The Death Of Guaranteed Pensions?

One in four final-salary schemes may shut up shop in the next five years. Will these superior pension plans have a future?

One in four final-salary pension schemes which no longer accept new members plans to shut out existing members in the next five years. This warning comes from the latest survey by the National Association of Pension Funds (NAPF). What's more, the NAPF found that more than half (52%) of the minority of schemes which still allow new employees to join plan to shut their doors to new members. This will bar new joiners at a further thousand schemes.

What's so good about final-salary schemes?

The great thing about final-salary schemes is that your employer bears all the risk. Your pension payment when you retire is based on your length of service and your wage at retirement. The higher your length of service and salary, then the higher your ultimate pension will be. For example, a member of a 1/60th scheme for twenty years, with a final salary of £33,000, can expect a guaranteed pension of 20/60 x £33,000 = £11,000 a year.

Of course, providing such guarantees in an uncertain world is very expensive. Indeed, the average employer contribution to a final-salary scheme is a whopping two-ninths (22%) of salary. In most cases, employees also contribute towards the cost of running such a scheme, usually a single-figure percentage of pay. Hence, a final-salary pension is perhaps the most valuable employee benefit there is.

Why are they under threat?

The escalating cost of running final-salary schemes is placing an increasing strain on their sponsoring employers. In fact, the Pension Protection Fund estimates that the total shortfall of these schemes exceeded £200 billion at the end of 2008. Currently, these deficits have to be paid off within ten years. However, the NAPF is urging the Pensions Regulator to increase this deadline to fifteen years, in order to reduce the strain on companies' profits and balance sheets.

At their peak, private-sector final-salary schemes had around eight million members. Today, membership has dropped by two-thirds (down 67%) and now stands at just 2.7 million. Indeed, only a quarter (26%) of 8,500 final-salary schemes in the private sector allows new members to join. Alas, if the NAPF's predictions are correct, then the number of private-sector workers still in final-salary schemes could drop below two million by 2014.

What about the alternatives?

Since the turn of the century, small and medium-sized companies led the way when it came to cutting costs by downgrading their pension schemes. In recent years, even large, profitable organisations have followed suit by closing their schemes to new members. The most hard-pressed have resorted to closing their doors to all members, effectively freezing members' entitlements. In almost every case, replacement schemes offer dramatically inferior benefits to workers.

Instead of closing down schemes, employers can take other steps in order to reduce the burden of funding their workers' retirement. Other measures include raising the normal retirement age; basing pensions on career-average pay instead of final salary; increasing employee contributions; or selling entire schemes to insurance companies or other financial buyers.

Increasingly, employers replace final-salary schemes with money-purchase plans. With a money-purchase plan, the risk is shifted from employer to employee. Instead of a guaranteed pension, the final payout will depend on the contributions made, the investment period and performance, and annuity (pension income) rates at retirement. In general, employer contributions to money-purchase schemes are fairly low, averaging just 6% of salary. These low contribution rates explain why these schemes are now favoured by employers.

What about the public sector?

Although there has been some trimming of public-sector pensions, this has been nothing like the shutdowns experienced by private-sector workers. In future, this will prove a big headache for all of us, because the state directly employs roughly 5.8 million people, with at least another million workers dependent on the government for all or most of their income. Hence, close to one in four of the UK's 29 million workers rely entirely or largely on the state for their pension provision.

The majority of public-sector workers are in final-salary pensions that are largely unfunded. In other words, there is no `pot of money' to back the government's pension promises to most of its employees. Indeed, it is estimated that these unfunded liabilities are the thick end of a trillion pounds, or £40,000 for each of the UK's 25 million households.

Of course, the big problem is that the government doesn't have a penny which it doesn't first collect from taxpayers. Thus, the only way to make good on guaranteed public-sector pensions is to raise the tax burden substantially. Personally, I can't imagine that private-sector workers would be willing to labour under higher taxes in order to support unfair and divisive `public-sector pension apartheid'.

Hence, unless the government grasps the nettle by getting to grips with public-sector pensions now, then this problem will become even more threatening in the years and decades to come. Indeed, in terms of our national debt and future creditworthiness, it could make the recent banking bailouts look like a storm in a teacup!

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