Death of the final-salary pension scheme
More and more lucrative final-salary pension schemes are disappearing. We explain why that is, where can you still find them, and what they could be worth.
Image: Scott Heppell - AP Photo
Few people were shocked when Unilever announced it was shutting its final-salary pension scheme earlier this month.
The manufacturer of a wide range of household goods, from Persil to PG Tips, became the latest in a long line of major UK companies to cut back on the pension benefits offered to staff.
According to recent figures from the National Association of Pension Funds (NAPF), 17% of Britain's final-salary pensions are now closed to both new and existing members, compared to 7% in 2009 and 3% in 2008.
Joanne Segars, NAPF chief executive, said: "The pressures on final-salary pensions are relentless, and their rate of decline seems to be shifting into a higher gear. The rate of closures to new staff seems to have levelled off, but now those who are already in a final-salary pension increasingly find themselves being locked out."
These changes are not just limited to the private sector: the coalition government has signalled its intentions to reform state-sector pensions and reduce their cost to taxpayers, although it is likely that public-sector workers will continue to benefit from guaranteed pensions rather than having to rely on the success of stock-market investments.
What's the problem with final-salary pensions?
The reason so many firms are shutting final-salary schemes is their potential cost.
With a final-salary pension, workers accrue a chunk of pension entitlement for every year they work at a particular company. This is typically the equivalent of 1/60th of their salary when they leave the company or retire.
So someone in such a scheme who worked for 40 years would get a pension entitlement of 40/60ths, or two-thirds, of their final salary.
If they earned £60,000 when they retired, therefore, their annual pension would be worth £40,000. The company running the scheme would be obliged to make investments designed to cover this yearly payment.
But this is where the problems start. If the investments don't perform well enough to pay the pensions, the company has to find extra cash from elsewhere in the business.
And if pension scheme members start living longer than expected - as is currently the case - the costs increase further.
As a result of these issues, employers in the private and public sector are making significant changes to the pensions they offer.
How schemes are changing
So what are organisations doing when they want to limit their final-salary pension liabilities? These are the most common options.
Closing the scheme
This is the most drastic step: the employer decides that staff can't put any more money into the final-salary pension, and no extra pension entitlement can be built up.
This is what Unilever announced last week. Since the start of 2010, Aviva, Asda and Tate & Lyle are just three other companies which have taken this step.
Tom McPhail at investment firm Hargreaves Lansdown told MSN Money: "If you were 48 when your final-salary scheme was closed and had 20 years' service up to that point, you'd have a 20/60ths pension."
This means you would get a pension worth a third of whatever your salary was when the scheme shut (although this would be inflation-linked until you reached retirement age).
The firm would probably introduce a money-purchase pension to replace the final-salary scheme: employees' pension contributions, along with top-ups from the company, would be invested in the stock market and other assets. The size of each employee's eventual pension would then depend on investment returns - so the workers would be taking all the risk rather than the employer.
No more new members
An organisation may simply decide that, from a certain date, new staff can't join the final-salary scheme. Meanwhile existing workers can continue to accrue pension entitlement as before.
Anyone who has started work for BP since last April, for example, has been excluded from its final-salary pension.
This step might be better for existing employees than a full-scale closure, but it can create problems for the employer further down the line, McPhail said.
"If there are no new members, in the very long term there will be an end date to the scheme and a cap on liabilities," he explained.
"But this can increase funding costs when new members aren't contributing to the scheme, and existing members are getting older. If more of them are in retirement and the scheme is in deficit, the situation can get worse."
Here the pension is based on earnings over the individual's working life, rather than solely what they earn just before retirement.
"Final-salary schemes can be overly generous when it comes to higher earners," McPhail said. "Senior staff are more likely to get big salary increases late in their careers, which raises their pension entitlements.
"With career-average, every year you accrue a year's worth of pension rights based on your salary at that time. So if you were on £28,000 last year, you'd accrue pension worth 1/60th of that; and that would be linked to inflation until retirement.
"With a career-average scheme, your 10 years as a lowly office junior will also be taken into account."
Retailer Morrisons replaced its final-salary scheme with career-average in 2009, while rival Tesco has a similar programme.
In Lord Hutton's review of public-sector pensions published last month, he recommended that the government take the same course of action for employees of the state.
These aren't the only ways that employers can make their pensions less generous.
Some schemes raise the age at which pensions become payable - this is another recommendation made in Lord Hutton's review.
In 2008, the NHS introduced an alternative pension scheme which had a higher accrual rate - every year's service was worth 1/60th of final salary, rather than 1/80th - but the income could only be taken from age 65, not 60.
With life expectancy rising in the UK and the government planning to raise the state pensions age to 68 in the next couple of decades, pension-scheme retirement ages of 60 are looking increasingly outdated.
Employers can also change the rate of any increases in annual payments. Until recently most pensions have been linked to the retail prices index of inflation (RPI), but employers are increasingly changing to the consumer prices index (CPI), which excludes housing costs and is normally lower.
As of last month, public-sector pensions are being uprated in line with CPI. But this week, a number of state-worker groups launched a bid to seek a judicial review of the government's decision to impose this change.
How to build your pension pot
Last men standing
So if you want to join a company to take advantage of its final-salary pension scheme what are your options?
Unfortunately, the pickings are slim. Among major employers in Britain's private sector, only Shell and the John Lewis Partnership have managed to keep their final-salary schemes open to new joiners.
Best pensions are in the public sector
Workers such as teachers and nurses understandably resent media references to their pensions as "gold-plated".
Average retirement incomes among these groups are not especially high, although the "gold-plated" tag is perhaps more to do with the fact that state workers do not run the risk of losing pension income through poor investment performance or employers going bust.
But some public-sector pensions really are a cut above, McPhail said. "The Governor of the Bank of England gets a two-thirds pension after 20 years," he explained.
This means that, for every year or service, he accrues a pension entitlement worth 1/30th of his final salary, which is twice as generous as normal schemes.
"Judges get half pay after 20 years' service, which means it is effectively a 40ths scheme. And don't forget MPs: they also have a '40ths' scheme, so they get [a] pension worth two-thirds of their final salaries after 26 years."
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