FOOL'S EYE VIEW
The Death Of Company Pensions

By Stuart Watson (TMFTiger)
February 26, 2002

Great Titchfield Street, London – There have been some fairly excessive headlines about pensions in the last couple of months. 'The Death Of Company Pensions' is my own little contribution. They all relate to the recent trend of companies shutting down their defined benefit, or final salary, pension schemes. These are schemes where the final pension is based on a percentage of the employee's final salary and the employer takes on the risks of making sure that there's enough money in the pot to pay it. If there isn't, then the employer has to put more in. If there's money left over, then the employer gets the excess.

In the last few years, more and more schemes had been closed to new members although those who had joined at an earlier date could continue with them. But now we're seeing many companies announce that the schemes are being closed down completely and existing members are seeing their pensions moved to defined contribution schemes instead. Here the pension payouts are linked to how much is put into the fund and how it grows. The onus is on the employee to monitor the pension and decide if more needs to go in. Of course, if the fund does especially well, then the employee gets the benefit. So it's the employee that's taking on the risks.

Why has it happened?

There are many reasons for this shift. The 1980s and 1990s saw rapid gains in shares and many companies were misled into thinking that their pension funds were stronger than they actually were. They cut back on their contributions to the funds, thinking that the difference would be made up by growth in the fund's investments. The last couple of years have been a nasty wake up call. On top of that, the government has made pensions less attractive by not allowing them to reclaim dividend tax credits. This meant that companies had to put more into these schemes to get the same level of pension.

A new accounting standard called FRS 17 hasn't helped either. This affects the way companies account for their pension costs and liabilities. Most of the effects are cosmetic as it only alters the presentation of the numbers rather than affecting crucial numbers like cash flow. In some cases though, the costs charged against profit reserves will impact upon the company's ability to pay dividends. But it' the cosmetic considerations that seems to bother companies the most, even though most investors and lenders can see straight through them.

One factor that doesn't get mentioned a lot is that stopping these schemes is a route to cut costs. And companies are desperate to find ways to make their profits look better at the moment. In the typical defined benefit scheme the company contributes around 10% of the employee's salary. However, it is reckoned that companies only put in around 6% of a salary into a defined contribution scheme. Slashing 4% off your annual wage bill at one stroke is too good an opportunity to pass up for many cash-strapped companies.

But the biggest single factor is that, with people now living longer, companies are having to put much more into these funds than they did in the past. Providing pensions for people expected to live for 25 to 30 years is obviously far more expensive than providing for those only expected to live for 10 to 15 years. The sums simply don't add up anymore, just as they didn't for the State Pension back in the 1980s when the link with earnings was abolished. In all probability, changes like the removal of the dividend tax credit and FRS 17 have only speeded up the demise of final salary schemes, rather than causing it.

Are defined contribution schemes worse?

Companies do pay less into defined contributions, but part of the reason for this is that employee contributions are fixed. If they were fixed too high, meaning the company's contributions were lower, few people would take them out in the first place! On the flipside, someone offering to pay 6% into your pension is not to be sniffed at. For an entire working life this could amount to over a third of what's needed. Is it really that unreasonable for us to stump up the remainder?

Defined contribution schemes are also a lot more transparent and portable. We know that the more we put in, the more we will get out and it's easier to see our pot build up each year. With many people changing jobs on a regular basis it is to our advantage having a scheme that we can take with us. This avoids the horribly complex calculations of transferring one defined benefit scheme to another where it is far too easy to siphon off a large chunk in charges without us being any the wiser.

A betrayal of workers' rights?

There has been talk that all this is a betrayal of workers' rights. However, exactly what rights are being betrayed is unclear. Most employment contracts don't say that the companies agree to give the employee a decent retirement income, and presumably they don't commit to continuing with a defined benefit scheme. The real problem is that expectations on both sides weren't realistic. Employees didn't realise that the rules could change at short notice and therefore failed to make appropriate back-up arrangements.

The need to be aware of where we stand with regard to our pension funds is now more apparent than ever. It was always important, but few of us realised that. For the majority, the most important determinant of how big a retirement income we receive is not where we put it or what sort of tax breaks we get. It is simply how much we tuck away. Decent pensions do not magically appear out of thin air. A report issued today by the Pensions Policy Institute acknowledges this, saying that the typical 25-year old will now have to delay retirement until 72 in order to receive a similar level of benefits as 25-year old would have done 40 years ago.

If you need a further incentive then it's worth checking out the State Pension Retirement Forecast. It takes a few weeks to come through the post (my own forecast was the inspiration for this article). Make sure you're sitting down before you open it though.

More: Pension Centre