In the past few years companies – both big and small – have decided to close their final salary scheme.   Increasingly, companies are following this trend and moving away from offering “gold-plated” final salary pensions to their staff.  Instead they offer the less valuable “money purchase” scheme.

Employers are closing final salary schemes for a number of reasons, including market volatility, increased life expectancy and regulatory rules.    Even the Government and local councils are being forced to review their pension provisions due to spiralling costs.   In a nutshell, final salary pension schemes are becoming too expensive for employers to offer their workforce.

What is a final salary scheme?

With a final salary pension scheme the employer guarantees to pay a certain percentage of the employee’s salary in retirement as a pension.  This is based on the number of years in service and the scheme’s accrual rate (the rate at which the pension builds up).

With this type of pension the employer carries the burden of risk with regards to the pension funds’ performance and increasing life expectancy.  In other words, even if the stock market crashes and people live to a rip old age the final salary scheme is still obliged to meet its obligations and pay out a pension to its members in retirement.

Most of the companies closing their final salary scheme have switched their employees to a defined contribution scheme.  This moves the risks of market volatility and longevity from the employer to the worker – making them less attractive to employees.

Market volatility and fund performance

The current economic downturn and steep decline in investment markets has seen several final salary schemes go into a funding deficit.  This has been the final tipping point for many companies that offer final salary schemes.  They have seen their pension funds go from surplus to deficits in just a few short years, with no real forecast of better times ahead.

Many are biting the bullet and closing their schemes (and angering their staff along the way) rather than prop up their ailing pension scheme.

The effect of greater life expectancy

Advances in medicines and healthcare have meant that Britain has experienced a surge in life expectancy.  These days a man can expect to live until they are 77 and a woman until they are 81 on average.

While it is great news that people are living longer, it also means that there are greater numbers of retired people.  They will require pension income in retirement for longer and final salary schemes are finding it too expensive to pay a pension to all these pensioners.

A shortfall in funds

If the pension fund goes into deficit against its obligations the company will be required to make additional funding to top up the pension fund – this can be quite a financial burden to the sponsoring company.

The pension trustees and the employer will work together to agree additional funding to top up the pension fund.  The rescue plan must be approved by regulators, which helps to protect the interests of scheme members.  Nevertheless, putting extra funding into a final salary scheme can be difficult for company and explains why they are cutting their losses and closing these schemes.

Final salary schemes are too expensive now

The current economic downturn and increased life expectancy have hit companies that sponsor final salary pensions hard.  Most can no longer afford the burden of risk associated with these pension schemes and have been forced to close them to new members, if not to all. If a final salary pension fund goes into deficit, this can place a big financial burden on the employer who will have to make additional funding to fill the shortfall in funding.   It seems, final salary schemes may soon become just a thing of the past.

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