Pensions Stock-take

Pension mis-selling, the indifferent take-up of stakeholder pensions, poor returns when people retire from their jobs and have to buy an annuity with their pension 'pot' are all common stories in the personal finance pages of the broadsheets and some of the tabloids.

But an issue which is very technical on the face of it gets just as much prominence - that big companies are giving up their final salary pension schemes and forcing new employees to join money purchase arrangements, or nothing. The Federation's Executive Board recently considered the implications of this development for the sector.

This Update provides a stock-take, aims to dispel some over simplistic assumptions, and also makes some points on the future of the Social Housing Pension Scheme, to which well almost 700 housing associations belong.

Future of final salary shemes

Rarely a week passes without an article in the press about the dire state of pensions and the pensions industry in Britain. Many of them are about the predicted likely death of final salary schemes (sometimes known as defined benefit).

This Update looks at some of the issues at stake, particularly related to the health of pension provision in the housing association sector and to the future of the largest sector wide scheme, the Social Housing Pension Scheme (SHPS). Pensions are for many people the biggest or second biggest purchase they will ever make.

Because it comes as a 'free gift' with their job, many think far too little about it until too late. Employers in the private sector have recently appeared all too often to exploit this indifference at the expense of a secure financial retirement for their staff.

The chair of the National Association of Pension Funds recently wrote: " the imminent demise of final pay pension schemes has been confidently predicted for as long as I can remember. However, these schemes, and the companies operating them, feel under more pressure now than ever before. There are many reasons for this... : cost pressures, regulatory pressures, and of course FRS 17."

To take the first and third of these in turn, beginning with costs:

The differences between a final salary scheme and a money purchase (defined contribution) one are broadly:

• final salary means that benefits on retirement are calculated from the years of service and the final salary of the employee, and so are not dependent on how well the scheme's investments have done
  
• money purchase benefits depend on the total of contributions which employer and employee have made to the scheme, and how well this sum has been invested; the employee on retirement will receive the results of that investment
  
• money purchase schemes normally give the employee more flexibility if moving jobs several times over their career to take their pot of investment with them, but place much more responsibility on the individual to ensure that they have built up enough assets to provide an adequate retirement income
  
• final salary schemes thus leave the risk of cost increases largely with the employer; money purchase leaves the risk of adequate investment return with the employee.

It is necessary to explore the issue of costs of final salary schemes a bit further. Through the 1980s the investment funds that had been set aside from employers' and employees' contributions performed so well that many employers were able to take contribution 'holidays' especially if benefits were not indexed to inflation. Public sector schemes were generally indexed but they also benefited from investment performance.

The 1990s brought a number of changes:

• the need to index benefits where this had not been included before
  
• life expectancy increasing, so that investment growth has to be better if benefit entitlements are to be maintained
  
• withdrawal of some of the tax benefits of pension schemes by the present government
  
• and now, a low inflation environment which has reduced likely investment returns.

The result has been that actuarial valuations – usually carried out every three years – have shown for many schemes the need to increase contributions for at least a period of years to restore funding adequacy.

If employee contributions have been left alone, this has geared up the percentage increase needed in employers' contributions. It is fair comment that employers bear most of the risk of cost increases for final salary schemes, just as employers benefited most from the years of high investment growth.

Employees are not immune from risk where a significant part of pension fund investments have been in the company itself. (This risk applies to money purchase schemes as well, as Enron bears out.)

Finally the fairly new accounting standard, FRS 17, increases for defined benefit schemes the transparency of the true cost of pension provision in published accounts. This applies in full to accounting periods ending on or after 22 June 2003, but will then require expanded notes about pension scheme contributions, investment returns and valuations, and most significantly a recognition of the scheme surplus or deficit on the balance sheet.

Multi-employer schemes such as SHPS (see below) will be exempt from the more rigorous requirements and can account for contributions payable to the scheme as if it was a money purchase scheme.

Many employers with their own pension scheme have been concerned at the effects of the FRS in increasing volatility of their accounting results. FRS 17 however has no effect at all on the economic fundamentals or viability of such schemes.

Private sector action

According to the Government Actuary's Department, by 2001 there were almost two million fewer employees in final salary schemes than there had been a decade earlier.

The press in 2002 so far has been full of stories of major companies closing their final salary scheme to new entrants. A handful of companies appear also to be changing the pension provision for existing staff.

The last National Association of Pension Funds (NAPF) survey (covering mainly the year to March 2001) showed that 42 out of 402 private sector respondents had closed a final salary scheme to new entrants in the previous 12 months (and so had 4 out of 61 public sector respondents).

Out of 456 respondents, 352 thought that FRS 17 made the offering of a final salary scheme less attractive, though a significant number intended to implement the standard before 2003. However of other factors currently affecting pension provision 28% of respondents thought that the proposed abolition of the Minimum Funding Requirement would bring a greater likelihood that the existing final salary scheme would remain open for new members.

There is a case sometimes made that final salary schemes are a somewhat paternalistic relic of the past. The Americans began to desert final salary schemes in the 1980s and money purchase schemes gained ground in a more flexible labour market, where employees gained more control of their own retirement savings. The last Economist survey of pensions (16 February 2002) makes this case strongly.

It did not balance some of its comments with the acknowlegment that, in the current low inflation environment, annuity rates ( what a cash sum at a certain age will buy as an annual pension until death) have fallen catastrophically over the last few years. This means that pensioners relying on money purchase provision will find it impossible. To obtain anything like the pension obtainable by pensioners with a similar 'pot' ten years ago.

But if there is a case for changing from final salary to money purchase in some circumstances, there seems much less case for companies using this as the opportunity to reduce often radically the cost of their current employer contributions.

The same NAPF survey shows that for final salary schemes in the private sector the average employer's contribution was 9.2% (10.7% where no employee's contribution).

Members'contributions where paid averaged 4.8%. In the public sector schemes, employers contributed 11.8% (11.9%) and members' contributions where paid averaged 5.1%.

Looking then at money purchase schemes, members contributed slightly more – 5.6%, but the average contribution of employers in contributory schemes where employees contribute was only 6%.

Judging by the press stories this year, employers closing their final salary schemes to new entrants are often cutting back very significantly on the contribution made to the replacement money purchase arrangements. Employees not only have to take all the risk of investment return in securing an adequate pension, but may be given a raw deal in the amount invested for them by their employer.

Sector issues

A number of Federation member associations are known to have their pension schemes under review. Housing associations reviewing their pension arrangements will need to do this in the context of their overall pay and benefit package.

At a time when recruitment and retention issues are of great importance to many in the sector, the potential effects of a change which adversely affects employee benefits could be damaging.

Good pension schemes can reflect and evidence the values of good employers – in terms of a secure future and the valuing of staff.

For employers with final salary schemes facing an adverse actuarial valuation, there are many options:

• increase employer contributions for the period necessary, in the knowledge that national insurance contributions will also be rising from April 2003
  
• increase employee contributions, as above
  
• some combination of these two
  
• review benefits given under present scheme with a view to trimming more generous ones for future service
  
• consider a hybrid scheme as some private sector employers such as Tesco have done, e.g. rebasing pensionable earnings as an average of perhaps the last ten years of service, or investigating the Pension Trust's CARE (career average revalued earnings) scheme
  
• offer only money purchase arrangements to new entrants
  
• consider also the scheme offered to existing members of the scheme for their future service.

It is worth considering that staff in an existing final salary scheme may well have their own views on how best economies can be made in order to protect the fundamentals of a valued scheme.

The social housing pension scheme

The Federation was responsible, with the Housing Corporation, for establishing this sector final salary scheme in 1977. While the Corporation has relinquished its interest, the Federation is represented (by Stephen Duckworth) on the Scheme's Committee, and the Committee has good representation from the sector generally.

SHPS has grown very significantly in the last 25 years. The membership now totals approximately 35,000, and the funds under management are around £660 million. Over 680 housing associations use the Scheme. Benefits paid out under the Scheme last year totalled approximately £12 million.

The size of SHPS brings benefits of scale in administration charges and in investment management costs. It is a good scheme in terms of benefits as well as offering wide transferability within the sector. Employers can use it as a positive element in recruitment.

The Committee at its last meeting in March thought it would be helpful to provide members with reassurance about its future in the light of the events and debate discussed earlier in this Update. A letter is currently going to all employers in the Scheme, and a letter to all scheme members is being sent with annual benefit statements in the next few weeks.

Some of the key points in the employer letter are referred to below:

• the Scheme continues to attract new employers and new members each year
  
• as a multi-employer arrangement, the Scheme is less adversely affected by FRS 17 than single employer pension providers
  
• the triennial valuation in September 1999 showed a small deficit which it is planned to eliminate by changes to the benefit and contribution structure already implemented
  
• the present contribution arrangements are an average rate of 4.5% of pensionable salaries from members, and 10.6% paid by employers
  
• the results of the September 2002 valuation are expected in spring 2003; at this stage best information is that an increase in the order of 1% in the total (employers and members) funding rate may be required. However this is based on limited data and the Committee must await the results of the full valuation
  
• if changes in contribution rates and/or benefits are to be considered, then consultation will be undertaken with members and employers
  
• the code of practice adopted by participating employers provides for any cases where employers consider closing the Scheme to new employees; they are charged a 'premium' given that the average age of their members would then increase each year and to avoid them being cross-subsidised by other employers who keep the scheme open to all employees
  
• this premium is currently 2% of pensionable payroll, and the Committee is seeking actuarial advice on whether it remains adequate.