Defined benefit pension schemes appear to be on the verge of extinction ­ but with clever strategy finance directors can keep them alive and make employers and investors happy at the same time.

What goes up, must come down ­ and recent events on the stock market underline this.

The effects of share price movements percolate through the economy, and any business with a final salary (defined benefit) pension scheme will feel the impact.

So why would an employer want to run a final salary scheme? Primarily, such schemes can be a boost to recruitment and retention, besides, any firm that competes for staff with the public sector may find itself at a severe disadvantage if it doesn’t provide such a pension scheme.

The costs of running final salary schemes have escalated in recent years, and the main underlying cause is increased life expectancy.

As a result, pension liabilities rise as the financial cost of supporting pensioners increases. Add to this a low return on bonds; the removal of the ability of pension schemes to reclaim the tax credit on dividends imposed in 1997; poorly performing stock markets earlier this decade ­ not to mention increased compliance costs ­ and it is clear why pension deficits have become so grave.

So, decisions taken by employers years ago for the benefit of employees may now be adversely affecting those businesses.

And while pension trustees have assumed increased responsibility for investment strategy and determining the size of scheme liabilities, FDs and CEOs are left to manage the financial impact on the firm. This power shift has left FDs in a relatively weak position.

There are a number of steps you can take to manage the situation and keep the scheme going; the key to success is open and clear communication with members.

You may need to explain that there is a shortfall and that it is unfortunately impossible for benefits to be provided at a certain rate unless contributions are increased. In such cases, members will generally accept an increase in their personal contributions.

The public sector has successfully negotiated extra contributions from its members, so businesses should be able to do the same.

Another option to consider is a reduction in future benefit levels ­ subject to any contractual employment rights. For example, rather than allowing benefits to grow at a rate of 1/60th of salary, this could be negotiated to, say, 1/80th of salary.

Similarly, you could look at the definition of ‘pensionable salary’. For some employers this is total salary, where others may count basic salary as the pensionable figure.
Also check out the position for those who have left the business, and consider offering enhanced rates to encourage those leavers to transfer out of the scheme.

Another area to consider is the arrangement for contracting out of the state second pension (S2P). Check out the national insurance rebates as these may not be worthwhile and it may be better for the employer to surrender their contracting out certificate.

Although some firms have closed their final salary schemes to new entrants, any deficit may continue to grow in line with increased longevity.

The deficit also remains subject to the vagaries of the stock market. Products that try and smooth these fluctuations have been developed. FDs could consider these as well the measures outlined above ­ and always with a strong policy of communication so that staff understand the situation.

There are a number of strategies and products to consider.

Leveraged buy-out bonds allow employers to crystallise the full buy-out liability by transferring scheme assets to an insurance company, which in turn secures deferred annuities (fixed payment) for members.

The difference between the value of assets transferred and the cost of purchasing the deferred annuities becomes a loan to the sponsoring employer from the insurance company.

Structured investment products, whereby, say, 80% of the scheme’s funds are put into AA-rated bonds, with the remaining 20% put into call options over a period of perhaps ten years, enables long-term exposure to equities while protecting the downside and reducing volatility.

As the fund value is not determined by stock market levels, but by the total value of the bond holding (plus income accrued), cash received from maturing options and the present value of the unexpired options combine to good effect.

It can also be worth looking at deficit insurance. Typically, the deficit (either full buy-out or FRS 17) can be insured, so that an insurance company extinguishes the debt held by the principal employer.

This vehicle can be extremely helpful if going through a merger or acquisition. No business can operate successfully if its hands are tied by excessive pension funding and fluctuating costs.

While there is no ‘one-size-fits-all’ solution, the combination of a number of strategies can work together to control an organisation’s pension deficit.

The route to success, however, is through effective communication with staff.

Rave reviews

How to manage a final salary (defined benefit) scheme when there is the prospect of a growing pension deficit:

Many employers seek to close their scheme and cap the liability, but there are a number of useful steps which businesses can take. It's important to maintain open communications with scheme members and review:

• Member contributions.

• Size of future benefits.

• Arrangements for contracting out of State Second Pension.

• Definition of 'pensionable salary'.

• Position for members who have left the firm.

Consider products which can smooth volatility, such as:

• Leveraged buy-out bonds.

• Structured investment products.

• Deficit insurance.

Bob Brassington is a director of employee benefits at Smith & Williamson