I have been discussing the winding up of final-salary pension
schemes, which I expect will be the subject of many more articles in
the coming years.
The main thrust of those articles is likely to be that a scheme can
be wound up without any further financial liability on the employer
so long as it is fully funded on an MFR basis. This basis assumes –
perversely for these purposes – that the scheme will actually
continue in force, with young employees in effect subsidising the
higher funding levels of older members.
Of course, where a scheme winds up, there will be no further young
blood, so the funding of members' benefits must be calculated on a
discontinuance basis, which will invariably show a much higher cash
requirement. Thus, it is rarely possible to buy out all members'
benefits in full and some will lose out – possibly by as much as 50
per cent or more – as highlighted in the recent cases of ASW (scheme
wound up as a result of the employing company's financial collapse)
and Maersk (scheme wound up even though the employing company was
Last time, I not only summarised my suggestion that the possibility
or likelihood of a scheme wind-up could or should influence a
recommendation of a transfer out by a deferred member (early leaver)
but suggested that current employees might want to consider
transferring out of the scheme.
Yes, this implies opting out and might sound a bit heretical but
think about a few combinations of possible factors for a 62-year-old
employee member of a scheme which announces or is suspected to be
ready to announce it is winding up. At his age, when his benefits are
bought out, he might expect to lose perhaps 20 per cent of his
promised benefit accrual and, even more likely, all his right to
increases to his pension in payment. This could lead to a loss of 50
per cent of the overall value of his rights.
Furthermore, on a transfer out, he gains greater flexibility in
determining the shape of his pension income as reg-ards choice of
spouse's and dependants' pensions and sel-ection of escalation or
otherwise. For bigger funds there is also the chance of considering
drawdown. This is especially so if this member is in ill health
and/or not married (so a spouse's pension in the current scheme
represents no real value).
Of course, it would be completely negligent to pretend that there
could be no possible reason to remain with the existing scheme, not
least where there is little or no certainty that the scheme is going
to be wound up. Even in the event of a wind-up, there is no certainty
that the fund will fall short of that required to provide all the
members' benefits in full. The main reason for my brief consideration
of opting out is to highlight the main factors which can affect
planning decisions for all deferred and current (but not retired)
members where a wind-up is anticipated.
This leads me on to the second question I posed at the end of my last
article. How can a future scheme wind-up be anticipated? After all,
once a wind-up is announced, it is likely that transfers will be
postponed and, even where allowed to proceed, advisers will in my
experience usually not be given full details of the level of the
members' benefits to be secured by the scheme, thus making an
accurate evaluation of a transfer decision impossible. I would like
to propose a few possible answers to this question – none of which
are universally reliable.
There are occasions where the scheme (or, more precisely, the
employer) openly announces its future intentions. Such an
announcement might be made to shareholders disgruntled at the damage
to the company's finances sustained by a pension scheme shortfall
(especially if the FRS17 accounting standard has been adopted).
Alternatively, the announcement might be made to employees and
deferred members, perhaps with the intention of encouraging transfers
out at a lower cost to the scheme.
Advisers with appropriate contacts might find out about the imminent
start of winding-up proceedings from a scheme trustee or a trade
union representative involved in employee benefit negotiations.
We have found that a useful indicator of a future wind-up is the
closure of the scheme. Closing a scheme retains existing members on
full accrued benefits, possibly with continuing accrual for future
service. However, no new members (that is, no new employees) are
permitted into the scheme. Without doubt, employers closing their
final-salary scheme are doing so with a view to limiting their future
liabilities. But a belief that closing a scheme achieves this
limitation to any great extent is largely illusory.
Within closed schemes, future liabilities on the sponsoring employer
may continue to accrue. Liabilities might increase due to the
continuation of underperformance of the assets against assumptions.
Continuing improvements in life expectancy and/or lower interest
rates would also increase the cost of providing retirement benefits.
Perhaps worse, legislation or court judgments which impose
retrospective benefit enhancements on a scheme (for example, in
recent years, for part-timers) can make employers regret closing a
scheme rather than winding it up.
So why would an employer close a scheme rather than wind it up? A
good pointer to the answer lies in the fact that a scheme cannot be
wound up unless it is fully funded on an MFR basis. Thus, where a
scheme is badly underfunded and the employer cannot meet the cost of
that underfunding in a single lump-sum payment, a wind-up cannot take
place. By closing the scheme, the employer ensures no liability is
taken on board for further accruals. Could this mean the employer
might be tempted to wind up the scheme as soon as it becomes fully
funded (either through dripfed additional contributions or investment
performance)? In one particular case, we recommended a big number of
deferred members to transfer out of a closed scheme despite critical
yields well in excess of 10 per cent.
There is much work to be done by advisers of members of final-salary
schemes. It is usually dangerous work requiring precisely presented
recommendations with all the risk factors clearly stated to the
client. Of much greater risk for the scheme members, however, is
where the adviser completely ignores the issue and potentially allows
clients to lose a huge proportion of the value of their promised
pension rights. Just ask the employees of ASW or Maersk.
I have been discussing the winding up of final-salary pension