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Gone with the wind-up

In my last article, I started to discuss recent developments which are setting the scene for what is going to prove to be the great pension issue of this decade – the closing and winding-up of defined-benefit pension schemes.

I noted, in particular, the examples of scheme closures at ASW (where the scheme wound up as a result of the financial collapse of the company) and Maersk (where the scheme was wound up by a financially sound company simply to bring to an end its future funding liabilities).

I suggest that Maersk is the most worrying of these two examples for current members of final-salary schemes as there is clear statistical evidence of a sharp rise in the number of companies which are in the process of winding up their final-salary schemes or seriously considering doing so.

The fundamental problem for members of final-salary schemes which are winding up is that the only financial precondition on the scheme (or, more precisely, on the employer sponsoring the scheme) is that it must be fully funded on a minimum funding requirement basis. Fundamentally, this actuarial calculation is based on the assumption that the scheme will continue in force with (cheap to fund) youngsters joining the scheme and, in effect, subsidising (expensive to fund) older members, producing an overall scheme funding rate to maintain the MFR.

This method of funding is sometimes known as a continuance basis – using the assumption that the scheme will continue in force. However, where the scheme is wound up, there are no new youngsters helping to fund the older members and so benefit calculations must be done on a discontinuance basis. This, as you should easily be able to conclude, is much more expensive than the continuance basis of the MFR.

Thus, in the wind-up, we might have an MFR-based pot of money of, say, £60m trying to fund the discontinuance cost of buying all the members&#39 benefits of, say, £100m. There is no debt against the employer and the shortfall is met by the members.

So, let us move on to identify the members who stand to lose most and then examine the ways in which financial advisers can anticipate which schemes will be most likely to be wound up over the coming months and years. This last point, by the way, is crucial. When a scheme has started to be wound up, it is usually too late for members or their advisers to do anything to safeguard their rights.

In a scheme wind-up, where there are insufficient funds to buy out all the members&#39 benefits, there is an order of priority as to which members get first bite at the cherry. Until a few years ago, guaranteed minimum pensions were one of the top priorities but this changed when GMPs were abolished. Now, the only significant priority is that pensions in payment, that is, pensions already being paid to retired members, should be secured in full before the remaining fund is divided between members – both current and deferred (early leavers) – who have not yet started to draw their benefits.

This sounds fine for these retired members but their place at the top of the order of priority excludes their right to future increases to their pensions, so they are only guaranteed to receive a level pension. In fact, their right to future increases comes at the bottom of the priority list and cannot even be considered unless benefits have been secured in full for all the other members. So even retired members will suffer, noting that the value of escalation frequently exceeds 30 per cent of the total value of benefits.

Anyhow, the remaining pot is divided between members not yet receiving benefits and, of course, the shortfall at this second level of priority (although other priorities, including AVCs, come in between these two main levels) is now greater than might have been first thought as the retireds have been paid in full. Here, not everyone suffers to the same percentage degree, with actuarial preference given to people close to retirement age and lower allocation awarded to younger members.

In the Maersk scheme, members close to retirement were awarded over 80 per cent of their promised benefits, excluding, of course, the right to increases to pensions in payment, while younger members (those under, say, 45) lost around half of their accrued rights.

Now, let us start on the messages from this knowledge for financial advisers who truly care about those of their clients who are members, either current or especially deferred, of final-salary schemes.

Taking deferred members first, it should be easy to see that the critical yield required to match the value of an early leaver&#39s full promised benefits will be much higher than the yield to match a reduced level of benefits which, especially following the Maersk experience, we know will almost certainly apply if a scheme winds up.

I will give you a quick example of a case in which I am currently involved. We know the scheme is planning to wind up in the near future but the scheme will not tell us the extent of the reduction, nor even will it confirm to us that a reduction is likely. However, we know that the scheme is only just fully funded on an MFR basis and has a fairly typical scheme membership make-up as regards, for example, the spread of salaries and ages. Thus, we can estimate that the following reductions to member benefits might be likely (see table right).

Now, by the time the scheme is in a position to eventually confirm the exact calculations, it will in my experience be almost certainly too late to request a transfer value, so we cannot possibly give advice based on accurate figures until it is too late. However, if we accept this means that we cannot give advice at all, we are surely doing the client a potentially huge disservice as we know that if he remains within the scheme “to the death” then his benefits are highly likely to be decimated.

Could I suggest that a compromise way forward is to process the analysis on a full benefits assumption and then on a reduced benefits basis, using an assumed reduction akin to the above table, remembering especially to pretend for these purposes that the scheme will not pay escalation to pensions in payment.

The critical yield, naturally, falls through the floor and usually indicates a strong recommendation for the individual to transfer his benefits before the scheme winds up.

Of course, all sorts of provisos and caveats must be included in the advice eventually given to the client but, in my opinion and experience, clients appreciate the honesty and guidance. In any event, if the recommendation is properly worded in this way, the client will be able make his decision with eyes wide open, fully understanding the poss-ible risks and benefits of each course of action and the acknowledged lack of precision in the assumptions used in formulating the recommendation.

The scale of the client&#39s possible loss if he leaves his benefits with his current scheme is such that I believe the adviser simply should not absolve himself of the admittedly difficult task of making a recommendation.

If this opinion has any validity, the next question is whether we should then consider making recommendations to current members of schemes we believe or know are planning to wind up. Yes, I know this means considering opt-outs but possibly with true validity and professionalism.

This then leads us to the question as to how we might be able to identify schemes which are likely to wind up in the foreseeable future. Both these questions will be answered in my next article.

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