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OK so the Carillion thread has brought to light the fact a lot of people are very much in the dark over Final Salary (Defined Benefit - DB) Pension Schemes. They have always been held up as "gold plated" and guaranteed and by and large they have been fairly excellent.
I'm going to run through a number of pros and cons and explain why so many DB Schemes are in deficit and why it's not always a case of the directors of a company taking the piss and buying more yachts.
So the majority of final salary schemes work on a 60ths or 80ths basis. That basically means if you work somewhere (in a 60ths scheme) for 30 years, your pension benefits will be half (30/60ths) of your final salary. These are obviously very attractive to the average person for obvious reasons. The problems now being faced by companies that run these schemes are two fold;
What happens if the company goes under?
The Department of Work and Pensions run the Pension Protector Fund via a levy on solvent pension funds. It currently has around £6bn in cash and over £240bn in net assets. It exists to ensure that if a company becomes insolvent then the scheme members aren't completely shafted. Once a scheme enters the PPF then there's an immediate 10% reduction in benefits for those that have not already starting benefits and it becomes impossible to transfer your benefits out the scheme into a Self Invested Personal Pension (SIPP) but at least members know that they will be able to retire on something.
Options if you are worried about your scheme
So everyone is welcome to a full valuation and to be told of all benefits accrued by the DB (or even DC) Scheme. Most people don't know the position of their scheme and what they are entitled to, which to my mind is crazy. It is usually either their highest or second highest asset after a property. People should be enquiring of their pension trustees as to;
If people wish to look at transferring out of the DB scheme
If any scheme member is unsatisfied with the answers they receive then they are fully entitled to transfer their pension pot from a DB scheme into their own personal pension. They would lose some of the guarantees that a DB scheme has, however;
As with all things like this, if you are concerned or want more information about your personal scheme and situation then get personal and professional advice. Transferring from a DB scheme is a big decision and it wouldn't be the right choice for everybody (due to the "guarantees" that they offer), but everyone should at least be educated on all of their options and the pros and cons of staying put or leaving.
I'm going to run through a number of pros and cons and explain why so many DB Schemes are in deficit and why it's not always a case of the directors of a company taking the piss and buying more yachts.
So the majority of final salary schemes work on a 60ths or 80ths basis. That basically means if you work somewhere (in a 60ths scheme) for 30 years, your pension benefits will be half (30/60ths) of your final salary. These are obviously very attractive to the average person for obvious reasons. The problems now being faced by companies that run these schemes are two fold;
- Firstly, people are now living a lot longer than was expected when these schemes were first put in place. When people were retiring at 65 and dying at 72, the scheme was paying out the full retirement income for only 7 years. Now life expectancy is far higher and increasing year on year, the actuaries have to show a higher liability. Unlike Defined Contribution (DC) or "Money Purchase" Schemes, a scheme has to show on their balance sheet - the total possible liability, even if they have been well funded and well invested. Using an example of a scheme member being in a 60ths scheme, having worked for 30 years and finished on £60,000 per year, the pension trustees know that they have a liability of (around) 20 years paying £30,000 per year. That means the liability for that one member is a minimum of £600,000 (plus any indexation/escalation) in income. Now the member may have paid in 5% every year and the company funds the rest for that guaranteed annuity (30/60th final salary) but the member may have had an average salary over his service of £24,000 meaning they have paid in around £24,000 over their employment (at 5% employee contribution). That is some jump compared to the assumed liability (£600,000) and it is the company/scheme that has to fund that gap.
- The second (and huge) issue these schemes have is that the liability of a scheme is based on interest (namely 10 year treasury gilt) rates. When a member starts taking benefits then the scheme bases their assumed growth on gilt yield rates. As interest rates have been at record lows over the last ten years, the scheme has to assume that the growth on their holdings are tiny, if anything at all. This means the liability is much higher that it would have been 15 years ago, even if the scheme has been well funded and has seen good investment growth. In our example above, when a scheme member starts taking their benefits and the liability is £600,000, rather than 15 years ago when the scheme could assume 3-5% growth in low risk gilts (meaning the £600,000 could be satisfied over the next 20 years with potentially only a cost to the scheme of £300,000) the low rate of return makes it much more expensive on the balance sheet.
What happens if the company goes under?
The Department of Work and Pensions run the Pension Protector Fund via a levy on solvent pension funds. It currently has around £6bn in cash and over £240bn in net assets. It exists to ensure that if a company becomes insolvent then the scheme members aren't completely shafted. Once a scheme enters the PPF then there's an immediate 10% reduction in benefits for those that have not already starting benefits and it becomes impossible to transfer your benefits out the scheme into a Self Invested Personal Pension (SIPP) but at least members know that they will be able to retire on something.
Options if you are worried about your scheme
So everyone is welcome to a full valuation and to be told of all benefits accrued by the DB (or even DC) Scheme. Most people don't know the position of their scheme and what they are entitled to, which to my mind is crazy. It is usually either their highest or second highest asset after a property. People should be enquiring of their pension trustees as to;
- The scheme's funding position
- Their accrued benefits (how much they will receive)
- What age they will receive
- What their spouse will receive (50% as a rule)
- What their kids would receive if you and your spouse pass away (Zero if they are over 18)
- Is a tax free lump sum available on retirement?
- What indexation applies to the benefits once crystallised (i.e. you start receiving funds)
- What is the transfer value if the member wanted to transfer to a personal pension (usually somewhere between 15 to 40 (FORTY) times the accrued annual income - i.e. if a member was entitled to £10,000 per year, the transfer value may be somewhere between £150,000 to £400,000 - transfer values are now actually at record highs due to the same interest/gilt rate calculation as mentioned before)
If people wish to look at transferring out of the DB scheme
If any scheme member is unsatisfied with the answers they receive then they are fully entitled to transfer their pension pot from a DB scheme into their own personal pension. They would lose some of the guarantees that a DB scheme has, however;
- They could leave all of their pension pot to their spouse or kids free of tax (although if the member was over 75, their kids would pay income tax at their marginal rate). This is usually a huge point as very few members of DB schemes are aware their spouse would only get 50% and that their kids would get nothing at all.
- They have the option of a 25% tax free lump sum.
- They can take benefits from age 55 onwards (as opposed to some DB schemes which are 60 or 65 and may penalise the benefits for taking them earlier)
- Flexible Drawdown - Where as a DB scheme will pay a flat (or indexed) monthly income, a personal pension now allows flexible drawdown, meaning you can take more income in the earlier years when you are younger and in a position to enjoy it.
- Investment control - Unlike a DB or even a DC scheme, personal pensions (or SIPP) members have full control over their investment decisions. This means that a member can choose the level of risk that suits them without a trustee making those decisions on their behalf.
- Also, if you transfer into a personal pension, it means that no board of directors can fuck up and instantly lose you 10 to 20% of your pension by forcing the scheme into the PPF.
As with all things like this, if you are concerned or want more information about your personal scheme and situation then get personal and professional advice. Transferring from a DB scheme is a big decision and it wouldn't be the right choice for everybody (due to the "guarantees" that they offer), but everyone should at least be educated on all of their options and the pros and cons of staying put or leaving.
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