Pension deficits: Should you be concerned and what are your options?
While the BHS pension situation has hit the headlines, the number of defined benefit pension schemes that are running a pension deficit have been growing over recent years, all the while the pension deficits themselves continue to increase.
While the pension regulators are doing all they can by working alongside the firms running the pension schemes in an attempt to minimise the pension deficits, in some cases the gap may now be too large.
If you have money invested in a defined benefits scheme or a final salary scheme, even if it is with a major organisation, you should investigate the options available for people to minimise the risk of their investments not delivering in retirement.
What is a pension deficit?
A pension deficit is defined as the gap between how much a pension is required to pay out vs how much money is available to pay out. The deficit occurs when there isn’t enough money to pay, i.e. when the liability is greater than the assets.
While a pension deficit is clearly not a positive situation, it does not necessarily mean that the scheme is going to fail. Once the deficit is reported to The Pensions Regulator, the sponsoring employer will create a plan to close the deficit – although this will often be over a significant period.
Funding the deficit means that the sponsoring employer is likely to have its growth affected as it directs revenue and profit into closing the gap, which could also have an impact on employment as salaries.
It is not impossible for a sponsoring employer becomes insolvent (i.e. it fails) and in such situations, the pension fund will be accepted under the Pension Protection Fund – but in many cases this will not necessarily mean that the pension will be fully protected and members therefore may not receive the full benefits promised.
Which pension schemes are particularly exposed to risk?
Typically, occupational pension schemes are particularly exposed to the risk of pension deficits. People who have been paying into final salary pension schemes, defined benefit schemes and any pension scheme which offers a guarantee of an annual salary at retirement are particularly at risk.
It’s already known that some major oil and gas companies pensions are running significant pension deficits including BP and Shell, while other FTSE 100 companies including BAE Systems and BT.
Why are there pension deficits?
It is important to note that, while there are some major employers whose pension schemes are in deficit, not all schemes are. Obviously “bad news” sells, so it is easy to automatically think that there is a problem with all occupational, defined benefit and final salary schemes, but this is not the case, it just so happens that these are the ones that get news coverage.
There are several factors as to why there are pension deficits.
Increase in life expectancy
Firstly, as people live longer, pension schemes which guarantee an income for life in retirement are therefore required to pay out for a longer period – which often means that far more money is being paid out than was planned for.
Under-performing investments and currencies
It is also possible that a deficit could be caused by a fall in the value of equities and bond yields, both of which are often used as investment vehicles for pension funds. These decreases may be short or long term, but the impact is still the same – the real value of the whole pension fund is decreased. Conversely, it is also possible for the values to increase over time, increasing the pension fund value and reducing the deficit.
In the current environment, particularly with the uncertainty surrounding the EU Referendum result and subsequent devaluation of the pound, bond yields have fallen significantly. However, some of these losses have been curbed by investors hedging on the falling pound.
Underfunding pension schemes
Another reason for a deficit to occur is simply that the company in question has underfunded the pension pot due to poor financial performance. However, this will often be offset in the longer term as company performance can be affected by significant political changes, restructuring, fines and other items which eat profits in the short term. Once performance improves, the deficit is often closed once more.
The effects of pension mismanagement
In very rare cases, a pension deficit can occur due to mismanagement of the pension scheme itself, with corporate owners taking dividends out of profits, rather than funding the pension schemes. For example, according to analysis by AJ Bell, 35 companies in the FTSE 100 have paid out more in dividends to investors than the size of their pension deficit. However, it is often not as straight forward as this, but companies should always be trying to balance profitable growth and shareholder pay-outs with retirement benefits due to staff.
The impact of long term low interest rates on pension deficits
Another key factor which has led to the deficit for defined benefit schemes is the historically low interest rates. In order to purchase ‘an income for life’ for a scheme member, because interest rates are at an all-time low, the scheme needs to set aside more capital to provide that guaranteed income.
Looking at historical annuity rates, the cost of providing the guaranteed income is much higher now than it was in the days where annuity rates were 8% per annum or more. Of course, because people are living longer these days the starting rate for an annuity is lower anyway as statistically, it will need to be paid for longer.
How historical decisions have also led to deficits
Conversely, there was a period in the late 1980’s and early 1990’s when defined benefits schemes were finding very good performance in their pension assets as interest rates and equities were providing double-digit returns each year.
Because of this short-sighted approach, a number of schemes took contribution holidays and went through a period where they no longer allocated further capital to the scheme. This will have made share-holder returns look a lot better during those times but is having a negative effect now that this needs to be put right.
When should you be most concerned about pension deficit?
As mentioned previously, not all pension schemes are in deficit but there are a number of high profile companies whose pension schemes are running a significant deficit.
The key factor which should raise concerns is when considering the future viability of the sponsoring employer/company behind the pension scheme and their likely future profit potential.
With so many factors to consider (political, economic, environmental, legal, social) that can impact on an organisations profitability, it is always sensible to seek independent advice to raise any concerns and get clarity on the potential risks and, ultimately, options available to you.
One thing to remember is that, even if there are negative headlines, there is normally much more to the story than is being reported. Therefore, before making any decisions – or getting overly concerned – you should seek independent advice to assess the situation in full and enable yourself to make an informed decision about your most suitable course of action.
What are the options available if you are concerned about your pension scheme?
Depending on your current situation, there could be a number of options available to you if you are concerned about your pension scheme. Below we provide an overview of a few of these options, but we are not making any recommendations. You must always seek independent advice before making a decision, and you should never use generic articles for the sole purpose of making your decision.
First and foremost, you have the option of doing nothing. While this might sound obvious, depending on your circumstances there might be nothing you can do. Similarly, there might be no reason to be concerned, or you might incur penalties for making changes. Remember, there are some protections in place so you may have no reason to do anything.
With final salary or defined benefit schemes, you will have the option of taking an income for life, or taking a reduced income with a lump sum (by commutation). The lump sum is known as a Pension Commencement Lump Sum (PCLS) and is currently free of UK tax.
Traditionally, people tend to opt for the lifetime income, purely because in most cases this equates to a larger sum of money overall. However, some people may find that having a lump sum could suit best and, while it will be subject to income tax (in the UK and potentially in your country of residence) there might be investment opportunities that could provide you with a greater return on your investment, and therefore a larger lifetime income.
With consistently low interest rates, many schemes are offering very good cash-equivalent transfer values (CETV). The actuaries of the scheme calculate the CETV based on what they would need to set aside if they needed to buy the income for life on behalf of the member.
In some cases the actuaries of the scheme will offer enhanced terms when calculating the CETV in order to get the future liability off the books. Something that people should always consider, even if they decide to remain with the existing pension scheme, is that they are entitled to a free CETV calculation every 12 months with most schemes.
Many advisers consider that this should become part of the annual review of all financial provisions.
Finally, if you no longer work for a company, but have some funds built up, you may wish to transfer it to another scheme either in the UK or overseas into a QROPS. Traditionally, this would not have been a recommended course of action due to the benefits of workplace pensions. However, with the deficits apparently getting larger and the retirement incomes reducing, there are a great deal of opportunities available which supersede that of some occupational pensions.
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