Brief summary of crisis facing UK employers running final salary schemes

by Dr. Ros Altmann

(All material on this page is subject to copyright and must not be reproduced without the author's permission.)

Our final salary occupational pension system used to be the envy of other countries, but is now in dreadful trouble. Almost all schemes are in deficit and employers are finding that their pension promises have become hugely more expensive than they ever expected. Basically, our schemes do not have enough money to pay out the promised pensions and contributions will have to increase sharply, to be able to afford the payments. Why is there not enough money? There are many reasons:

  1. Successive Governments have piled extra obligations onto final salary schemes, which have added enormously to the cost. Compulsory revaluation of leavers' benefits, spouse cover and indexation have all made providing these pensions more expensive than originally thought.

  2. Pension funds relied on equity investments, which delivered exceptionally strong returns in the 1980's and 1990's and actuarial valuation methods failed to predict future interest rates, inflation, investment returns and mortality correctly. This meant that the actuarial valuations underestimated the liabilities and over-estimated the expected assets, to suggest that schemes had more than enough money to pay out all the pension promises.

  3. This allowed employers to take contribution holidays, since it looked as if their funds had surpluses.

  4. Employers also used their pension funds as a cheap way of funding industrial restructuring, by providing early retirement pensions in voluntary redundancy, which were financed by the pension scheme, rather than company funds.

  5. These early retirement packages led others to want to retire earlier, so although workers were increasingly living longer, they were also trying to retire earlier, both elements adding to the costs of providing these pensions.

  6. Government also imposed extra costs on schemes due to regulatory expenses and removal of ACT relief on dividends.

  7. UK final salary pensions are now about three times more expensive to provide than US final salary pensions. This is due to the extra requirements of spouse cover, indexation and revaluation. The employers are unable to reduce pensions, so they are stuck with these liabilities. This will, in my view, be an enormous problem for corporate UK in the coming years. Somehow or other, companies and their workforce are going to have to find a way to change the benefits or increase contributions substantially.

  8. There may be several major companies which will be forced into bankruptcy by the costs of trying to meet their pension liabilities. How long will shareholders stand for this? Essentially, these schemes are no longer really 'funded', but have become more like 'pay as you go' schemes, where the contributions today are funding benefits for the older members, but who will be there to fund the pensions when the younger workers want to retire? I have actually suggested they are now 'pray-as-you-go'!

  9. Maybe the Government did not really get to grips with this issue because the public sector schemes are all final salary and no-one wanted to rock the boat and highlight the enormous costs of public sector pensions.

  10. Or perhaps the Government simply failed to realise how bad the situation was until it was too late. The official line always was that these pensions were 'safe' and 'guaranteed' and, like everyone else, perhaps Government believed that these funds were strong and could provide generous pensions for ever. There was not really any 'scenario' testing, or 'what-if' analysis, to try to predict what might happen if schemes found they could not pay out the promised pensions that people were relying on.

    The bottom line is that final salary pension schemes are a hugely expensive, open-ended commitment by employers to pay a promised level of pension to former workers, for as long as they live. Employers do not know how much this will cost, but have signed a blank cheque to keep on paying, often with yearly increases, for the indefinite future. Governments continually tried to put more costs onto the schemes, because state pensions were being cut and the ideology was that private pension funds, invested in equities, could make up for the low state payouts. In the end, it has become clear that this is unaffordable.

© Dr. Ros Altmann  |  Home  |  Profile  |  Disclaimer