Final salary pension schemes are fast approaching extinction – with fears over funding and the impact of inflation coming to a head in recent weeks.
The schemes, which have been closing at a rapid rate during the financial crisis, are facing a battle on two fronts.
The first is inflation. Expectations of inflation in the UK are at the highest in nearly a year. This has a damaging effect on final salary schemes, which calculate their liabilities according to how much their future payouts will be.
With most payouts to members linked to inflation, an increase in inflation expectations leads to an increase in expected liabilities. As a result, pension scheme deficits on the UK’s top 200 schemes rose in October from £15bn to £77bn, according to Aon Consulting.
But final salary schemes have other problems too. The Pension Protection Fund (PPF), which was set up to compensate members of final salary schemes whose employers go bust, has also reported a large deficit.
In the last financial year, the PPF’s deficit rose from £517m to £1.2bn.
The PPF currently pays out pension benefits to about 210,000 people whose company schemes have gone into administration. Benefits, however, are capped at a maximum of £28,743 a year.
The PPF funds itself through levies on existing final salary schemes, but also has £3bn invested – and it made a 13.4 per cent return last year.
It insists it is in good condition in spite of its deficit and says its members should continue to see payouts. “People should have confidence they’ll get the compensation they’re entitled to,” says a spokesperson.
But pension experts are not convinced. “In the short term, everything is fine – but I think there are significant funding problems for the PPF in the long term,” says Tom McPhail, head of pensions research at Hargreaves Lansdown.
He warns that as the final salary sector closes down, which it is doing “increasingly rapidly”, the PPF will have a decreasing source of funds to draw on.
There has been a rise in the number of final salary schemes closing to new members and switching employees into defined contribution schemes, where members’ pensions are dependent on stock market performance. Schemes could make further changes for existing members, as they struggle with their huge liabilities, including raising the age at which pension benefits are paid – for example, from 60 to 65, or paying a lower proportion of final salary.
Another major change that schemes could make is to reduce the amount of inflation-proofing they provide to members, a valued benefit of final salary schemes.
Many companies have not yet taken these steps – but consultants expect them to do so in the near future.
“I don’t think we’ve yet seen the changes to benefits that will come through as a result of the market conditions,” warns Sarah Abraham, a consultant at Aon Consulting.
