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When the wind-up blows

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&#39 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&#39

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&#39s financial collapse)

and Maersk (scheme wound up even though the employing company was

financially sound).

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&#39s and dependants&#39 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&#39s 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&#39 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&#39 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&#39s 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.

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