Why am I writing this paper now?
Over my 28 years as an Independent Financial Adviser (IFA) I have had the pleasure and good fortune to work with many decent people. People who have sacrificed, saved, planned and been careful with their money.
Those people, and many more, who are in final salary pensions, also known as defined benefit pensions (DB Schemes), have been told that this is the best type of pension you could have. It is often referred to as a "Gold Plated" pension and that the pension was guaranteed.
I am writing this paper now because the shine has come off these gold plated pensions and there are systemic problems with them that we expect to lead to much lower pensions for members of these schemes.
Why you should read this report now
You should read this report as it is highly educational in examining systematic problems in defined benefit pensions which will cause reduced pension benefits to people in these schemes. It includes a real case study and has up to date detail. We examine how these schemes could be rescued and show why the only reasonable option is to expect member benefits to fall, no matter what they have been promised in the past. Importantly, the report also discusses how, currently, you can secure your accrued fund before any of these expected changes happen.
History of DB Schemes
DB Schemes became very popular in the 1960s. During this period more people tended to stay longer with their employer than they do now and some stayed with that employer all their working life. Government agencies such as the military, teachers and civil servants also had DB schemes. Indeed, an often quoted phrase was that you could afford to work in some of these Governmental jobs where the pay was lower than the private sector because the pension was so very good and would make up for it. There was some truth in this comment.
A critical component of these schemes was, and still is, that the sponsoring employer would always ensure that there was sufficient money in the pot to meet the liability to pay the pension. Some schemes did not ask members to pay anything, others a small amount to reduce the cost of funding the scheme for the employer.
When these pensions started the average life expectancy in retirement was around 12 years. Scheme actuaries calculated how much was needed to pay pensions for this length of time. In the 1970's this changed rapidly with increased life expectancy. This change is forecast to continue as shown by the statistics from the Office of National Statistics shown below.
How DB Schemes work
When a scheme is established a board of trustees is appointed to look after the interests of the members of the scheme. The trustees have legal requirements to follow in exercising this duty.
The members may or may not have a representative on the Board of Trustees although most of the larger schemes do have member trustees.
Employers and employees contribute to build up a sum of money which will be used to pay all the promised benefits during the retirement of all the scheme members and any death benefits that may be due. If there is insufficient money in the pot to meet these liabilities the EMPLOYER must add more to make up the shortfall. This shortfall is also known as a deficit.
The benefits come in many different forms and are specified in the trust deed of the scheme. Pensions were often calculated as follows:
Pension = 1/60th of your final salary x by number of years membership of the pension up to a maximum of 2/3rds of your final salary
Death Benefit = Lump sum of up to 4 x salary if death occurs whilst working for the company and/or widows pension and possibly a children's pension if you died after retirement.
When the money is in the pot there are regulations and guidelines on how the money is invested. In broad terms, the pension has to demonstrate the ability to pay the retirement pensions when required. This requires the matching of these liabilities with assets that produce an income. Government bonds which pay a regular income is the primary asset class and was favoured by regulators and schemes to meet this liability. It had the benefit that Government Bonds are "Safe". More on this later.
The Economic Situation
The two most significant issues that have caused the problem for defined benefit schemes are life expectancy and low interest rates. These are not exclusively the result of our current economic crisis, nor indeed of Brexit. As can be seen from the life expectancy graph above, men's life expectancy at age 65 will have doubled from 12 years to 24 years by 2030. Yet the income available from 10 year Treasury yields, which is one of the main methods of matching the liability to assets, are at historic lows.
So, liabilities have doubled but the ability to generate income has never been so low in the entire history of DB schemes.
These events have made the situation worse and have now brought the DB schemes to a decision point. The UK Government also is aware that something has to change as these schemes are unsustainable with increasing longevity and with the current low interest rates.
Actuaries Hyman Robertson now calculate the deficit on the remaining final salary pension schemes as £1 TRILLION.2
Historically, these deficits have not been viewed as a problem as there are three things that can happen to rectify these deficits:
- Employers can be forced to pay into the pension to make up the deficit.
- Interest Rates can and will go back up again.
- The value of investments that the pension fund holds will go up which will reduce the deficit.
All these actions are possible solutions in theory. When we look more closely at these options we see that whilst these are practical in theory, low interest rates and increasing longevity will overwhelm these options. Indeed, a recent report in the Financial Times suggest that of the 5,945 schemes, 1,000 employers could be forced into bankruptcy by their pension deficits with the resulting collapse of the pension.
The best way to illustrate the difficulty for a DB scheme is with a case study.
Case Study – The no win problem
This case study is based on our analysis of an employer who is "mid range" in the size of its deficit. It is not the worst but it is also not the best. There is no need to name this major employer as the problem is a systemic problem not a problem of the employer. Consequently, it would be unfair to name it. However, these examples show the degree of improbability that DB pension schemes can continue.
The annual accounts of the pension scheme show this employer paid in £221 Million pounds to its defined benefit pension scheme in Employer contributions. The expenses of the scheme (include paying people's pensions) were £454 Million. Investment income was £222 Million and so the payments out in this year and the money into the scheme were broadly equal (Investment Income plus Employer Contributions). It appears on the surface to be all well.
The scheme, however, has a capital deficit to meet future liabilities of £2 BILLION. A rescue plan has been agreed between the employer and the Pension Regulator to make good this deficit over a 13 year period. In the period to 31st March 2016 the employer paid in an additional £100 Million to the pension fund as part of this rescue plan. In the current year it will pay in an additional £220 Million pounds for the rescue. Combined employer contributions and employer deficit rescue payments will be touching Half a Billion pounds in the current year. Over the period of the rescue plan contributions and the rescue plan will be in the region of £7 Billion. Yet by the time of the end of the rescue plan, life expectancy is likely to increase by another three years leaving the scheme again playing catch up.
So deficits are a problem, but what if there were no deficits? A study by LCP3 shows that the cost of providing a pension scheme with 1/60th benefits per year employed will cost an employer a contribution level of 50% of the person's salary!! This is a non-starter for most companies and shows how difficult it will be to contribute sufficiently to meet the expected (guaranteed) pensions.
The next possible saviour on the list is that investment return could be sufficient. However, our case study pension fund had an investment return to 31st March 2016 of 2.2%. So as not to draw too much of a conclusion from a single scheme we have investigated different modelling schemes to estimate what the impact of rising investments will be. Using the data from the PPF 7800 Index it is estimated that a 7.5% increase in share price would give an increase in the fund value of 2.5%. This is because the pension is not invested just in shares and so the return for the fund is only a proportion of the increase in share prices.
Other investments can include commercial property, unquoted companies, interest rate swaps and more. Yet the investment which has to be used to match investment income with pension payments is a Government bond (in the UK known as gilts). These come in all sorts of forms and they are issued for all sorts of lengths of time, from 3 years to 50 years. What is very significant is that 77% of these around the world now yield less than 1%. Most have a purchase price of greater than their maturity value. As an example, UK 10 year gilt with 9 years to maturity would cost you £110 to buy but the maturity value is just £100. This is a guaranteed loss.
Rising interest rates are often quoted as the potential saviour of DB schemes. If the interest rate goes up, the deficit on the scheme goes down because it does not cost so much to buy the Gilt. This is true for new gilt purchases. However, the pensions' regulations have required DB schemes to buy gilts to match income with liability. Schemes typically hold in excess of 48% of the scheme in this type of investment. Using the same model from the PPF 7800 Index it is estimated that a 0.3% increase in interest rates could reduce the deficit by 5.9% for a scheme. This is very welcome. However, there is also a direct relationship between the capital value of a gilt and interest rates.
Whilst interest rates rise which reduces the deficit on one side, the value (price) of gilts in pension schemes will fall. The impact of rising interest rates vs capital value of the investment is difficult to model because the number of years of a gilt has left to run makes a huge difference to the amount of capital loss. However, a rule of thumb is that a 0.3% increase in interest rates will reduce the pension scheme value by 1.6%.
Notice how sensitive pension funds are to changes in interest rates. Whilst a 7.5% rise in share prices will increase the value of the pension fund by 2.5%, an increase of just 0.3% in interest rates will cause a fall of 1.6% in the pension scheme value.
It is often expected by members, and indeed, this is supported by the law, that the Trustees of a DB scheme will protect the member's interest. However, we are now in this situation. If a trustee insists on the scheme paying the benefits it has promised, this can bankrupt the sponsoring employer. In our case study trustees insisting upon unchanged benefits would potentially result in the loss of jobs of 21,045 employees, many of them also members of the pension they are supposed to protect. With the sponsoring employer gone, the problem of funding the scheme gets much worse. Trustees are really caught between a rock and a hard place.
Should an employer become insolvent the DB pension scheme can join the Pension Protection Fund (PPF)
How the PPF works
It is not necessary to go into the mechanics of how a scheme is put into the PPF, what the position is for the member nor what investments the PPF is currently invested in.
What is very important is this. DB scheme members should be warned that the PPF is not the guarantor of pensions in the last resort. Indeed, I would be specific and issue the warning that the PPF itself is nothing more than a big Defined Benefit pension scheme; the very type of pension it should rescue.
It has employer contributions in the form of a pension levy to other schemes, it has investment assets and it has a liability to pay pensions based on their salary, to members whose DB schemes have been put into the PPF. Yet, what is there to say that the PPF will be so much better as an investment manager that investment returns will be so good that this reduces the pressure on the fund? Interest rates may rise and make it easier for the PPF and it appears that the PPF have addressed some of the issues relating to loss of value in gilts when interest rates rise. This interest rate part is good.
The pension levy, however, bears examination. The PPF is NOT a government sponsored scheme. The remaining DB pension schemes that have not been forced into the PPF have to pay an annual levy. As more schemes go into the PPF there are less remaining to fund the levy; a levy which goes up each time a new scheme goes into the PPF. It is a vicious circle. In theory, the last pension scheme not in the PPF will have to pay a levy to make up the shortfall of every other scheme in the PPF.
When the PPF was set up it was expected to protect the pensioners from an odd rogue employer. The method of funding an ever growing number of schemes in the PPF by an ever reducing number of schemes is a systemic problem.
It is clear there are issues and that these issues are coming to be understood by the PPF. Here is a statement included in the PPF 2016 annual report.
"The Board has two main levers it can use to address the risk that we have insufficient assets to meet our liabilities. The first of these is to change the levy collected. The second is to alter its investment strategy. The Board also has the power to restrict inflation-linked increases to compensation or to ask government to reduce the level of compensation payments, however these actions would only be considered in exceptional circumstances."4
We have examined the two main levers in this statement in our analysis above. This only leaves the third option in the quote above from the PPF annual report which is to reduce the level of pensions (compensation) that they pay out.
Scheme Members should expect a cut in benefits when staying in the scheme.
We have many, many examples already of changes to the pensions that members are going to get. Some members have already had their pension drastically reduced. However, as pensions are complex the impact of these changes is not readily appreciated. Changes are often subtle and wording describing the change is at best unhelpful.
Here are two examples of changes that have already been introduced. Many schemes are moving from a method of annual increases based on the Retail Price Index (RPI) to the Consumer Price Index (CPI). This is a small difference at retirement but the difference grows bigger the longer you are drawing your pension. A number of actuaries have calculated that, as CPI is lower than RPI this change will reduce the amount of pension a person will get over their lifetime by between 25% and 30%. I don't imagine there are many people who will have willingly taken a 25% pay cut through their entire working life. Yet people are doing so without complaint on their pensions. There have been some challenges in court but the change from RPI to CPI has been ruled legal and the changes have now been happening on schemes for the last 4 years.
The second example, is a use of wording to flatter the change. People were asked if they wanted to stay on the old scheme or go on to the new Care pension scheme. They were asked to make the decision quite quickly. The "Old" pension was a pension based on the final salary. The Care pension was a pension based on Career Average Earnings. This was the effect of the change:
People willingly transferred from one scheme to another because the information was not presented to them in this way to show the loss.
We strongly advise that if you, a family member or a colleague receives a notification from your scheme administrators that the scheme is about to change and it contains any of the following, you should seek professional advice. Every single one of these items will result in a loss of pension benefits:
- Changes to the Accrual rate
- Change to Career Average salary basis
- Change in basis of indexation, often from CPI to RPI
- The Normal Retirement date on the pension (We anticipate some schemes will move this from 65 to 67 to match the state retirement age)
- The death benefits before you retire
- The death benefits in retirement
- Widow's Pension
- Children's pension
- Any notification of change which uses language you do not understand
What do I need to do?
It is currently possible to request to withdraw the value of your Defined Benefit scheme and transfer into a scheme that you control. This not a panacea by any means and your personal circumstances are very important in whether or not to make the transfer. Indeed, your scheme may be one of the 17% that is not in deficit and so you may not need to move. Also, your pension will only be based on the amount of money in your pot at retirement. It will not relate to your salary. Indeed, it used to be said that as a member of a final salary pension you did not take the investment risk. However, as we have demonstrated above, the investment return does very much count towards how much pension you will get from a DB scheme.
What might happen?
The most likely thing is that benefits on DB pensions will be reduced in one or more of the forms indicated above. However, people are already securing their pension funds by transferring their benefits into another pension arrangement whereby they have control of their own pension funds.
These transfers are a problem for the DB schemes. We believe that the situation is so bad that we will have a ban on pension transfers in the future. I predict a Government Minister to say something like "Due to the economic crisis and the effects of Brexit, as an emergency measure we are banning all transfers from Final Salary pension schemes with immediate effect". Why do we expect this? Pension deficits are now at £1 TRILLION and this is what happened to the Teacher's pension scheme and six other pension schemes in April 2015.
After the announcement, changes to individual scheme rules can be introduced to reduce the scheme pensions without members being able to vote with their feet.
Pension scheme deficits are huge at £1 TRILLION. There are three actions to take to clear the deficits including increasing pension contributions, a rise in interest rates and an improvement in investment returns. These actions seem unlikely to be able to solve the problem. Consequently, the benefits paid to members is likely to fall.
Members of defined benefit pension schemes should have their pension reviewed immediately before a ban on transfers is introduced.
Pensions are complex and hidden behind this complexity, change is being introduced which reduces member's pensions. This change is dramatic as our examples show (loss of £174,993). Due to the systemic problems added to economic problems these changes are coming soon.
1 ONS Mortality Compendium NPP Reference Volume 28th March 2014
2 Hymans Robertson 3D Analytics report 12th August 2016
3 23rd Annual LCP Accounting for Pensions Report 2016
4 Pension Protection Fund 2015/2016 Annual Report and Accounts
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.