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Levy mettle

At the beginning of this year, I started a series of articles reviewing the progress of certain key pension issues and highlighting opportunities for pension advisers to assist corporate and personal clients.

I notionally categorised these issues according to their relevance to defined-benefit schemes, defined-contribution schemes, state pension benefits and pension schemes in general. I thought it might be useful at this stage to relist these topics before progressing further with this review (see table right). Issues already covered appear in italics.

In my last article, I started to conclude a series of discussions about the protection afforded to members of final-salary schemes by scheme funding requirements, transfers of undertakings (where employees and their pension rights are transferred from one employer to another) and the priorities of various categories of members on scheme wind-ups. I now want to cover the forthcoming Pension Protection Fund.

I have already noted the improved situation for members where a final-salary scheme is wound up by an employer which is financially solvent, where better terms are now offered for preserved or transferred benefits. But these developments do little or nothing to assist members of defined-benefit schemes where the employer is bankrupt or has lapsed into liquidation. A number of high-profile cases can be cited to illustrate these problems, including ASW, a steel works in Wales which went into liquidation while the scheme was heavily in deficit.

Faced with such problems, the Pensions Act introduced the PPF, which is designed to bail out schemes where the employer is unable to rectify a funding shortage. Fundamentally, all defined-benefit schemes will be required from next month to pay a levy into this fund. However the question remains – on what basis?

The structure of the PPF closely follows a similar scheme, the Pension Benefit Guaranty Corporation, which has been running in the US for a number of years. However, a particularly worrying aspect for the possible future of the PPF is that this US forerunner is in deficit by more than $10bn.

In the US, it has been noted that the strongest and most financially secure employers and pension schemes have frequently been subsidising the weakest employers and schemes. Of course, this is a fundamental principle of any kind of compensation scheme but understanding this concept does little to placate employers and schemes whose funding levels have increased significantly in recent years.

So how is the PPF seeking to address and avoid the problems suffered by the US model? Funding of the PPF will operate within three separate categories – fraud compensation, administration and (most important for many members) pension protection.

It is feared that the levy collected from schemes in the early years may not be sufficient to cover a possible initial surge in claims, throwing the fund into deficit. It is hard to see how the fund would operate effectively in this scenario.

Interestingly, the PPF levy will be calculated in two ways – a scheme-specific formula taking into account, in essence, the total value of accrued benefits of all the members, and a risk-related formula based on the degree of underfunding within each individual scheme. Thus, the weaker the financial position of the scheme, the higher the risk-related part of the levy.

Most commentators agree that this is entirely fair on the stronger schemes, which will pay proportionately less into the PPF, but the increased cost to weaker schemes could be a significant factor in the demise of those schemes, placing increased pressure on the financial viability of the PPF itself.

In truth, no one has any clear idea as to the long-term future of the PPF, which is to be managed by a board which will set the levy on a year-by-year basis. It is not yet known what the likely cost will be to final-salary schemes in the longer term.

Turning to the way in which the PPF will compensate members of underfunded schemes of insolvent employers, it should be noted that only members who are already in receipt of benefits will be guaranteed 100 per cent of their entitlement. Even for these people, all is not quite so simple. That part of their benefit which accrued after April 5, 1997 will be increased each year in line with increases in the Retail Prices Index or 2.5 per cent a year, whichever is lower. For that part of their benefit accrued before that date (which will be the majority of most people’s benefits) there will be no annual increases, so the real value of their benefits will reduce as the years go by.

Members not already being paid a pension will be guaranteed 90 per cent of their entitlement, with the 1997 rule applying to increases to their eventual pension in payment.

How does this affect scheme members? First, as I have noted in previous articles, there is a great deal of additional protection for members of final-salary schemes where the employer is – and is expected to remain – solvent. Advisers should therefore not only consider the funding position of the scheme but also the financial security of the employer. Where the employer is likely to remain solvent, members and their advisers no longer need to be concerned about the reduced value of benefits where a scheme is being closed or wound up.

Where there is concern about the financial future of an employer, the PPF will provide a much improved degree of security but it would be wrong to assume this safety net will replace or guarantee all benefits accrued by every member – remember the lack of annual increases and the 10 per cent reduction for members whose benefits have not yet come into payment.

I would suggest these considerations are particularly important to early leavers considering the advantages and disadvantages of a transfer from a defined-benefit scheme. I am by no means implying that a transfer could be justified only or mostly on the basis that the PPF does not guarantee members full replacement of their benefits. However, I would suggest that members who might in some circumstances be justifiably worried about the financial security of their former employer should not be led to believe that the introduction of the PPF will entirely secure their promised pension rights.

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