Should you worry about your final salary pension as deficits deepen?

Workers with final salary pensions are likely be fearful about deepening deficits, not to mention the survival of their employers, thanks to the the coronavirus markets crisis.

Many savers have ditched these traditionally safe and generous pensions in recent years, tempted by huge transfer value offers, greater potential investment growth and inheritance advantages.

But those considering following suit should think about what it feels like on the other side right now – exposed to a devastating financial crash, without the protection of an employer or the pension industry lifeboat scheme.

If you are thinking of abandoning a final salary pension, or have set things in motion but are still able to pause the process, it’s worth some deep deliberation beforehand.

That applies even if you are anxious your employer is in dire financial straits, and may not come through the current economic lockdown. Find out six things to consider below:

1. Most generous and safest pensions available: Final salary or ‘defined benefit’ pensions provide a guaranteed income for life after retirement, and ongoing payments to bereaved spouses if you die before them.

Public sector schemes are backed by the taxpayer, and members don’t have the option to leave. 

But there are around 5,400 private schemes, virtually all of them closed to new entrants, which people are giving up on for a range of reasons.

These include huge transfer valuations from employers keen to get them off their books, a desire to invest savings in the hope they will continue to grow, and the opportunity to leave whatever is left over to children and other loved ones as well as spouses when they die.

Meanwhile, pension freedoms launched in 2015 give people in ‘defined contribution’ schemes, where they and employers contribute to a pot invested for retirement, the power to do what they want with their savings once they reach the age of 55.

Those still saving into final salary pensions cannot take advantage of these freedoms unless they transfer to a defined contribution scheme.

However, leaving a final salary pension scheme means you must bear all the investment risks to your retirement pot going forward.

The Financial Conduct Authority is concerned that two in three savers who receive financial advice about final salary pensions are told to abandon them.

Advisers are supposed to start from the standpoint that transferring out is ‘not suitable’. And ‘no transfer, no fee’ offers to savers – known in financial jargon as contingent charging – can cause conflicts of interest.

Some industry experts have also warned advisers ‘harvest’ pension investment business by putting clients in their own in-house funds and on their own platforms, and then get a cut from the fees they generate as well as for ongoing advice.

Jon Greer, head of retirement policy at Quilter, says: The current uncertainty is understandably making people uneasy about a number of things including their finances.

‘Those with defined benefit pensions are lucky to have an incredibly valuable asset, but at the moment that asset may be leading them to some sleepless nights.

‘Is their scheme financially stable enough to stay afloat? Would it be better to have access to that money at 55 and have flexibility on how and when you can access it?

‘While these questions may start you to lean toward transferring your pension you need to be absolutely certain.

‘For a minority of people it may indeed be the right option, but for the majority of people retaining your defined benefit pension will be the best choice.’

2. Employers are responsible for closing deficits: There was alarming news last week that private employer final salary pension deficits have soared from £10.9billion at the end of last year to £135.9billion at the end of March.

There were 3,606 schemes in deficit and 1,816 in surplus, according to the figures released by the Pension Protection Fund, which rescues any that go bust.

But unless they go out of business, whenever there is a shortfall it is the employer’s job to tackle it, as our pensions guru Steve Webb explains in his latest column. 

‘The Pensions Regulator will expect the scheme to come up with a plan for dealing with it. This is known as a ‘recovery plan’.

‘It usually involves the employer agreeing to make additional payments over a number of years until the deficit is closed.’

Webb says recent stock market falls and really low interest rates are bad news for company pension schemes, but the regulator is currently allowing employers to postpone payments into them for a three-month period if necessary.

‘As long as this doesn’t go on for too long, it should be possible to make up for lost time and get the pension funding level back up.’

Tom Selby, senior analyst at AJ Bell, says of the latest PPF deficit data: ‘While such figures may understandably give the members of defined benefit schemes the jitters, it’s worth remembering the most important thing in most cases is not the value of any deficit today but the ability of an employer to survive long enough to pay your pension both now and in the future.’

He adds that the Pensions Regulator has given struggling companies breathing room when paying off deficits, including allowing them to delay providing transfer figures – known as ‘cash equivalent transfer values’ – to members for up to three months.

‘This flexibility is undoubtedly better than nothing. However, ultimately what defined schemes will really be waiting for is market conditions to turn back in their favour.’

We looked at final salary pension deficits and what size they need to get to before you start worrying here. 

3. Lifeboat scheme is there if firms collapse: Final salary pensions are rescued by the Pension Protection Fund in the last resort.

For those yet to retire, reductions to payouts are relatively low except for those due a very large pension, and people who have already retired get 100 per cent.

Greer says: ‘If you’re worried about the safety of your pension scheme, remember there is already a robust system in place to protect defined benefit pensions and legal obligations on employers to fund the pension promises accrued by members.

‘Even in the worst case scenario, where an employer becomes insolvent, the responsibility for paying pensions passes to the Pension Protection Fund.

‘The PPF pays a full pension to scheme members who are already retired, and 90 per cent to those still saving up to a cap.’

The PPF explains the rules for members on its website here. 

4. Bearing the brunt of stock market volatility: Transferring out of a final salary pension means investing it until you are at least 55, and after that there are tax and other restrictions on taking too much of it as cash. 

Most people leave anything over and above their 25 per cent tax-free lump sum invested, and draw an income from it to fund their retirement. 

(You can also buy an annuity, but they are poor value, and there is no point coming out of a generous final salary pension and then buying one of these.)

Savers who are novices to the world of stocks, bonds and funds might find the whole business something of a challenge, and struggle to manage their investments successfully enough to enjoy a comfortable old age.

And market calamities happen, leading to massive losses, as we see at the moment. 

Taking an income from shrinking investments, especially early on in retirement, can do disproportionate and irrecoverable damage to a portfolio.

If you decide to invest your retirement savings, you will need to choose a portfolio spread across a number of different asset classes, review the strategy around once a year, and rebalance when necessary.

Some ‘off the shelf’ investment portfolios based on your attitude to risk can be fairly straightforward, though you should still ensure you fully grasp where you’ve put your money. You can also pay a financial adviser to do all the work for you, although that doesn’t come cheap.

One important point to consider before ditching a final salary pension is the preference of your husband or wife.

If you stay in and you die before them, they will typically get 50 per cent of your guaranteed income until their own death, but if you leave they will normally inherit your investments.

Some spouses will be happy to manage an invested pension portfolio, especially since unlike with a final salary pension income it can be bequeathed to your children, but others might prefer to have a guaranteed income even if it dies with them.

Read our starters’ guide to investing through your old age here, and find out ways to protect your pension fund in troubled times here. 

5. Leaving a final salary scheme is not always straightforward: You have to get paid-for financial advice if your transfer value is £30,000-plus.

This is to ensure people avoid financial pitfalls most will be unaware of, and deter them from making irreversible mistakes with a valuable asset. 

That said, the Financial Conduct Authority has raised concerns that the quality of advice on final salary pensions is not always up to scratch. 

Pension firm Aegon has drawn up seven questions to ask yourself to help spot red flags before you fork out for financial advice. 

Meanwhile, as explained above, the Pension Regulator is allowing final salary schemes to delay providing members with CETVs for up to three months, due to the current upheavals in financial markets.

Greer says industry data indicates transfer values fell 3 per cent in March, probably because returns from UK government debt – known as gilts – fell quite dramatically.

‘Recent changes in transfer values have largely been a reflection of fluctuations in gilt yields and investment markets, as the true impact of the COVID-19 pandemic became apparent. 

‘Which way transfer values will move in the future is hard to predict, and the state of each scheme can be an important factor which can lead to transfer values being reduced.’ 

But he warns: ‘The size of a transfer value should not be the only focus. Just because transfer values seem relatively high does not mean members of these schemes should consider transferring out.

‘The guaranteed income from a defined benefit scheme should not be downplayed and a transfer will only be in a member’s best interest in the minority of cases.’

6. Inheritance rules are favourable, but might change: One of the major reasons people in final salary schemes look to transfer out is that it gives them the opportunity to bequeath retirement savings to children.

This is a major advantage, especially as the tax treatment of inherited pensions is relatively benign at present.

However, Steve Webb, our pensions columnist and a partner at consultancy LCP, has warned that the Chancellor might look to tighten up the inheritance rules at some point. 

There is a credible argument that retirement funds are meant to provide an income for old age, not be used as an inheritance tax planning device by wealthy people with pots they aim to pass on not spend themselves.