The End Game?

Ask any Finance Director if they would like to get the deficit under their Final Salary Scheme off the books and they will welcome you with open arms.  However, when it comes to working out the cost of doing this, things tend to grind to a halt.

Recently there has been an explosion of new entrants to what is known as the Buyout market, bringing with them new and innovative ideas.  However, these in the main tend to be aimed at the “larger” schemes with assets in the many millions.

What’s on offer for the smaller schemes?

In simplistic terms, running a Final Salary Scheme these days is mainly about managing the scheme deficit.  A deficit is quite simply the difference between the assets and the current liabilities of the scheme.  Unfortunately, things are never simple.  Trustees understand that asset values can fall and rise but have greater difficulty in understanding that liabilities can do the same.  Liabilities are calculated using assumptions, the more conservative the assumptions, the greater the liabilities appear.  That’s why a scheme deficit is different on an ongoing valuation basis and a buyout basis.  The only way to pin down the liabilities is essentially to get someone else to take them over.

Since June 2003, if a scheme wants to wind up it has to ensure that all members’ benefits are guaranteed.  Traditionally the way to achieve this is to pass the risk to an insurance company.  However, insurance companies have much greater solvency requirements than pension schemes and if asked to guarantee a benefit, must invest the assets accordingly, ie: in low risk assets.  Hence, the buyout cost for a lot of schemes tends to be prohibitive.  Using a phased Buyout could spread the cost of securing the liabilities but it is still an option that may be beyond the current reach of many employers.

So what other options are there for smaller schemes?

Managing the deficit covers a lot of ground, again simplistically, you either increase the assets by investment performance and/or additional contributions, or you reduce the liabilities, ideally you do both.

Increasing the assets is perhaps the easier option.  A review of the scheme investments to see how they are aligned to the liabilities can deliver better returns.  A significant number of smaller schemes have a large mis-match between their assets and liabilities.  In a lot of cases, this is not due to a conscious decision but more the case of nobody has reviewed the investment in light of changes to the scheme.  A significant number of schemes have, for example, investments in a Balanced Managed Fund with an equity content well in excess of 75%, yet they are paying pensions from the fund, ie: having to sell equities to pay pensions; not a great idea in a volatile market. 

Reducing the liabilities can be tricky.  A lot of schemes will have taken the step of closing the scheme to future accrual.  Whilst this will limit the increase in liabilities, it will not stop the increase totally.  Improving mortality affects the benefits that the scheme has already promised.

Buying annuities, either in full or in part, can transfer some or all of the risk away from the scheme.  Independent advice needs to be taken as the annuity market needs careful consideration and expertise.  This exercise means reducing the scheme assets, however, if the liabilities are reduced by a greater amount, then the deficit has been reduced.

Another method becoming more common is to “persuade” members to leave the scheme with transfer values.  If the scheme is in deficit, then transfer values will be reduced to reflect the solvency of the scheme. 

The employer may decide to enhance the transfer values up to and possibly beyond the full entitlement.  The idea here is to encourage members to take the transfer and therefore reduce the liabilities of the scheme.  Great care needs to be taken in these exercises that members receive independent financial advice and trustees need to ensure that anything they do is in the best interest of the scheme members.

A variation of the above is to offer the member a reduced transfer value but in addition offer a cash incentive, if he/she takes it.  Previously these cash incentives used to be tax-free, however, HMRC has, not surprisingly, now decided that any payments will be subject to tax and National Insurance.  Even greater care needs to be taken with this sort of exercise from both the trustees and members’ points of view.  The Pensions Regulator has issued guidance to trustees on how to deal with these exercises.

In summary, therefore, there are steps that schemes can take to begin the process of managing the scheme deficit until the end game comes into sight.  Like most situations, it is rarely a case of a single silver bullet, but more a case of a series of smaller steps that in isolation may not have a dramatic effect but collectively provide a light at the end of the tunnel.