The bad news surrounding final salary schemes could encourage members to transfer out – and lose their ‘gold-plated’ benefits.
BHS and Tata Steel are the latest companies whose pension funding has come under intense scrutiny, as the extent of the black hole in their final salary schemes (also known as ‘defined benefit’, or DB schemes) becomes clear.
In 2014, struggling steel-maker Tata reported a £2 billion deficit in its scheme: despite subsequent investment, it is still underfunded to the tune of £700 million1. BHS’s prognosis is also dire; its pension scheme is £571 million in the red2.
In naming his original pension deficit rescue plan ‘Project Thor’, Sir Philip Green, former BHS owner, may have unwittingly suggested that only a hammer-wielding superhero could put things right. Yet the hammer blow may be felt by Sir Philip himself if he decides to pay reparations of more than £100 million to members in an effort to, as he put it, “sort out” the pension schemes.
Most DB schemes have become a luxury that companies simply cannot afford. A small number remain open, but the majority have been closed to new members for years. They now exist under the strain of having to meet their promises to remaining members; battling against the headwinds of low interest rates and rising longevity.
The unfortunate demise of both BHS and Tata’s UK steel operations throws a spotlight onto other companies that continue to operate DB schemes. The Pension Protection Fund estimates that there are over 11 million people in funded DB plans with over £1 trillion in assets and liabilities. As of May 2016, there were 4,864 schemes in deficit and 1,081 schemes in surplus.3
DB or not DB?
Experts say that the bad publicity surrounding DB schemes could motivate members to transfer out, especially with the greater flexibility now offered to people with defined contribution (DC) schemes. But some warn that transferring out might not be the right thing to do, even if the DB scheme is heavily underfunded.
“There are a few circumstances where transferring out might be okay, but I always start from the position that it would be a bad idea,” says Steve Moy, Wealth Management Consultant at St. James’s Place.
“Defined benefit, or final salary, schemes are still the ‘gold standard’ – they are arguably more secure and more generous than DC pensions and pay an income that increases in line with inflation,” says Moy.
All DB plans pay a levy to the Pension Protection Fund (PPF), the state-backed safety net, which pays compensation to members of eligible schemes if a DB scheme cannot meet its obligations.
If there are insufficient assets to pay members, the PPF normally takes over and pays 100% compensation to members who have already reached their scheme’s normal retirement age. For those who are yet to reach this age, it offers up to 90% compensation (capped at £33,678.38 p.a. for someone at age 65) to members on reaching the normal pension age of their scheme.
If a DB scheme goes into the PPF, the compensation could still represent more income than an annuity purchased with the lump sum received from transferring out of the scheme.
“Take somebody in a DB scheme with £8,000 a year guaranteed income,” says Moy. “That scheme might have a transfer value of around £100,000, which at age 60 may only get you an annuity of £3,000 or £4,000 a year on the open market.”
“Even if the PPF had to step in, it would be hard to replicate the advantages of a DB scheme. So if you’ve got one, I would probably hang on to it,” says Moy.
While it is clear that many of the laws surrounding DB pension schemes are outdated, members shouldn’t rush to transfer out, even if their scheme is in deficit.
They should, however, seek financial advice on how they might be able to mitigate the risks that their scheme could face.
1 British Steel Pension Scheme: Public consultation, Department for Work and Pensions, 26 May 2016
2 Work and Pensions Committee & Business Innovation and Skills Committee Oral evidence: Pension Protection Fund and Pensions Regulator HC 55, 8 June 2016
3 PPF 7800 Index, 16 June 2016
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