Confusion among the ruins of final salary schemes

PRIVATE sector final salary pension schemes are mostly closed to new members and many are likely to close to existing members in coming years. Their replacement will be defined contribution schemes, also known as "money purchase". Pressure will also increase for changes in public sector final salary pensions as the private sector moves overwhelmingly to money purchase for new and existing employees.

Money purchase schemes are usually regarded as being inferior to final salary schemes, but they are not inherently bad. There are, however, problems in most current implementations that need to be addressed. Contributions levels need to be higher to ensure decent retirement incomes and schemes need to be more efficient and simpler for members to use.

We entered the current financial crisis in a situation where most private sector final salary pension schemes were already closed to new members. Some public sector and larger private sector schemes remained open to new members.

Schemes have been closing for several years now, but the rate of closure was highest during and immediately after the previous period of falling stock markets from 2000-2003. Ongoing improvements in life expectancy have also raised the costs of pension provision creating financial pressures encouraging closure of schemes.

The recent financial crisis looks set to spark another wave of closures of final salary schemes. Pension fund asset values been reduced by falling stock markets at a time when scheme sponsors face difficult business conditions and will be reluctant to make additional pension contributions.

More sponsors will now consider closing final salary schemes to further accrual by existing members. This is politically difficult to sell to employees, but economic conditions are tough and it is getting harder to justify 'two tier' workforces where some employees are in generous final salary schemes and others in less generous money purchase schemes. The divide between final salary schemes in the public sector and money purchase in the private sector also looks unsustainable

The replacement for final salary schemes is likely to be money purchase schemes. In a money purchase scheme, typically both employer and employee make contributions to the fund, but the employee bears the risk if the investments do not perform well. 'Hybrid schemes' which combine elements of final salary and money purchase are possible and provide employees with important risk sharing benefits, but the complexity and ongoing risks involved mean few employers have wanted to go down this route.

Contribution levels in money purchase schemes are typically lower than final salary schemes and often at levels that are likely to result in disappointing pensions. Few members are aware of how little these schemes are likely to pay out. Complexity is another issue, with most members unprepared to make decisions on how much to save and which investment funds within the scheme to choose. Financial education can help, but only a bit and only over the longer term.

The other major issue on the horizon is the government's proposed personal accounts scheme, due to be implemented in 2012. This will be a national money purchase scheme into which employees will be automatically enrolled if they are not in an occupational scheme. They retain a right to opt out, but if they do not, combined contributions of 8% of salary (to a limit) are payable split between employee, employer and government. Key details of the scheme are not yet known.

The personal accounts scheme itself is a reasonable way of providing additional retirement income to employees who currently lack access to a good quality occupational scheme. However, the main concern is the relationship between the scheme and means-tested benefits. There are fears that for many low earners the benefits they get as a result of saving in personal accounts will merely replace means-tested benefits they would have received anyway. This issue doesn't invalidate personal accounts, but the benefits system needs to change to allow personal accounts to work well.

It remains to be seen how sponsors of occupational schemes respond to personal accounts. For less committed employers, stopping providing their own pension scheme and rolling employees into the 'state-endorsed' personal accounts scheme would appear to be the path of least resistance. Employers with more generous employee benefit arrangements may choose to keep their own 'gold-plated' schemes.

As money purchase schemes become more common and represent a larger part of retirement income provision, it will be important that these schemes are fit for purpose. The financial services industry needs to focus on development of better money purchase schemes. This does not mean ever more complicated investment products, but rather more efficient schemes that are easier for the public to understand and use.

We also need to ensure that members are aware of the levels of benefits they are likely to receive from their money purchase schemes and can adjust their contributions if required.

Dr Alistair Byrne is a senior lecturer in finance at the University of Edinburgh and a Fellow of the Pensions Institute at Cass Business School in London. His research and consulting focus on pension fund investment and pension scheme design. ([e-mail]]