When is a guarantee not a guarantee? The slick response is: “It depends what you mean by guarantee.” But the honest answer is : “In virtually all circumstances in which it is used.”
Comments reported in the press of a meeting between the FSA and pension consultant Ros Altmann about the Turner & Newall pension scheme crisis makes interesting reading. Altmann is reported to have brought up the wording of FSA consumer booklets on occupational pension schemes, in particular, the reference to defined-benefit or final-salary schemes giving guaranteed levels of benefit at retirement. (The booklets have since been revised). The FSA is reported to have said: “We never said that guaranteed means guaranteed in all circumstances.”
The word “guarantee” appears to be at the root of many financial services problems, for example, guaranteed annuity rates, guaranteed payouts under endowments and guaranteed benefits under final-salary pension schemes. The FSA's response could equally be applied to guaranteed annuity rates where the guarantee applies only on a specific date, for example, the planholder's 60th birthday, but not one day before or after that date. Similarly, the guaranteed payout under an endowment policy does not apply on early surrender.
The guarantee under most final-salary schemes was always much more tenuous. The guarantee depends on a number of factors including the ability of the employer and member to pay the required levels of contribution to meet the funding requirements of the scheme.
The calculation of the contribution depends on many variables such as the investment assumptions, the average age of the membership, the impact of mortality, the cost of buying annuities or paying out pensions from the fund and the level of National Insurance rebates under contracted-out schemes.
The effect of legislative improvements adds to employers' costs, such as the requirement to revalue retirement benefits during retirement. In practice, employers have been prepared to add these legislative improvements to existing benefits rather than reduce the core benefits to keep overall costs unchanged.
As we have seen, some employers have not been prepared to meet their obligations to meet accrued benefits, sometimes because they have become insolvent. Some scheme members may have been prescient enough to consider that their employer might renege on their promises/guarantees or even end the scheme due to straitened economic circumstances but few would have considered that some employers might be unable to pay out accrued benefits or pensions to existing pensioners.
Would employers allow their schemes to make such guarantees if they understood the consequences of their actions? Probably not, as the guarantee is subject to so many qualifications that it is worthless.
Rather than referring to guarantees in scheme literature, employers and trustees would do better to include text on the following lines:
“The employer is aiming to provide you with a pension of one-sixtieth of final salary for each year of service. However, the employer does not guarantee that you will receive a pension of this amount because it cannot know now what might happen far in to the future. Economic conditions may change, medical advances will probably mean that the scheme will have to pay out pensions for longer in future and Parliament may require us to make improvements to the scheme which we may not be able to afford.
“Currently, the employer makes substantial contributions to the pension fund to meet the cost of providing benefits, with members sharing in the cost. Nevertheless, a deficit in the fund may arise in the future which the employer may not be able to make up, or wish to make up. The existence of a deficit may mean that the employer may have to cease trading and that another company may not be willing to take over the company and its scheme liabilities. This may cause the employer/trustees to reduce benefits, including those of existing pensioners.
“The employer and the scheme trustees undertake to keep members fully informed about the fund finances and any proposals to amend the scheme in the future.”
With such a qualification, the employer and members may well think there is just as much certainty with a defined-contribution arrangement.