the PPF provide for members?

Once a pension scheme is transferred to the PPF, the scheme will provide 100 per cent of the pension for members over the normal pensionable age as defined in their schemes. But Raj Mody, partner at PricewaterhouseCoopers, cautions that not everyone should expect the full benefits their original sponsor intended to pay.

If you haven’t reached pensionable age you will receive 90 per cent of your accrued benefits, capped at £26,050 a year. Those entitled to PPF can take 25 per cent of the compensation as a lump sum within six months of their pension take-up.

Early retirement is also possible under the scheme, as long as an individual is over 50 and notifies the PPF at least six months before they want to start receiving their pension. In these cases you will get less than 90 per cent of your benefits (up to the annual cap).

If your original scheme provided a pension for your spouse or civil partner the PPF will provide 50 per cent of the main member’s compensation. Dependent children will be paid 25 per cent of the member’s pension per child up to a total maximum of 50 per cent.

Will my pension increase in value?

Once the PPF has taken responsibility for a scheme, members can no longer pay in any contributions. The PPF says that, if you are in retirement, only final salary pension income accrued after April 1997 will rise in line with retail price inflation, subject to an annual cap of 2.5 per cent. If a member is not yet receiving a pension, their final salary entitlement will rise in line with RPI subject to a higher cap of 5 per cent a year.

Which schemes are considered by the PPF?

Only private sector defined benefit schemes are eligible for the PPF. The sponsoring employer must be insolvent and there must be a deficit in the scheme, meaning that the employer cannot honour its pension promises to at least as generous a level as the PPF. If a scheme meets these criteria there is then an assessment process that lasts for at least 12 months.

What happens after the assessment?

During the assessment period, the pension trustees remain in day-to-day control of the scheme and members will continue to receive payment at PPF compensation levels. Once a scheme has been taken on, the employers pay premiums to the PPF. These are calculated using a number of factors such as the number of members in a scheme and the risk levels.

How has the PPF performed in its first year?

The fund has yet to start paying out any money to members but has started the process of protecting 43,000 members.

However the fund is also facing nearly £1bn in probable and possible claims. Consultants have warned that levies on employers might need to double to meet this shortfall. The chairman of the PPF has said that the £324m of levies collected were intentionally less than the £575m expected rate of risk.

The PPF said: “The PPF expects to carry a deficit in its early years of operation as it grows into its role. The PPF is 86 per cent solvent, and has sufficient assets to meet its short-term cash flow requirements. The PPF will not be required to pay out against all of its liabilities at once, and will look to reduce its deficit over time.”

Why are experts concerned?

Mody points out that it’s impossible to predict what demand on the PPF there will be in the future and that the PPF can alter the rates of compensation members are provided with if it runs into difficulty.

As the fund raised a lower than necessary premium to start with, premiums are also likely to go up.

“It remains to be seen whether they will have to make that deficit good in the future by increasing the levy or whether they can take some risk with the way they invest the levies,” says Mody. “But there is no painless solution.”