I am the finance director of a UK listed company employing over 500 staff, all of whom are members of the final-salary scheme. I have become increasingly alarmed at the number of final-salary schemes that are closing to new members or winding up. What is causing this situation and what should I do regarding our scheme?
A number of factors have caused the current situation to develop. Some of these are the result of Government reforms to pension law and changes to the accounting standards but the poor economic climate has also had an effect.
The first law of pension scheme reform is: “For every extra cost imposed by legislation on employers' defined-benefit schemes, fewer such schemes are fully maintained.”
The aim to create more secure pensions based on final salary usually results in more employers opting for cheaper and generally lower quality employee pension provision via money-purchase schemes.
For those employers who have already thrown in the towel on their defined-benefit scheme, there are benefits to winding it up quickly. The alternative is to maintain it for perhaps another 25 years or more, with no future pension benefits being generated but considerable inconvenience and running expenses being incurred.
A chip was taken out of the foundation stone of final-salary schemes when, following pressure from the press, which argued that employers were using their schemes as tax shelters, the surplus above a statutory limit had to be reduced. Tinkering with the foundation stone when you have not understood how it relates to the pillars of the building is a dangerous pursuit. These temporary surpluses would have been very useful in today's perilous economic climate.
The cull on schemes gathered momentum in 1997 when, as a result of the Pensions Act 1995, higher statutory minimum transfer values became payable and extra compliance costs were incurred. Indeed, minimum funding requirement transfer values are due to be replaced in 2004 by a scheme-specific basis, based on the yields underlying corporate bonds, implying higher transfer values than currently quoted.
The introduction of annual solvency tests in 1997 created an incentive to hold less rewarding gilts at the expense of equities, indirectly increasing future contributions as the employer is obliged to make up the anticipated lower investment returns.
The industry has always sold pensions on the basis of them being a long-term investment and accepting that poor returns in any discrete period will be offset by favorable ones in a subsequent period. So it is paradoxical that the approach applied to scheme solvency is now on a year-by-year basis.
Taxation of UK company dividends went some way towards removing money from pension scheme coffers. Similarly, the proposed introduction of a lifetime cap of £1.4m will cause the high earners in a final-salary scheme to lose interest in this type of vehicle when they reach the cap. Unfortunately, these people tend to be influential and this bodes ill for the future of schemes.
Accounting standard FRS17, which is currently a footnote to the balance sheet, will almost certainly lead to pension fund assets and liabilities being fully disclosed in the company balance sheet. This will result in volatility in company results, as the impact of investment gyrations on pension scheme funding levels is put through the profit-and-loss account at the operating profit level.
Although full implementation of the standard has been delayed in the UK, the chairman of the US Accounting Standards Board has come out in favour of the FRS17 approach, suggesting the new international standard will mirror FRS17.
Will companies sponsoring final-salary schemes be viewed like houses with subsidence problems – unsellable because they are blighted? For employers with a discontinued final-salary scheme or concerned about their “live” scheme, there may be no time like the present to take action.
Let there be no doubt – for those members staying to retirement who are in good quality, well-funded final-salary schemes, the members' interests are best served by continuing these arrangements unless the cost causes the bankruptcy or downsizing of the sponsoring company. You should take professional advice on the pros and cons of continuing the scheme or winding it up.