Finality looms for final-salary schemes

A report into public sector pensions has provided further proof that final-salary schemes – also known as defined-benefit schemes – are unsustainable.

For years, the private sector has been turning its back on final-salary schemes, but now a report from advice firm Hargreaves Lansdown’s has provoked debate about whether the public sector’s defined-benefit schemes should also be reformed.

The research suggests that the public-sector schemes, in spite of being partially paid for by taxpayers, have made promises to members that they cannot easily keep.

The spiralling cost of public sector defined- benefit pensions has become, says Laith Khalaf, pensions analyst at Hargreaves Lansdown, “the elephant in the room”. A government estimate of liabilities stood at £650bn in 2006. But independent estimates put the total at closer to £1,000bn. Under current arrangements, for example, nurses who have worked in the NHS for 40 years can expect to receive two thirds of their final salary in retirement.

The largest schemes – for teachers, doctors and nurses, civil servants, the police and the army – are unfunded. This means that no pool of money has been set aside to meet the payments of benefits to these retirees. The cost of providing the benefits will be met by future employees in the sectors, and by the taxpayer. If contributions are not being set aside for future retirees, this prompts the question: how will they receive their pensions?

Hargreaves Lansdown has calculated that a defined-contribution scheme, where members contribute money that is then invested, could accrue the same nurse around 43 per cent of his or her salary, based on the scheme earning 6 per cent net growth each year. Although less than the previous state-funded scheme, this is still a comparatively generous pension.

There are, it seems, no easy answers. Changing the public-sector pension scheme would mean a period of pain where payments to current final-salary pension recipients would have to made by taxpayers alone, while the scheme members yet to retire put their contributions into the new scheme.

But traditional final-salary schemes are simply too expensive, say experts. The way to cut costs is to reduce what is on offer. This means either raising the retirement age, reducing the rate of benefit accrual or increasing member contributions.

Recent research from Aon Consulting, the pension consultant, revealed that two thirds of companies expected to reduce their contributions to final-salary schemes next year.

This is as a result of many succeeding in reducing their deficits, which currently stand at £25bn, and hoping to reduce their spending in light of economic uncertainties.

But Aon said employers would be in for a shock if they believed they had done everything necessary to reduce deficits. Difficult market conditions mean deficits are likely to increase over the next year.

Final-salary schemes give their members a guaranteed percentage of the salary they receive in their last year of work when they retire.

The proportion depends on how long the employee has worked with the organisation. An employee who has worked for 40 years and has a typical accrual rate of 1/60th will be entitled to 40/60ths, or 2/3rds, of final salary as an annual pension at retirement.

Ten years ago, just over one third of employees were members of final-salary schemes; last year only 15 per cent were.

In the private sector, the number of final-salary schemes has fallen sharply. Hit by tougher regulation, greater longevity and market volatility, employers have become less willing to sponsor the schemes.

Of the final-salary schemes that remain, only a fifth are open to new members, meaning that most employees joining a company with a pension will be offered a defined-contribution scheme.

Alterations to pension rights remain an emotive issue. Plans to close a final-salary scheme for new employees at Grangemouth, one of Britain’s largest oil refineries, resulted in a two-day strike by workers.

But for those employers still shouldering the burden of a final-salary scheme, there is some comfort. As they are now comparatively rare, employee groups say a final-salary pension has become a powerful tool for attracting the best staff.

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