Final chapter for final salary

by Dr. Ros Altmann

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The latest news on pension funding makes worrying reading for UK final salary scheme members, employers and their shareholders. After perhaps breathing a sigh of relief last year, when accounting figures suggested FTSE 100 companies had a combined pension surplus of £12bn in July 2007, the latest estimates from Lane Clark and Peacock, for July 2008, show this turned into a net deficit of £41bn.

Last year’s ‘surplus’ lulled many people into a false sense of security but was probably an illusion. Accounts can massage pension numbers, due to lack of standardisation of discount and mortality rates, creating a misleading picture of pension scheme health. But the reality is that most schemes do not have enough money to pay all members’ pensions over the longer-term.

Worryingly though, pension contributions for FTSE companies fell from £13.4bn to £13.1bn in the past year and the new research concludes that most companies have not done much to reduce their pension risks. Given the current economic weakness, such news is particularly problematic. Rising inflation, falling stock markets plus increasing life expectancy have all added to the costs of providing pensions, but finding the money to increase pension contributions is a significant challenge.

In the face of the credit crunch, rising energy and food prices, everyone is struggling with higher costs and the amounts available for pension funding have reduced – and are likely to fall further. This is a real problem for scheme members, who are still – in most cases – just unsecured creditors of their employer, but are relying on their company pension to top-up the meagre state pension. Obviously, if their company fails, they will still be protected by the Pension Protection Fund, but this will only pay reduced pensions.

Of course, scheme trustees and members need to be careful about demanding too much money from their employer, but as the economy worsens, there will be competition between the interests of shareholders – who want to delay putting money into a pension scheme – and members, who need more money in the schemes to make up the deficit.

The real costs of our final salary pensions are too high, too volatile and ultimately too uncertain for many companies to cope with. It is inevitable that employers will keep on closing schemes to both new and existing members in the face of so much uncertainty around the funding and cost levels. In order to properly fund a final salary pension promise, employers and members must contribute over 25% of members’ salary every year; and even that may not be enough if markets decline or liabilities grow faster than expected.

This is surely the final chapter for final salary schemes. The recently retired generation are the lucky ones and ‘guaranteed’ employer pensions will not be available to most future private sector employees.

So far, of course, public sector workers are immune from such problems, but taxpayers will face mounting funding pressures in future, just as private employers are struggling with pension costs now. At least the private schemes have some money invested to help pay the pensions, whereas in the public sector most schemes are completely unfunded. This is bound to be a problem going forward.

The bottom line is that companies will become increasingly desperate to find ways to get rid of their pension scheme risks and reduce the long term costs. If employers can afford to offload their schemes to an insurance company by buying annuities, or to one of the new pension buy-out firms, they will do so. The trend is just beginning and still has a long way to go.

A word of warning though. As more final salary scheme liabilities are converted to annuity-style contracts, there is bound to be pressure on conventional annuity markets with rates worsening overall for pension annuities. This could be a problem for future pensioners who need to rely on annuity markets to provide their pensions. As with so many of our pension problems, the Government has not yet recognised this looming risk but it is there nonetheless.

As economic weakness prevents larger amounts being put aside now to fund pensions, and private pensions become less reliable and less generous, there the risk of pensioner poverty rises. Final salary provision is fading away and contributions to personal pensions will not be an adequate replacement (personal accounts will only require maximum 8% of salary).

Sadly, our state pension, which is the lowest of any developed country, is predicated on most people having a reasonable private pension and relies on means-tested top-ups for the half of pensioners that have no private pension. But means testing penalises any private pensions or earnings that could add to pensioner incomes and therefore the state pension system undermines private income.

This is an unsustainable situation and the Government must face up to the need for a much fairer and better state pension, paid to all without the indignity of means testing, if future generations of older Britons are to have a chance of a decent lifestyle.

At the next election, older people will form the majority of voters and will demand better pensions. Final salary schemes cannot last, personal pensions are not a proper replacement and the sooner the Government gets to grips with this, the better, for all our futures.