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Lehman’s terms

Former staff of investment bank Lehman Brothers face a wait to see how much of their accrued pension they are going to get. Could this happen to other firms and, if so, how can advisers help their clients understand the risks?

The collapse of Lehman Brothers has revealed a £100m deficit against assets of only £180m. This means that there could be as little as 50p or less to cover each £1 of promised benefits.

Trustees of the Lehman Brothers’ scheme have made an application to transfer the assets and liabilities to the Pension Protection Fund. The PPF will assess whether the scheme is eligible for protection but in general, unless it has sufficient assets to pay PPF-level benefits or the administrator finds a buyer who will accept responsibility for the scheme, it will be eligible to enter the PPF.

Once the PPF assessment period has begun, it is not possible to transfer out unless the member had received an offer of a transfer value and accepted it. Even then, trustees can still reduce the transfer value available.

If the PPF accepts the scheme, no transfers out are allowed and the member is entitled to PPF-level benefits at normal retirement age.

The consequences for the member of the PPF paying their benefits rather than the scheme depends on how old they are, how long they were a member of the scheme and how much they earned.

Those already in retirement have 100 per cent of their benefits protected but those still to reach retirement receive only 90 per cent of their entitlement. They also face a benefit compensation cap of £27,770 a year.

The PPF increases each member’s pension from the assessment date to normal retirement age in line with price increases up to 5 per cent. Once in payment, price indexation applies only to benefits accrued after April 1997 at a capped rate of 2.5 per cent.

However, there is no absolute guarantee that the current PPF benefit is safe. If the PPF was to accept more defined-benefit schemes in the same underfunded state as Lehman’s fund, it has to find the difference between the value of the assets that it inherits and the benefit that it promises. It is reasonable to expect that more employers with DB schemes will fail, given the economic outlook. Insolvencies in England and Wales in the second quarter of 2008 were up by 63 per cent on the same quarter last year.

When the PPF was set up, the possibility that it could face funding strain was recognised in its constitution. If it runs short of funds, it has two main options:

  • It can raise the funding levy on remaining DB schemes or
  • It can cut benefits, starting with removing indexation of benefits. In other words, benefits can be frozen in current money terms.

    The PPF has just proposed a record levy of £700m for 2009/10. Employers with DB schemes that must pay this levy also have to ensure that their own schemes are funded properly. Recent economic events have increased scheme deficits markedly. Among the 7,800 DB schemes monitored by the PPF, the combined deficit was £36.7bn in August compared with a surplus of £59.1bn in the same month last year.

    With employers facing a double whammy of lower profits and higher DB funding costs, the scope for the PPF to make that a triple whammy by increasing levies further is limited. It will depend on how long and how deep the economic contraction turns out to be but a cut in PPF benefits is a possibility.

    Former Lehman employees earned £112,000 a year on average before the company’s demise which means that an employee could have accrued more than the current PPF maximum benefit with only 15 years service.

    Advisers need to show a great deal of care when advising employees with DB pensions. An active member is unlikely to be advised to transfer out except in exceptional circumstances. However, there may be rare cases where the client has serious concerns about the future of their employer and has accrued benefits above the PPF maximum. Those transferring out under such circumstances should expect no further pension accruals and are unlikely to receive alternative compensation.

    Deferred members are an entirely different matter as they have already stopped accruing benefits in the scheme. I am sure that some of the 2,400 deferred members of the Lehman scheme, particularly those with benefits north of the PPF cap, now wished they had transferred out.

    So how can advisers spot the next Lehman Brothers? One method of assessing a company’s risk of failure is to examine its credit rating. The PPF uses Dun & Bradstreet to assess every company that runs a DB scheme to determine its risk-based levy but companies may have credit ratings from other agencies such as Standard & Poor’s, Moody’s or Fitch.

    Advisers should ensure that communications to deferred members are fair and not misleading. The Pensions Regulator offers some pointers on what former members should be told. For example:

  • Explain, where a transfer out of a DB scheme is involved, that the scheme which accepts the transfer value may not provide the same level of benefits.

  • Explain, where a transfer out of a DB scheme is involved, the risks inherent in and the guarantees offered by the member’s DB scheme. This should cover the risk of employer insolvency, the protection afforded by scheme wind-up legislation and the PPF. It would also be helpful if members were given an indication of the likely cost of replicating the PPF level of benefits.

    Few clients are likely to transfer off their own back, so advisers should seek out opportunities to advise senior employees of weak companies. Although the advice may be to stay put, you could prevent your client from having to face the same benefit cuts as some former Lehman employees.

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