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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: Pension suffocation

In the private sector, getting to grips with the runaway costs of financing final salary pension schemes has been - and in many companies, continues to be - a very painful process. Now, as the public sector takes its turn in the pensions spotlight, amid pressure to control government spending and debt, it would be easy to miss the trouble which potentially lies in store for the third sector. The alarming reality is that some charities have yet to face up to their own potentially crippling pension deficits, let alone take the necessary steps to cap future liabilities.

Over the past five to ten years, many employers have lost control over their occupational final salary pension schemes. This has been as a result of the growth in very trustee-orientated legislation, as well as the advent of the Pensions Regulator, who has the power to take draconian enforcement action against the sponsoring employers of inadequately funded schemes.

Alongside this, investment returns over the last ten years have been poor, with many schemes suffering a negative investment return over the period, notwithstanding the rise in the FTSE 100 since March 2009. All of this has led to schemes having substantial deficits, which have been thrown into sharp relief by changes in the way they are valued and increasingly stringent requirements on funding.

In actuarial circles, serious questions are now being raised over whether charities have the assets necessary to meet their existing obligations. Yet, a recent survey by the Charity Finance Directors’ Group found many charities have no plans to close the defined benefit pension schemes to new joiners.

This situation potentially leads to a unique and unwelcome set of new challenges for the third sector, whose entire existence is predicated on the good will of donors. Accounting standards oblige companies to provide details in their annual accounts of any deficit within their schemes. If a member of the public making a donation to a charity were to see huge pension deficits in the charity’s accounts, they might reasonably conclude that their donation may not have as much impact on the ground as they would have wished.

The public has a right to know how much of their donation is used solely for charitable purposes, rather than incorporated into the administration costs of the charity concerned. After all, why should the public make donations to a charity which may technically be insolvent?

There are understandable historical reasons for the persistence of final salary schemes among charities. Primarily, the provision of such a scheme for charity workers is seen as important by those employees who may well be on a substantially lower salary than they would receive in similar job for a non-charitable employer. While maintaining accrual in final salary schemes may help retain workers in the medium term, the provision of future accrual could bring the charity to its knees in the longer term.

So, is it essential not only that charity finance directors seek to cap the liability of the pension scheme, but that they do so with urgency? The longer the situation is allowed to persist, the bigger the scheme deficit will become, requiring an ever greater proportion of donations to make good the past service deficit. This could make the charity less attractive to donors, causing donations to fall and the proportion to rise even further in an inescapable vicious circle. Donors might favour charities which have no final salary scheme.

First steps in a move to cap liabilities would include stopping all future accrual of benefits. Of course, this would need to be on the condition that cessation of accrual does not cause a trigger of a winding-up of the scheme, which would lead to the employer immediately becoming liable to cover any shortfall on the extremely costly ‘annuity buy-out’ basis.

An alternative would be to add a money purchase section to the scheme, into which people could be moved for the future. Enhanced transfer values to deferred pensioners might be used to entice people to leave the scheme, thereby removing unknown future liability, but subject to complying with the Pension Regulator’s guidance.

If the employer wished to continue future accrual, this could be at a reduced rate or based on career averaging. Alternatively, final pensionable salary could be frozen, so that any future pay rises given by the charity will not be taken into account for pension purposes.

Fundamentally, an employer cannot trade while insolvent. Given the volatility of stock markets, it would be very easy for a charity employer to suddenly find itself doing just that. Even given the need to attract and retain the best staff, it is time for charities which have failed to tackle this issue to take their heads out of the sand and look to the long term interests of their beneficiaries.

Gary Cullen is a partner and head of the national pensions unit at Maclay Murray & Spens LLP