The billion-pound black hole

Last month, 170 employees of Keller Group became the latest victims of an employer's decision to "do a Rentokil". No longer could they bank on the comfortable retirement they thought they had been saving for - the firm was closing its final salary pension scheme, freezing their benefits and moving them to a far less generous alternative, just as Rentokil had before Christmas. Like Rentokil, the motive was to cap a liability - Keller's pension fund had a £11.3m deficit.

They will not be the last. Building's survey of the top 20 contractors found they had a combined deficit of just over £1bn, a heavy weight on the industry's balance sheets at a time of mounting pressure to reduce debts. Most firms have already closed final salary schemes to new employees - among the top 20 contractors, only Amec has not. But as deficits continue to grow, it is becoming clear that this is not the solution to the problem, just the first step in the painful process of reneging on promises that companies cannot afford to keep.

"This is the one thing that's going to be on the agenda of every company in the UK for the next 12 months at least," says Paul Drechsler, chief executive of Wates. "Final salary schemes are the world of the past. They just don't work any more." Wates closed its final salary scheme to new members in November 2001 and has since raised employee contributions twice, but Drechsler admits that it cannot guarantee not to make further changes in future. "The future for pensions is a very long time," he says.

Final salary pension scheme your balance -£1,000,000,000.00. Available funds: £0.00

An unsustainable situation

Final salary schemes give an employee a lifetime's entitlement to a proportion of their salary, with rises linked to inflation. They are also known as defined benefit schemes - and herein lies the problem: whereas the benefits for members are guaranteed, companies must gamble on an increasingly volatile stock market to ensure that there's enough money to look after members over the course of their ever-lengthening lifespans. This is a situation that most companies consider to be unsustainable. The alternative to defined benefit is a money purchase or defined contribution scheme where both employer and employee pay fixed amounts into a personal fund and it is the employees who take their chances on the stock market. Switching from a final salary scheme to a money purchase one can be quite a blow.

There are simply too many variables in pension schemes to make final salary workable in the long term, according to Charles Cole, finance director of Costain. "It's very difficult to control the uncontrollable," he says. "Equity rates, bond rates, inflation, mortality rates - you can't influence most of these variables." From April, Costain will pay members only an average of their salary throughout their career. "What career average does is take the sting out of inflation, and gives us more control over it," says Cole.

Of the top 20 contractors, nine have already increased the amount employees must pay into the scheme or cut the amount they will receive. For example, Carillion gave members the choice of keeping their contribution rate at 5% of pensionable pay but accruing only one-80th of their final salary for every year worked, or increasing their contribution to 7% and maintaining the previous accrual rate of one-60th.

The rest of the industry is unlikely to be far behind. "I'm sure you'll find that member contributions will rise across the sector over the next five years. That's a safe prediction," says Keith Clarke, chief executive of Atkins, which closed its final salary scheme to new employees in 2001, and has since raised contributions from 3 and 5% to a standard 8.5%. Clarke adds: "Most companies are recognising that the cost of providing pensions is going up and as long as it's done properly this is a good way forward - 8% is a perfectly reasonable contribution today." Clarke believes firms that have yet to take action are burying their heads in the sand.

Corporate pressures

New accounting rules introduced last year, called FRS 17, have put greater pressure on firms to control deficits, by forcing them to disclose the figures more openly on their balance sheets. "FRS 17 didn't worsen the situation, it just means that disclosure is greater," says Alastair Stewart, an analyst at Dresner Kleinwort Wasserstein. "It was always there but hidden away. It's much more volatile now on the face of the balance sheet rather than stuck away in note 40 to the accounts. It will probably concentrate minds wonderfully."

Deficit in this context is just another form of company debt, which is particularly bad news for construction firms. As Stewart says: "The higher your deficit is relative to your assets, the more risky it becomes. Contractors have large numbers of people working for them relative to asset values or market cap, whereas in a big materials company there aren't so many people. It's a problem getting worse across all of the industry. People are living longer and everybody's going to have to pay in more to bring down deficits."

In the worst cases, the deficit could pose a threat to the health of the company. "It's perfectly possible for companies to go under because of pension problems," says Paul McGlone, principal and actuary at Aon Consulting.

Having a large pension deficit is also a break on corporate activity - a firm with a fast-growing debt is less attractive to potential buyers. The flurry of mergers and acquisitions predicted in the industry has ramped up the urgency with which company directors are addressing the gaping holes in their funds. "Pension fund deficits are now major issues in delivering mergers and acquisitions," says Mark Aedy, head of European multi-industries at investment bank Merrill Lynch. "If there's a sizeable deficit, that will be a deterrent to any investor or venture capital involvement." Though Carillion's directors weren't put off buying Mowlem by its £99m pensions shortfall, they had to agree to pay in an extra £13m a year for the next 12 years - a factor that will certainly have influenced the price.

Firms must also fear the scrutiny of a beefed-up Pensions Regulator. Since April last year, it has had the power to step in if any corporate activity puts the fund in jeopardy, an unwanted hassle for companies engaged in merger talks. Then there is the possibility of intervention from the fund's trustees - usually a mix of members, current or former executives and independent advisers who are there to protect employees' interests. For example, when a private investor tried to buy WHSmith in 2004, its pension trustees stepped in to demand the repayment of a £215m deficit - effectively scuppering the deal.

However, members have little recourse when firms do decide to change the terms of their pension scheme. A company must obtain the consent of the pension fund's trustees, but their role is arguably to protect the existing fund rather than argue for future benefits. If the firm can convince the trustees that there is no way it can meet the shortfall on its own and that the deficit is posing a real threat to the future of the company and its employees, they will have little choice but to negotiate.

On 6 April, one of the provisions of the Pensions Act 2004 comes into force. This requires all companies to consult rather than simply inform the members of a pension fund before changing its terms in certain ways. But, according to Iona Whitaker, a partner in the pensions group at law firm Pinsent Masons, this will confer no extra powers. "Employers have to consult, but they still don't have to get members to consent. Members could threaten to go on strike, but apart from that, they can't really do anything." About three-quarters of Whitaker's clients, which includes several in the construction industry, are considering changing the terms of their schemes' benefits.

The higher your deficit is relative to your assets the more risky it becomes, Alastair Stewart, Analyst

Can the unions help?

Trade union leaders have vowed to fight any moves to chip away at pensions. While at least parts of the construction industry are more unionised than firms such as Rentokil or Arcadia, this could be easier said than done. As far as Bob Blackman, head of construction at the T&G, is concerned, closing the scheme to new employees is merely the thin end of the wedge. Once the firm has taken this crucial first step, staff turnover ensures the number of active members in the scheme will drop off quickly, so relatively few employees have any financial interest in preserving it. "It's hard for unions to intervene because you're bargaining for people who don't work there. People won't fight to maintain a scheme they're excluded from." In the case of Rentokil, for example, only 3000 of its 48,000 staff were affected by the final salary scheme's eventual closure.

Employees can take some crumbs of comfort from the fact that there is clearly some unwillingness on the part of employers to think the unthinkable, not least because many senior managers will be part of the final salary scheme. The fact that construction firms are competing for skilled staff is another reason not to cut the total remuneration package, as Wates' Drechsler points out. "Employees have a lot of choice, so whatever you do, you've got to be competitive. If the contributions are high, it's employees trading off take-home pay against pension benefits. What any company wants to do is fulfil its obligations to employees - if you're going to change things, you don't do it lightly. I don't think people will do it unless they have to."

Nevertheless employees may find they have little choice but to accept the passing of their generous retirement packages. As one industry watcher comments: "It's not wicked capitalists. There is a finite pot of money and people are living longer. There's no two ways about it - you either pay more or benefits go down. You can't make money out of thin air." When you put it that way, it looks like the final salary dream is well and truly over.