I mentioned at the end of my last article that we would be moving away from current issues surrounding money-purchase schemes to look at defined-benefit schemes but few readers could have begun to imagine the importance of the topics I am about to discuss. After all, only a very small proportion of IFAs are authorised to give advice regarding membership of this type of scheme, most notably in respect of possible transfers of benefits for early leavers and opt-outs for current members, and an even smaller proportion give advice to the schemes themselves.
So it is hardly surprising that developments relating to these schemes are widely dismissed by most advisers as being irrelevant to their work.
This is a great shame. Without doubt, the most important pension issue of the next decade relates to final-salary schemes and affects a huge proportion of IFAs' clients. Advisers not involving themselves in this area of their clients' financial lives could be missing a tremendous opportunity. What is happening and why do so many millions of people need urgent advice?
Most of the key areas of concern are centred on the fact that an increasing number of defined-benefit schemes are winding up or closing. Why should this be of concern?
First, it is important to distinguish between a scheme closure and a wind-up. Simply, where a scheme closes, it continues to exist and provide ongoing benefits to members and preserved benefits to deferred members, that is, early leavers. It continues to control its fund investments – for better or worse – and continues to be liable for the increase in benefits already accrued, for example, revaluation up to the date of drawing benefits and escalation thereafter.
So, closing a scheme does not really mean closing. But where a scheme is wound up, the scheme really is closed to all further business. All existing members are kicked out. This means their benefits or, to be more precise, the actuarially calculated value of their benefits, must be transferred to an alternative pension arrangement. The scheme will make arrangements for the destination of these transfers without the consent of each individual member although well advised members will usually be able to secure a better deal for themselves if they act quickly enough.
Let us deal with wind-ups first. There are two massive recent cases here – ASW and Maersk. ASW, a steelworks in Wales, wound up its pension scheme mostly as a consequence of going into liquidation. The defined-benefit scheme was heavily in deficit, meaning there was not enough money in the fund to secure the accrued benefits of all the members and almost all of them lost big chunks of their promised benefits, with some of them likely to lose almost everything.
The only people who have profited out of this debacle have been the actuaries and administrators of the wind-up, whose fees serve mostly to take an even bigger part of their promised benefits.
Would it have been good advice to transfer out of this scheme before its eventual demise? You bet your bottom dollar it would. So what if the critical yield for a transfer to a personal pension or pension buyout bond might have been high? That yield is calculated on the assumption that the ceding scheme will pay all the benefits it has promised. Even the most severe stockmarket crash could not, within a transferred pension scheme, have matched the losses inflicted by ASW.
Is the ASW debacle a one-off? If it were, it would not be attracting as much attention. Enter Maersk, the huge and highly profitable (contrast with ASW) European shipping group which bought out a much smaller UK competitor a few years ago. During this takeover, Maersk realised that the final-salary scheme which was due to come as baggage with the deal was a potentially huge future liability for the profitability of its subsidiary so it decided to close the scheme. Maersk's advisers suggested it should be wound up.
Now, here is the clever bit. The scheme was fully funded on a minimum funding requirement basis. This actuarial standard seeks to confirm that a scheme's assets are of at least sufficient value to meet its future liabilities. However, MFR calculations assume that the scheme is going to continue in force, with youngsters entering the scheme and older members reaching the end of their tenure. A fundamental mathematical fact of funding final-salary scheme benefits is that younger members are relatively cheap to fund (much less than 10 per cent of earnings on an annualised basis) while older employees are very expensive (often more than 30 per cent of earnings). If there is a broad range of young and old members, the overall average funding rate might finish up at, say, 20 per cent.
What if you cut off the oxygen supply of young members? What if the mix of members remains unchanged and, therefore, progressively pushes up the average age? The funding rate goes up, of course.
The MFR basis of assessing a scheme's solvency is calculated on a continuance basis, assuming the average age of the scheme's members remains the same. But, of course, if the scheme is wound up, the average age will not remain the same. Existing members will grow older and there will not be any youngsters coming in to mask this increasing cost. An acknowledgement of this extra strain on the scheme's funding position is known as a discontinuance basis or, more technically, past service reserve.
But, to get back to our story, why should Maersk worry about that? It could, and did, wind up a healthy defined-benefit scheme which was fully funded on an MFR basis but with scheme assets which were anything but sufficient to pay all the benefits of the poor souls who thought their final-salary scheme provided guarantees of their past promised benefits.
What happens now? Move on but with much lower benefits than you thought you had accrued over the 20 or 30 years you worked for the company. Remember, this is not Maxwell (fraud) nor ASW (company failure with no suspicion of fraud) – this is a simple example of a company which just got fed up with a pension scheme.
Could we have anticipated the ASW debacle? Probably. Maersk? Definitely. What can advisers do to help clients avoid problems in future? This issue is massive and in my next few articles I will give the answers.