Commentary - Walking through a minefield
The Pensions Regulator recently published a consultation document on the way it plans to regulate the new funding requirements for final-salary pension schemes. The new funding arrangements, as I am sure you already know, will soon replace the old minimum funding requirement that came about as a result of the 1995 Pensions Act.
Final-salary pension schemes are based on promises made by employers to their employees. Employees in final-salary schemes are lucky - they know exactly what their eventual pensions will be in relation to their length of service and level of earnings at or near retirement. Employers promising such well-defined pensions are not so fortunate, in a way - they cannot know for sure in advance what the true cost of making such promises will be. For a start, they cannot know in advance what rate of return they will make on the funds invested to pay for the promised benefits, nor can they be certain of how long people will live on after they have retired.
These twin uncertainties of future investment returns and changes to the general levels of mortality and longevity mean that employers putting aside funds over the long term to meet such commitments need to keep reviewing the adequacy ( or otherwise) of the amount of money being put into their pension funds. The minimum funding requirement was supposed to help employers do that but it is possible for a pension scheme based on benefit promises to be fully funded on the MFR basis and yet have woefully inadequate funds to provide for the benefits promised to employees to date in the event of winding up.
Some fully-funded schemes have as little as 50 per cent of the money they would need to buy out the benefits that members have earned to date. The thin ice that employers are skating on has been known about for some time and the change in the way schemes will be required to put funding aside in the future is the result.
Basically, employers running final-salary pension schemes will have to put aside more money in the future than the old basis would have required of them. That is even more necessary these days as the changes made by the Government in 2003 mean that final-salary schemes that are closed by solvent employers must be funded at the level necessary to buy out all the promised benefits. Before 2003, solvent employers could get out of their pension commitments by simply closing their schemes. Now they can't.
Employers which become insolvent, however, are unable to make good underfunded schemes and it is for that reason that the 2004 Pensions Act gave birth to the Pension Protection Fund. The Pensions Regulator was also established as part of the 2004 Pensions Act and is responsible not only for protecting the rights of members of final-salary pension schemes but also for protecting the Pension Protection Fund itself. That is a difficult juggling act. Getting employers to put aside more to meet the real costs of the benefits they have promised their employees is one thing but doing it in such a way that would make companies insolvent would be self-defeating. This consultation is all about the fine line that the regulator is proposing that employers should walk through this particular minefield.
Overall, the aim seems to be that employers will have to take steps to improve the level of funding against the promises they have made to their employees but over a timescale of something like 10 years. This is something that seems reasonable to me - indeed, it is exactly what Scottish Life suggested at an early stage of the consultation on the Pensions Act.
It is just a shame things have had to get so bad before anything could be done about it but that is something we cannot undo now.
First published in Money Marketing, 17 November 2005