That comforting nest egg for your loyal employees, the company pension scheme, may be hatching into a ravenous monster that will eat your business alive. Victoria Madine explains why – and what companies can do to escape.
The chairman was looking forward to drawing his company pension. He had ploughed in up to 20% of his salary throughout his working life; now it was time to harvest the rewards of 40 years of industry and thrift. Or so he thought. Instead, he found that he had to say goodbye to 30% of his accumulated savings just to keep his company's scheme afloat.

This is an extreme – and true – example of how the boss of a medium-sized contractor got caught by the demands of running a final salary pension scheme. But companies of all sizes are trying to cope with the potentially crippling costs of these schemes. A Building survey has revealed that 15 of the top 25 contractors still operate them, and any competent pensions adviser would urge a client to join then immediately.

Most of the schemes are generous, but then final salary schemes are generous by their nature. Employers agree to pay a percentage of their employees' salaries when they retire, irrespective of the companies' financial state or the performance of the stock market. In other words, the employee has a guaranteed outcome and the employer takes on the risk associated with providing it. As John Jory, deputy chief executive of pension provider B&CE Benefits Schemes, puts it, these are "Rolls-Royce" pensions. "The individual knows precisely what he or she will get. But for the employer, it's an open-ended financial commitment, which represents a real headache – it wants certainty so that it can budget."

What has changed in recent years is that the risk and expense of operating a final salary scheme has increased. This can be attributed to three trends, all beyond an employer's control: people are living longer, investment returns on the stock market are falling and fund regulations are being tightened. The result is that they are eating up more and more of companies' profits.

Paul Hodgkinson, chairman and chief executive at contractor Simons Group, says many companies are in a "desperate panic" to sort out pension funding. "Companies are holding their breath; a final salary scheme is a huge contingent for a company to bear. They are jumpy about the subject because they know that these schemes are untenable in the long run – partly because people are living so much longer. But it takes a long time to transfer; we've spent over 15 years sorting our scheme out."

Graham Rice, managing director at Heery Construction, says final salary schemes have no future and calls them a huge long-term gamble, where the odds are getting longer. "Pensions are a massive problem. Our company offers a final salary scheme – we're part of Balfour Beatty – and at the moment we've a surplus. But what about in 30 or 50 years' time? People are going to live longer, until they're 100-plus. Companies can't afford it."

How it works – and doesn't
Final salary schemes (or defined benefit schemes, as they are also known) are the most traditional form of pension provision. Between 80% and 100% of the eventual payout is related to the employee's final salary. Most commonly, pensioners receive one-sixtieth of their final salary for each year of membership. Under Inland Revenue rules, this can reach a maximum of two-thirds of their final pay. Membership of the scheme means employees must pay in a fixed percentage of their salary, for which they receive tax relief; the employer usually contributes a higher amount, which it is legally obliged to maintain.

It is becoming increasingly likely that some of this money will come out of a company's profit, given the decline in the value of equity markets and dividends, and the government's imposition of tax on pension fund investments. Wealth management consultant BDO Stoy Hayward says the average company pension scheme has fallen 15% in value over the past two years. Actuary Richard Tewkesbury at BDO says it is also becoming harder for companies to manage their pension funds because of the uncertainty in the stock market. "Projections are very important for these types of fund, and the volatility of the stock exchange means it is harder to plan for the fund's future," he says.

Another burden for companies is that they have to pay more into their schemes to keep them fully funded. The government introduced this "minimum funding requirement", or MFR, in April 1997 as a response to the Mirror Group pension scandal. As you will recall, Robert Maxwell raided his pension fund to try to prop up his tottering network of companies - and thousands lost their pensions as a result. The MFR tries to prevent that happening again by requiring companies to top up underfunded schemes quickly.

Many companies have found the requirement too stringent. BDO's Tewkesbury says the MFR has hit smaller contractors particularly hard because it requires them to make a dramatic increase in employer contributions. The government has promised to scrap the MFR, but it will take up to two years to remove it from the statute books and its replacement will not necessarily be any less onerous.

Escape routes
In other industries, companies have started to move away from final salary pensions – Marks & Spencer is the latest to close its scheme to new employees. Major contractors are, however, proving slower to heed warnings that final salary funds are impossible to maintain.

The preferred escape route is increasingly the so-called money purchase schemes. These require an employee to put a percentage of their salary into their own fund (rather than a collective pool) to which the employer contributes a specific amount as well. When the employee retires, the pension is based on that fund. If the stock market falls, the value of the fund falls with it – and the employer is under no compulsion to make up the difference. This means that the scheme carries no risk for the employer, but has no guaranteed value for the employee.

Smaller companies have been the first to switch to money purchase schemes, as they can least afford final salary pensions. Simons, Norwest Holst, Bowmer & Kirkland, Mansell and YJL have all switched in the past 18 months. Kier Group and Galliford Try are in the process of transferring now. Annette Sale, Kier's pensions manager, explains why: "We want certainty of cost. We don't think that a money purchase scheme will actually save us money - it's expensive to set up – but at least we'll know exactly what our outgoings will be."

Most large contractors, however, are sticking with final salary schemes for the foreseeable future. Peter Fryer, group pensions manager at Mowlem, offers an insight into this: "We've had a final salary scheme since 1946. Our directors are members of it – they value it, and they consider it a major benefit to employees. But we realise that the world is changing, and it might be that in five years or so we'd look into an alternative arrangement."

However, actuaries say it will become increasingly difficult to move out of final salary schemes as the government is likely to replace the MFR with even tighter regulations. Jerome Mercer, an actuary at BDO Stoy Howard, says companies, especially smaller ones, should think about reviewing their final salary schemes now. "There will be stringent control of companies wanting to wind up their defined benefit schemes, because there is a general view in parliament that pension funds should be further secured," he says.

Yet another reason that companies in other industries are closing their final salary schemes is that a fearsome new accounting rule hovers on the horizon. This is Financial Reporting Standard 17, and it comes into force in June 2003. It stipulates that a company has to give financial details of the state of its pension fund in its accounts, which means that shareholders will be able to see in advance where a company may have to top up its pension fund out of its profit. BT, which has nearly twice as many pensioners as paying members, has already warned that its pension scheme has a £4bn deficit.

Hodgkinson says the the introduction of the rule will leave companies' balance sheets "rattling around like mad". He says: "This, as much as anything else, is causing companies to carefully review their pension provision." The risk of a deficit becoming public knowledge is encouraging companies to review the way pension funds are invested.

An alternative to equities
Recently, Boots turned its back on equities and put its entire £2.3bn fund into bonds, a debt issued by a company or public corporation at a fixed rate of interest. The more usual level for bonds is 30%, which is how much Kier has.

This makes it a stable investment, but its yield is relatively low; only companies with a healthy surplus can afford to put the bulk of their assets into bonds. Still, with so much uncertainty in the stock market, some contractors are looking to bonds to stabilise returns on their pension funds. Balfour Beatty says that most of its cash is in bonds. A spokesperson said:

"Our investment policy changed very recently; we've decided that bonds are more reliable than equities."

The construction industry is proving to be a leader in one aspect of pension provision – stakeholder schemes. Since last month, all companies employing five or more employees were required by law to provide employees with a stakeholder pension scheme. Only those earning less than £30,000 are eligible and members receive tax relief on their contributions.

Construction workers hold more than 60% of all the stakeholder pensions so far issued in the country. Most – 160,000 workers – are members of the B&CE's Easybuild stakeholder scheme.

This is good news, although unions warn that stakeholder schemes can leave people short of funds when they retire, and employers are not obliged to pay a contribution.

For Rice at Heery Construction, the pensions question will be settled by demographics, and it is not just construction that will have to rethink pensions: "The world's major economies are slowly waking up to the fact that their populations are ageing. In the long run, more countries will have to set up systems like that in the USA where the individual runs their own pension trust. Ask an American how much their pension is worth and most will be able to tell you straightaway. Ask the average person in this country and they won't have a clue. This says a lot about people's attitudes."

Colin Harding, chairman of Bournemouth contractor George and Harding, agrees that the future of pensions lies with individuals: "The notion that it is up to your employer or the government to look after you in your old age has got to change, because soon they just won't be able to." He adds: "Who knows? It could even become compulsory for underfunded schemes to be wound up – and then what choice will members have about their future?"

Moving to money purchase: the Morgan Sindall way

When contractors Morgan Lovell and William Sindall merged in 1994 to form Morgan Sindall, the directors decided on day one that final salary schemes were an “open cheque book”. So the two companies closed their schemes in favour of a money purchase arrangement. Since the merger, the company has made six acquisitions. Ray Johnston, company secretary at Morgan Sindall, explains how the firm tackled the pension funds of the companies it has bought. “So far, each of the businesses we’ve bought has been part of a larger holding company, so we’ve not actually taken on a company that had its own scheme. Where we’ve acquired a company that contributes to a final salary scheme, we’ve offered the employees two choices: they can remain as a deferred member of the scheme, or they can get a transfer value. This means that an actuary calculates the value of the contributions made by the employee into the scheme, and this is transferred into a money purchase scheme.” John Bishop, group finance director, says the money purchase scheme is preferable for company and employees. “It’s portable, and gives the individual more choice. Our employees are trusted to make important decisions for the company – so why should they not be able to decide how to invest their own money?” he asks. After each acquisition, Morgan Sindall gives every employee the chance to meet the company’s pension adviser. The adviser works out if the individual has anything to lose by transferring to the money purchase scheme. If an employee would lose out, their salary is increased to make up the difference. Bishop says: “We’ve had no complaints about the system we operate. The employees don’t lose anything, but we gain certainty.”