Final Salary Schemes Under Siege as Funding Gap hits £1 trillion
A defined benefit, or final-salary, pension has long been regarded as the holy grail of the pension world; a gold-plated, pension for life with inflation linked annual increases and generous provision for surviving spouses.
Advice to those seeking to cash one in would have been short and unequivocal – ‘don’t do it’.
However, it is now estimated that there is a gap of £1 trillion between the provision companies currently have and the payouts they are committed to and there are very real fears that hundreds of schemes could fail leaving pensioners far worse off than they expected.
Many schemes are currently in crisis meaning that companies may be unable to invest in current staff or deliver future growth because of the requirement to continually top up a burdensome pension scheme.
‘many schemes are currently in crisis’
The situation appears totally untenable and outgoing pensions Minister Baroness Altmann has said that scheme members would do well to compromise on the level of benefits they receive on the grounds that they are likely to be better off than they would be in the alternative scenario.
If a pension scheme fails, pensioners are provided for by the Pension Protection Funds (PPF), but the level of support it can provide will diminish as demands upon it increase.
However galling, pensioners may benefit by agreeing a compromise deal that gives up some of the elements of the scheme they expected, but delivers a better income than the lifeboat fund.
Around 11 million people in the UK have entitlements in around 6,000 final salary schemes and anything up to 5,000 of these are in deficit.
If these schemes are to pay out everything they are committed to, they need to find £935 billion of extra funding, the highest funding gap ever recorded.
If the PPF is required to step in, the majority of already retired members of the scheme will continue to be paid as normal and most yet-to-retire members get 90% of their expectation, although some may get less.
There are steps that companies that remain solvent yet under severe strain because of their pension scheme can take, including switching index-linking to a lower measure of inflation; they may also switch their investments away from government bonds which currently offer such poor returns.
However, in an attempt to reduce the burden, some are offering savers ‘irresistible’ deals to leave, the scheme, as they struggle to fund their future liabilities on terms that are so good that even cautious savers are being tempted.
Those considering cashing in a final salary scheme are obliged to take professional guidance, but whereas the response in the past would have been entirely predictable, it is increasingly common for advisers to suggest that it could be possible to improve upon the income achieved from the scheme by taking an enhanced payment and investing it in a self-invested personal pension (SIPP)
‘some are offering savers ‘irresistible’ deals to leave’
Those receiving an enhanced transfer value for their final salary pension can invest the money in a SIPP and then achieve dividends and bond interest that matches, or indeed surpasses, the income promised by their scheme.
In this scenario the pensioner may be able to keep their capital intact, or even grow it and thanks to last year’s pension freedoms, it would no longer attract inheritance tax.
In a final salary scheme there is no ‘pot’ of money held on behalf of each pensioner, so for the sake of valuation an entitlement is considered to be worth a twenty-times multiple of the initial annual payment; a scheme paying £20,000 p.a. is therefore valued at £400,000.
However, in order to tempt members away, some schemes are now offering sums that represent up to forty times the annual payment, which some consider is reasonable given the cost of purchasing an income for life – an annuity – in the open market.
Rising transfer values are also another side effect of low interest rates, which have pushed returns on safe assets, like government bonds, to record lows; schemes are prepared to pay in order to offload the burden.
The success of the investment strategy utilised within the SIPP will decide whether this is a sensible strategy and until recently it has seldom been worth the extra risk; however, the fact that transfer values are currently so high is helping to mitigate some of the dangers.
An additional consideration is that there is a lifetime pension contribution limit of £1 million and with enhanced valuations, many pots may go beyond this threshold leading to tax implications.
If the pensioner can employ an investment strategy that both keeps pace with inflation and leaves the original capital sum intact, the money held within a pension is free from inheritance tax and can be bequeathed as the pension owner wishes; there is no tax at all to pay if the owner dies before age 75, and only income tax at the recipient’s marginal rate thereafter.
Of all the decisions facing the DIY investor there can be few greater than that to cash in a final salary scheme and go it alone.