The number of people seeking to exit final salary pensions could jump as fallout from the BHS scandal raises new questions about the future of the schemes.
Pension firms expect more people to request transfers out of their defined benefit (DB, or final salary) schemes after the BHS and Tata Steel crises sparked fresh concerns over the ability of sponsoring companies to meet their pension promises.
While the percentage of schemes open to new members has plunged from 43 to 13 per cent over the past decade, according to the pensions regulator, another 51 per cent continue to accrue benefits and there are still nearly two million active members of the schemes.
But in its report on the demise of BHS the Work and Pensions Select Committee warned that the future of DB schemes was perhaps “the greatest challenge facing longstanding British businesses”.
It added that “in an environment of rising longevity, interest rates close to zero and intense international competition, DB pension liabilities accumulated in a different age can appear burdensome and unaffordable”.
Of the 5,945 schemes covered by the Pension Protection Fund (PPF), 84 per cent had liabilities (including the cost of paying benefits) greater than their assets.
A deficit doesn’t necessarily mean there’s a danger of a scheme being unable to pay out benefits. But efforts to plug shortfalls in recent years have added to the financial pressures on companies. The bleak outlook in the wake of the EU referendum and the high-profile crises at BHS and Tata suggest big decisions may have to be taken.
The referendum has already had a detrimental impact on DB pensions by driving down the gilt yields used by schemes to calculate how much they need to meet future liabilities.
“It’s possible in the short term that the increase in deficits and the demand for greater employer contributions to fill the hole will cause more companies to get into financial difficulties,” said Karen Theobald, Edinburgh-based principal of Xerox HR Services.
“Although we should remember that pensions are a long-term issue and we are looking to fund pension arrangements which will be around long after Brexit is done and dusted, many companies will no doubt be looking not to increase contributions but extend the length of any recovery plans.”
The concern for members, including those retired and receiving benefits from their scheme, is how they will be affected by measures aimed at tackling the problem.
The chair of the work and pensions committee, Frank Field, said the very future of DB schemes had to be considered due to the impact on younger generations of covering promises for today’s pensioners.
Suggestions made recently include a reduction of the benefits paid to members already in retirement. That measure was proposed in the government’s consultation on the British Steel rescue, which closed to responses in late June, but it “flies in the face of legislation and case law”, according to Theobald.
“Section 67 of the Pensions Act 1995 stops accrued benefits being reduced without consent yet the government is planning to do that for British Steel because it is politically expedient. It’s a dangerous route to take and I am not convinced it will in due course happen,” said Theobald.
“It wouldn’t be the first time the government changed the law to help one particular scheme because it felt it was politically expedient to do so. But British Steel aside, I would be very surprised to see measures allowing companies to get round section 67.”
The BHS issue differs in that the company failed to sufficiently fund its scheme when it was able to. “The question is how much can Philip Green be persuaded to pay into the scheme to reduce the amount other DB pensions schemes have to pay to meet its PPF liabilities,” said Theobald. “One suggestion from the Green camp is that enough may be paid in to stop the scheme going into the PPF but not the full deficit.”
Another option is for members to be offered a transfer to a different scheme with lower benefits above the PPF level, or choose to stay put and go into the PPF with the rump of the scheme. They would then get the PPF level of benefits but not their full entitlement.
The slightest hint that future benefits may be under threat could trigger a wave of transfer requests, however. The number of people seeking to exit their DB schemes has surged since the so-called pensions “freedoms took effect last year. The reforms applied only to defined contribution (DC) schemes, so members of DB schemes have to transfer out if they want to take advantage of the greater choice and flexibility offered by the changes.
The big advantage of DB schemes is the guaranteed income in retirement, with their pension based on their earnings and length of service. DC schemes offer no such certainty, with the pension depending on the amount they pay in and the performance of the investments (after charges).
Transferring out of a scheme entails giving up your guaranteed income in exchange for a lump sum, which means responsibility for using that money to provide an income in retirement is passed to the individual.
So transferring out of a DB scheme is fraught with risk, which is why anyone with a transfer value above £30,000 must take advice if they want to do so. Yet many people take cash out of their schemes even after being advised not to, usually when their employer has offered them a cash incentive to exit.
But some incentive exercises may be on hold for now, according to Edwin Mustard, pensions partner at Shepherd and Wedderburn, as Brexit causes employers to reconsider short-term decisions concerning their DB schemes.
“Where a transfer-out exercise has been contemplated, a pause for thought is likely to be appropriate, since DB transfers may have increased in value as a result of market conditions and, in some cases, a review of the transfer value factors underpinning scheme transfers may be appropriate before any action is taken.”