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