The dark ages

Nothing on the industrial landscape generates so much fury and fear as pensions. Indeed, if TUC translates speeches into deeds, it could mean direct action on a scale not seen since the three-day week. The inequality is glaring. On the one hand we have Fred the Shred and the Phoenix Four padding their pension pots while the organisations they led slid into catastrophe. On the other hand, we have millions of people who worked hard for years in the expectation of a predictable, if not gilt-edged retirement, only to find the prospects changing faster than they can blink. And now, if there is a Conservative victory, many of them can even expect to work at least a year longer before they can even get their hands on the state's contribution. It's all very well for Shadow Chancellor George Osborne to say "we are all in it together". With personal wealth estimated at £4.3 million, most ordinary folk would be only too happy to share his lot. On the other hand, even if you don't agree with his solution, he is undoubtedly squaring up to an unpalatable truth. The sums needed to fund direct benefit pension schemes just plain don't stack up. Look at hard reality. Our current government is pilloried from all quarters for a budget deficit of around £175 billion. Yet it is actually less than the deficit on British pension funds. A recent study by KPMG reveals that the black hole in private sector pension schemes now stands at a staggering £180 billion. And if you really want economic indigestion, the last official estimate of unfunded pension liabilities in the public sector – in March 2006 – put the cost at £650 billion, which is close to half GDP. And that may be the prettier version. According to the CBI, if it employed the private sector methodology for calculating pension liabilities, £1 trillion would be closer to the true number. Many industrialised nations are facing similar nightmares. Unless it is tackled, this black hole is capable of swallowing up people, companies, governments and, indeed, whole national economies. Jacqui Timmins, pension partner with legal firm Pinsent Masons, has clients describing their situations as "small companies attached to huge pension funds". She says the pensions tail is wagging the corporate dog. The management of these liabilities, which are disclosable on balance sheets and are seriously affecting investment, is a huge priority now. "But if you look into the future and the impact on employees, it's even more frightening. Twenty years out, it's a financial tsunami heading for these shores because the investment risk and the onus for ensuring adequate funds in retirement is all being pushed outwards to employees, most of whom haven't got the financial knowledge to invest. The inevitable consequence is that they won't have sufficient funds and we will see people working on long beyond current or even prospective retirement age, possibly as long as 75." The shift of responsibility from employer to employee is undoubtedly accelerating. For the last decade, the private sector has been steadily closing defined benefit (DB) pension schemes – which guarantee a certain payout at retirement – to new employees in the hope that they would become more sustainable. They haven't. So now many are closing to existing members, too. Pirelli has become the latest UK employer to do so. The firm has started consulting with its staff with a view to closing the scheme in December 2009. The 743 staff will be allowed to join the defined contribution (DC) scheme – which pays out according to the money contributed and how well it has been invested – already in existence for new recruits. Pirelli joins Dairy Crest, Costain, Morrisons, Barclays, IBM and Fujitsu in announcing closure plans for 2009. David Yeandle, head of employment policy at the manufacturing employers' organisation EEF, says that manufacturers may bear an even larger proportion of the pension deficit than other sectors because of their long history of DB schemes. "Many have been around a long time and in the 70s and 80s it was the norm. There is also a strong history of unionisation and unions have always been very keen on these types of scheme. And some manufacturers have historically taken a paternalistic approach. They saw it as a way of attracting and retaining employees – often offsetting parts of the package which were possibly less attractive in comparison with other sectors." Earlier this year EEF, in conjunction with CPH Consulting, undertook a survey of the changing nature of pension provision in manufacturing. Although some form of DC arrangement is clearly now the most common type of pension scheme for all categories of employee, nearly a third of firms still have a DB scheme for at least some of their employees. However, a significant proportion (62%) of DB schemes are now closed to new members while a further 14% are closed for future service to existing members. The type of DC arrangement has also changed; stakeholder schemes with an employer contribution have become much more common at shopfloor level. Interestingly, DB pension schemes are actually disappearing slightly faster for executives and management than for shopfloor. This picture is at marked odds with the union contention that companies have only retained DB schemes for their senior management. Not only are they more expensive to provide for senior managers but they are also less attractive to them because of the cap introduced under Nigel Lawson's chancellorship on the earnings that could be used to calculate defined benefits. The writing is on the wall, even for companies who still have DB schemes. "Obviously there is a cost implication," says Yeandle, "but there are also fewer and fewer of their employees who are in that scheme as they have left or retired." He sees many companies wanting to get away from the sheer amount of board level time that DB schemes take up. Jacqui Timmins is heavily engaged in advising companies on managing the risks associated with existing pension liabilities. One of the biggest is, bluntly, that people are living longer than was expected. "In crude terms, the actuarial experts have underestimated the true cost so figures have to be revisited and the deficits and liabilities are escalating. We believe that longevity is one of the biggest issues facing manufacturers." Pinsent Masons recently advised Babcock on the UK's first longevity swap, where one of its pension schemes sought security on future mortality risk. Basically, an insurance company or bank takes on the 'risk of longevity' in return for an income stream from the pension fund. The benefit is that the fund knows exactly what it has to pay out each year, even though predictability means additional cost. Timmins says the other bear trap is getting pension trustee boards to agree to change since it is they, rather than the company, that control the assets and how they are invested. Trustee boards are mixed – they can be employees, managers and union reps. But, regardless of the part of the business they come from, their primary duty is to protect the interests of their scheme members rather than the company's. It can produce real conflicts of interest. She cites an extreme example: a pension scheme where the bulk of the members are former employees – pensioners or leavers with their pension benefits still in the scheme. If the trustee board doesn't like the way the business is going, it may trigger a winding up of the pension scheme. But this might put the company in financial difficulty because legislation requires it to make good any deficit. With a small pool of active members, a trustee who is also a union rep could well have to protect past employees even if it jeopardises his own members' jobs. She advises any company managing a change of pension scheme to think carefully about the decision-makers from the company's side and the potential for conflict among the trustees. If they aren't managed properly up front, there is a risk of members challenging the objectivity of trustees' decisions at a later date, in view of their other responsibilities to the business. She believes communication can avoid a lot of acrimony. "There is a lot of confusion over the term 'scheme closure'. Many members and union reps panic, assuming the company is somehow reneging on benefits already built up. But closing the scheme doesn't lose past service benefits. Legally the company has to protect those rights." But where the absolute cost of the current provision is too high or the volatility on the balance sheet has got a stranglehold and is losing investors' support, the company may well be totally destabilised unless it manages the risk decisively. To keep people onside, the company has to be clear about what's being proposed and why, demonstrate it has considered other options to keep the DB scheme going, and show honestly and openly why they aren't sufficient. "Nine times out of 10, it's not companies trying to extend their dividend return; they are just looking to stabilise the business to operate on a sustainable level. I would say to any employee that your best hope of a reasonable income in retirement is to have a pension scheme where your sponsor is financially secure. Yes, there is the Pension Protection Fund [PPF]. But the PPF has started at the Rolls-Royce end of the pension scale and, in the future, they may have to scale back." Whichever way you look at it, it's a bleak picture and bitterness is understandable. Feelings about pensions are running so high, it's easy to see conspiracy where companies are just trying to choose the least worst option. Thorn Lighting, winner of the 2009 Best Factory Award, is one of many companies trying to be fair to all sides. It closed its DB scheme to new members some years ago and existing members got no further accruals after April of this year. However, benefits earned up until then are secure and all employees were offered membership of the company's stakeholder plan. The company contributes 5% of pay and employees choose their own contribution level. Deferred members of the DB scheme now receive more generous ill-health and death in service benefits, and long-servers have had the opportunity for early retirement reinstated. The company is continuing to pay into the fund even though it's closed, at the rate of £3.3m per annum increasing yearly at 4% until 2016, to address any deficit. This is rather more generous than the government safety net due to come into effect in 2012 for the majority of the population with no personal pension provision. Under the new system, all employees will automatically be included in a Personal Account pension scheme unless their employer already offers a suitable alternative. Employees will be compelled to contribute 4% of band earnings and employers will contribute 3%. A further 1% will be paid in the form of tax relief. EEF is broadly supportive and Yeandle believes that even a Tory administration is unlikely to unpick the package, although David Cameron has promised to raise the basic state pension in line with earnings rather than prices (a small spoonful of sugar to take away the taste of the hike in state pension age?). Timmins, however, sees it differently. "The worst of all worlds will be where companies choose to close down their existing schemes and meet the minimum requirements. Many of them are currently paying more than 3%. They may choose simply to comply with what is required of them and cut the red tape and administrative burden they are experiencing." Whoever is right, one thing is certain. It's going to be a lot harder to get out of the pensions black hole than it was to get into it.