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The final countdown

With final-salary pension schemes in terminal decline and more employers looking to initiate member transfers, Tim Sutcliffe, managing director of Pi Financial, says advisers must move fast to open a door on this sector

Final-salary pension schemes are becoming millstones around companies’ necks. Fewer private sector employees are accruing new rights to final-salary pensions – only around one in five non-Government jobs would come with a defined-benefit pension if it were vacant.

In 2004, the Pensions Com-mission thought the decline in DB provision might never get this bad. In fact, it has become considerably worse and it does not get any better with news that experts are predicting many private sector companies will be bankrupted by their pension deficits this year.

Despite companies paying large sums to try to get rid of their deficits, the situation has been exacerbated by the economic downturn. Many firms will not be able to meet the huge extra sums while keeping their businesses afloat.

The National Association of Pension Funds found that, for all the UK DB schemes open to new entrants, more than 1,000 could face closure. Most commentators agree that the decline in final-salary pension provision is irreversible. For IFAs, it means a dwindling number of clients may still be active members and, if so, they should probably remain so for as long as possible.

However, many clients will have paid-up final salary pension rights from a previous or even current employer. But how often have they reviewed these entitlements? Advisers need to ask the following questions:

  • How much pension benefit does the client need to meet their retirement aspirations?
  • Does the client understand how much he/she will receive and when from their existing DB pension?
  • Is there a shortfall?
  • How secure are they?
  • What is the client’s attitude to risk and how much risk do they reasonably need to take to meet their objectives?

With a DB scheme, the employer effectively bears the investment and mortality risk of providing a certain level of income for the member’s life from a particular date. This is true for both current and past employees. Although DB pension rights can be transferred to a money-purchase environment, the misselling scandals of the 1980s and 1990s cast a long shadow.

In addition, increased regulatory attention, complexity and the perceived cast-iron guarantees and security of DB pensions in a time of increased stockmarket volatility has left advisers reluctant to advise in this area. In most cases, it has not been considered viable to transfer the risk of providing the pension benefit from the employer to the member through a transfer from a DB scheme to a money-purchase arrangement.

As the economic downturn takes hold, the limitations of DB guarantees are becoming more exposed

However, a combination of regulatory, fiscal, economic and demographic pressures means employers are looking to shed the burden of DB.

At the same time, recent Government measures that aim to slow the demise of DB will gradually reduce the degree of protection against inflation that DB members enjoy without offering any certainty that DB scheme closures will reduce or that members’ overall entitlements will be any more secure.

There is also new guidance from The Pensions Regulator relating to the calculation of cash-equivalent transfer values. This is expected to lead to an improvement in the terms offered.

In short, this could potentially result in transfers becoming more viable for many. Also, as the economic downturn takes hold, the limitations of DB guarantees are becoming more exposed. Savers should not assume their pensions are guaranteed, despite the safety net provided by the Government’s Pension Protection Fund.

There is some protection but it is only really effective for those who are already retired or claiming their entitlement. The PPF was established to insure members’ pensions if a private sector sponsoring employer fails. It essentially acts as a statutory safety net intended to protect pension savers against company failure. It is funded by levies on those companies that have a DB or final-salary scheme.

If a company fails, taking its final-salary scheme with it, the PPF should pay out the entire pension every year as long as the client has already retired. If the client had to retire early on the grounds of ill health or is a widow, widower or someone receiving a pension as a result of somebody who has died, the PPF will usually pay 100 per cent of the pension they should have received at the time the employer went bust.

However, if the client is still working and has not reached retirement age, the PPF will only pay up to 90 per cent of what the entitlement would otherwise have been.

The level of compensation is subject to an overall maximum value currently set at £29,748 a year for people aged 65. If funding pressures on the PPF grow, some experts believe the protection levels could be reduced from 100 per cent for pensioners and 90 per cent for employees down to 90 per cent and 75 per cent respectively.

This means that people who have large entitlements and are concerned about ending up in the PPF should look seriously at taking a transfer value out of their pension scheme. This is especially worthwhile for those people in poor health who may receive an impaired life annuity.

The DB promise is only as strong as the solvency and long-term commitment of the employer sponsor. Even employers and schemes that would in the past have been viewed as extremely safe cannot be assumed to be immune from trouble. The only certainty is uncertainty.

Sponsoring employers are increasingly seeking to initiate member transfers as a way of limiting their exposure to risk. For advisers looking to move into the corporate market, this is an ideal opportunity to move ahead. Just one finalsalary review can open the door to this sector but it is moving rapidly and becoming increasingly competitive so moving quickly is key.

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