UK: Defined Benefit Pension Schemes - Has Pray And Delay Failed The 'Rolls Royce' Of The Pensions Industry?

Last Updated: 23 September 2013
Article by Derek Ryan

The Pensions Board states in its own annual report that some 75% of all defined benefit (DB) schemes are in deficit and in many cases the deficit is substantial.

Under the Pensions Act, where a DB scheme falls into deficit and fails the statutory funding standard, they are obliged to submit a funding proposal to the Pensions Board showing how they intend to get the fund back by the next actuarial valuation. Since the funding standard was introduced by the Pensions Act, the three-year deadline to restore a scheme to solvency has been extended to ten years, following lobbying by the industry as a result of dips in the investment market. So how likely is it that these schemes will be able to pay the benefits that have been promised to the members?

It is well known that most companies have closed their DB schemes to new entrants and the trustees of the schemes still have a bias towards equities in their investment asset mix. It is therefore more likely that the funding position of these DB schemes will in fact deteriorate further rather than improve due to the following issues.

  • As the age profile of the scheme is increasing with more pensioners likely to join and new entrants prohibited from joining, the scheme liabilities will increase.
  • If it is decided to reduce the volatility of the investment return, and reduce the reliance on equities in the asset mix, the investment return assumptions used in the actuarial valuations will decrease, thereby increasing the liabilities and the deficit even further.

Deficits that currently exist in the DB schemes are not one-offs but are more likely to be a systemic deficit where the liabilities of the scheme are in effect pre-ordained to continue growing faster than its assets.

So if we now recognise that the deficits are indeed systemic and not temporary in DB schemes then the solution to these deficits will have to come from the Government, the employers and the scheme members themselves.

Various Government agencies involved in this area have introduced a number of solutions.

1. Section 50 of the Pensions Act allows deferred members' and pensioners' post-retirement increases to be reduced.

2. Post retirement increases for pensioners have been removed in the scheme wind up priority list.

3. Sovereign annuities were introduced. They are intended to offer trustees a lower cost option to secure pensioner liabilities by purchasing sovereign annuities. However, the regulatory authorities would only allow the assumption of sovereign annuities to be used if the scheme actually invested in these instruments rather than benchmark against them.

These Governmental solutions on their own are not going to make systemic deficits disappear overnight so the employer and the members can do a few things also.

1. Stop the clock now! The employer could decide to stop further accrual of benefit in the scheme immediately with future benefits likely to be provided under a separate DC scheme. This would have the effect of capping the employer's future pension liabilities. The DB scheme could either continue but only in respect of service already accrued to the 'stop date', or being wound up immediately. Employers need to be careful here because a scheme wound up now will throw up an immediate deficit and lead to active and deferred members getting a reduction in their accrued pension expectation. However, the employer could look at making a one-off large contribution to make up the deficit before wind up which has an attractiveness of a fixed defined cost.

2. Stop or reduce the deficit from growing by one or a combination of the following.

  • Reduce the rate of future accrual.
  • Reduce pension benefits already accrued for all or some members.
  • Revise the definition of final pensionable salary. Impose a cap on the level of earnings to €60,000 max.
  • Members make a contribution or an increased contribution if already contributing to the scheme.
  • Employer increases contributions to the scheme. The employer may well be at the limit as it is.
  • Ask senior executives (i.e. those with the largest liabilities) to transfer out to a Defined Contribution (DC) Scheme.

These proposals could be on future service benefits or on past and future benefits. If there is any reduction on benefits that have already accrued then the trustees need to undergo a procedure called a Section 50 /50a direction. This is where the trustees inform the Pensions Board that they need to reduce the scheme benefits as an alternative to winding up the scheme with a deficit.

DB schemes are likely to be in a systemic deficit which it is not realistically possible to deal with in any reasonable period of time or by assuming any reasonable set of future assumptions. The deficit is even likely to grow bigger over time. The reality is that many schemes have, in good faith, over-promised benefits relative to the scheme assets, the financial ability of the employer and the members to contribute to the scheme. The sooner this basic fact is recognised the better for all concerned, as the deadline to face up to this problem approaches.

The majority of DB schemes seem to be adopting the 'pray and delay' approach to the deficit problem, hoping that there will be a significant reduction in the funding standard and that equity markets will continue to recover to close the deficits in the schemes. That said, many of the DB schemes are winding up. In 2010, according to the Pensions Board annual report, 200 DB schemes were wound up. In addition, the Board also advised that in 2000 there were 1,956 DB schemes in operation. This was reduced to 1,013 by the end of December 2010.

Section 50 orders are small but increasing (according to the Pensions Board) where the employer is looking to decrease the benefits rather than wind up the scheme.

Finally, some of the senior executives who are members are looking to transfer out of the schemes to solidify their benefits and work towards a reasonable standard fund threshold of €2,300,000 under a DC scheme.

Many DB schemes are now winding up and stopping the continual increase in the deficits. This is drawing a line in the sand for the companies and gives some certainty to both employer and members alike.

DB schemes were the 'Rolls Royce' of benefits for employees many years ago and a privilege to be a member of, but perhaps now it's time that the car was exchanged for something a little more ordinary and a lot less expensive.

Footnote: Waterford Glass ECJ Judgement: The state may be partially liable for pension scheme deficits in DB schemes as a result of a recent ruling by the European Courts of Justice in April 2013. This judgement refers to DB schemes that are wound up as a result of the insolvency of the employer. Though we do not know the full implications on this decision as it has now been referred back to the High Court in Ireland, some may consider taking it into account if they are considering a transfer value from a DB scheme in deficit where the employer is also in financial difficulties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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