Millions of people with “final salary” pensions may have to accept cuts to their income as radical plans emerge aimed at saving thousands of struggling small funds.
Writing for this newspaper, the pensions minister hints that in future pensioners will have to accept reduced benefits to take the pressure off embattled funds.
For decades, the companies that back these schemes – where retirement income is guaranteed and based on salary and length of service – have struggled to keep them fully funded. Most are now in deficit, meaning the value of their pension promises outweighs the assets in the fund.
Some savers have been enticed to give up their final salary benefits by offers from employers to swap their guaranteed payments for lump sums up of up to 40 times the size of annual pensions.
Now, in the wake of the BHS scandal, which saw Sir Philip Green forced to pay £363m to fill a hole in the staff pension fund, the Government is looking for ways to ease the burden on firms by watering down benefits.
Richard Harrington, the pensions minister, explains why the system needs to be reformed. Britain is a “very different place” from when many of the schemes were set up, he says.
His stance today is in contrast to the tone of an earlier interview with this newspaper last September. Then, he said he was “very conscious of the fact” that final salary pensions were “part of an employee’s package and were used extensively as a way of recruiting staff”.
He added: “People were joining a company and were given a promise that was as much a part of their deal as their salary was.”
But now he concedes that savers will have to feel some pain if the system is to survive.
He writes today: “I have a very clear set of criteria in mind when it comes to the future of the defined benefit [final salary] sector. Any changes must balance the needs of consumers, employers and schemes and I don’t want to see it tipped in favour of one particular group.
“To restore confidence and build a more secure sector it’s vital that the interests of no one group dominate.”
50:50 chance of pension cut
A recent government consultation paper suggested that firms be allowed to freeze pension payments so they don’t keep pace with inflation.
That would save employers billions of pounds, while pensioners would find their income falling further and further behind rising prices. The Pensions & Lifetime Savings Association (PLSA), a pension fund lobby group, has estimated that there is only a 50:50 chance that the weakest schemes – which number in the thousands – will be able to pay out to members in full.
Part of the problem is that there are thousands of schemes, mostly set up decades ago when the companies that backed them were stronger and people didn’t live as long. They are often run inefficiently by part-time trustees who meet infrequently, and the industry regulator lacks the budget to oversee them properly.
The PLSA, among others, has suggested creating “super funds” that would enable employers to pay a one-off fee to absolve them of responsibility for the pensions. It said pooling assets in this way would protect pensions and make high-profile failures less likely.
But actuaries warn that companies could use the funds as a way to unfairly dump schemes they are perfectly capable of funding. Part of the reason final salary schemes are so valuable – and costly to employers – is that the payments are increased each year in line with inflation.
The rules vary from scheme to scheme, however, meaning that some pensioners have their payments lifted by the consumer prices index and others by the retail prices index.
One of the Government’s ideas is to allow trustees to override rules that prevent them from using the CPI, which is normally lower, or suspend increases entirely if the company is in financial difficulty.
A shift from increasing pensions in line with the RPI to using the CPI may sound minor but over the course of a normal retirement could result in pensioners receiving many thousands of pounds less. Cutting pension increases in this way was proposed at the height of the Tata Steel crisis.
The Indian parent company said the UK division’s £15bn pension scheme was draining resources and blocking a vital restructuring. Mr Harrington points out that public sector pension savers have already gone through such changes.
“CPI has already replaced RPI for the pensions of civil servants, the military, teachers, NHS staff and MPs,” he writes.
“And if using a modern and more accurate measure [of inflation] which still protects pensioners against rising prices also makes the scheme more sustainable in the long term, it is worthy of consideration.”
Because of the huge costs, the vast majority of private sector final salary schemes are now closed to new staff. However, almost all public sector workers – including MPs – still have the right to join their scheme.
Will your pension get swallowed by a “super fund”?
There around 6,000 final salary schemes in the country, but most are tiny and many are poorly run despite looking after billions of pounds of assets. Both the Government and the PLSA think giant “super funds” could be the answer.
The idea is that the pensions paid by super funds would be better than those offered by the Pension Protection Fund, a lifeboat scheme that guarantees the pensions promised by failed companies. It caps payouts for people yet to retire at 90pc and has an overall cap of around £38,000 for most people.
Under the PLSA’s plan, employers could pay to hand over responsibility for paying pensions to the super fund. Firms can already pay to have a scheme taken off their hands by insuring benefits with household names such as Legal & General – but the costs are extremely high, driven by rock-bottom interest rates.
Tom McPhail of Hargreaves Lansdown, the pensions company, said: “The terms of how weak employers can go into a super fund will be critical.
“For a super fund to be fair to the other participants you have to apply the same entry requirements, otherwise you’re just shifting liabilities.
“There is a recognition in the Government, PLSA and everywhere that we have too many schemes. It’s not a question of if we do it, but how we do it – and how much pressure is brought to bear to make it happen.”
I’m worried my employer will go bust – can I move out of the scheme?
You have the right to swap your final salary pension for a “defined contribution” plan at any time before you start to receive payments. Trustees have to give you a “transfer value”, normally guaranteed for three months. This will be a multiple of the initial annual income the pension would have paid you.
So £5,000 a year could be swapped for a £125,000 lump sum, for example. In the past transfer offers were typically around 20 to 25 times annual income, but in recent months offers have rocketed to multiples of 40 or more.
Giving up the guaranteed, inflation-linked income of a final salary scheme should not be done lightly, but defined contribution pensions have attractions too. You have far more control over your money, with the option of taking ad hoc lump sums.
And on death, unused funds can be passed indefinitely down the generations. In final salary schemes the pension normally ends with the death of the pensioner or surviving spouse.
The City watchdog requires you to take financial advice if the value of the transfer is £30,000 or more. Charges vary but 1pc of the transfer value is typical.
Telegraph Money has previously reported on readers’ struggles to find advisers prepared to recommend a transfer.
Some advisers have refused to carry out a pension switch because they did not think it was in the best interest of savers – or feared they might make a complaint in the future.
The Government’s consultation on reforming final salary schemes closes on May 14.