8. Why has our pension scheme been closed?
Like many other final salary or defined benefit pension schemes, that for Royal Ordnance has been closed to new members since 2000. Of course we do not know the precise reasons for the decision taken by BAE Systems but the following is a brief summary of those factors which have caused other schemes to become closed and, in a number of well publicised cases, to be wound up thus causing considerable hardship to those involved. The main reasons quoted in the popular press for the pensions crisis are the "£5 billion raid on pension funds by Gordon Brown" and the dramatic fall in share prices since 1999. Whilst these two may be the principal causes there are several others which have made the problem more complex:
1. "The £5 billion pound raid on pension schemes by Gordon Brown"
The Treasury argued that pensions funds, when compared with all other forms of savings, are highly privileged because they are tax exempt both for payments on the way in and, as far as any lump sum is concerned, on the way out. The 25 per cent tax credit on share dividends was therefore considered to be an excessive advantage over these other savings schemes and was removed. At the same time the Chancellor reduced the advanced corporation tax paid by companies, somewhat naively believing that the companies might pass this saving on by making additional contributions to the pension funds to compensate the latter for the loss of the tax credit income. That just didn't happen of course. Actually the sum involved was nearer to £3.5 billion rather than the £5 billion quoted but nevertheless it was a significant blow to pension funds.
In ROPS we can see the 25% fall in investment income by comparing the mean 4.1% return for the 4 year period prior to 1997 with the 3.1% for the following 4 years which represents a total loss of income of about £25M or about £6M pa. (This sum is of course dwarfed by loss in the total assets caused by the stock market crash (see below) which for ROPS amounted to an estimated £220M over the same period.)
2 The stock market crash
The average pension fund has 60-70% of its assets invested in equities (shares) with some even investing up to 90%. This is on the grounds that in the long-term, they will generate higher returns than the alternatives such as lending via corporate bonds, government gilts and the like. The greater the investment returns the less the company then has to provide in contributions to the fund. However, the reason equities have higher returns than bonds is that they have higher risks. ROPS held 75% in equities but started to reduce this towards 65% commencing in mid 2000 after the stock market had already begun its downward spiral. In contrast the Boots pension fund moved all its assets into bonds at this time to protect them from the continuing fall in share values they could foresee coming. However in general, fund investment managers prefer to advise fund trustees to maintain a high level of equities because this type of investment is hugely profitable for them. At the peak the UK pension funds held a total of about £800 billion of assets of which about 70% was in equities and the total assets value dropped by about 30% to about £560 billion. By comparison Gordon Brown's £3.5 billion per year raid over this period looks rather small. ROPS assets fell from £890M in 2000 to £627M in 2002, a loss of £263M.
3. FRS17
The new Financial Reporting Standard 17 being phased in from 2000 to 2003 required companies for the first time to declare the extent of their pension fund assets and liabilities in their annual accounts. Exposing a pension scheme's deficit on the balance sheet initially reduces a company's profits and possibly restricts its ability to pay dividends. In stable market conditions the future effect of the pension scheme on the company accounts would be small. When, on the other hand, stockmarket conditions or interest rates fluctuate during an accounting period, a company's reported results could be grossly affected by its defined benefits pension scheme. Thus companies felt it might be best for their long term viability to discontinue this type of pension scheme.
4. Taxation of surpluses
A decision was taken in the late 80s to tax pension fund "surpluses" to prevent companies using the pension funds as a sort of money box for tax avoidance purposes. This tax threat subsequently lead the companies to adopt a much tighter rein on the pension funds on the grounds that they had to "use it or lose it" to the Inland Revenue (but see the IR comments ). In fact this has turned out to be largely untrue because we have learned that only about 30 pension funds out of the 100,000 schemes in existence have ever been taxed under these rules. During the early 90s companies including RO were using surpluses for "industrial restructuring", ie offering very generous early retirement schemes to employees in their 50s for "downsizing" or in some cases so that they could be replaced by younger less expensive recruits. In the late 90s when the equity market was booming they also awarded both themselves and their employees "contribution holidays". This meant that labour costs were held artificially low and those companies thereby gained a market advantage. As far as the pension funds were concerned it would have been much wiser to allow the surpluses to build up in anticipation for the inevitable fall in the stock market. It is estimated that the long-term impact of the contributions holiday from 1987 onwards has accounted for around 30 per cent of the current deficit in pension funding. In ROPS the figure is 74% with a total of £196M "surplus" being spent on contribution holidays and early retirements.
5. The Minimum Funding Requirement
The 1995 Pensions Act introduced the "Minimum Funding Requirement" for occupational pension schemes as a result of the Robert Maxwell pension scandal. Its very name induced people to believe that henceforth their scheme assets were safe from predators like Maxwell if it was "fully funded" on the MFR. Although the Institute of Actuaries quietly pointed out that this was in actual fact far from being the case, by allowing "surpluses" to be defined in an over-optimistic way it encouraged the culture of extensive contribution holidays. The situation was then made worse by the government actually reducing the MFR level by up to 19% in 1998 and by a further 8% in March, 2002 as a result of lobbying by the National Association of Pension Funds to ease some of the pain caused by the removal of the dividend tax credits in 1997. The MFR funding requirement typically now covers no more than ~50% of the guaranteed liabilities.Thus pension fund assets were reduced to levels which no longer matched the liabilities and when the stock market collapsed companies faced the prospect of having to pay huge sums to restore even this lowered MFR level. By this time though members of the pension schemes began to realise to the deficiencies of the so-called MFR and started to press for funding to the "discontinuance level". The employers viewed the prospect of these rapidly escalating costs with dismay and acted accordingly before new government legislation could be introduced.
6. Increased longevity
When final salary pension schemes were first conceived they were based on a much shorter life expectancy than exists today. People are now living much longer and expecting to retire earlier and earlier. Pensions were never meant to last for 30 or 40 years. Pension fund actuaries were very slow to react to this and typically increased their assumed expectation of life for a 65-year-old male to slightly over 15 years. However new data published in 1999 indicated that this person's life expectancy had by then risen to almost 20 years, and was set to continue rising steeply for those employees who would not be retiring until well into the twenty-first century. An extra five years is an extra one-third on the time the pension was due to be paid. That extra cost of living longer comes to around 30% on the typical pension.
For those taking early retirement, the effect is greater. There is quite a lot of evidence that your life expectancy can go up if you retire early, so long as you've got enough to live on comfortably - though it goes down if you are poor and unemployed and depressed. So early retirements are potentially hugely expensive for pension schemes and it is somewhat doubtful that the actuarial calculations of these additional liabilities were adequate.
7 Increased management costs
Increased bureaucracy is often cited by the smaller schemes as a reason for closure. Many of the prescriptive safeguards introduced in the 1995 Pensions Bill did impose additional costs on pension funds. The current pensions bill going through parliament seeks to reverse this trend but, to place this burden in context, for a medium sized fund such as ours the management costs are currently less than £3M pa which is about 0.5% of the fund value.
8. Restrictions on higher earner's pensions
The cap on the higher salary levels influenced some directors to close their pension schemes as they sought alternative nest eggs for themselves elsewhere.
Conclusion
Thus there are many reasons for the current trend towards the closure of final salary pension schemes and we pensioners should consider ourselves fortunate that we already have them in payment although we will have to be continually vigilant to protect them. The running of final salary pension schemes has been likened to riding a bicycle: you are fine providing you continue to pedal but if you stop pedalling (or close a scheme to new members) you start to wobble when going uphill and you may eventually fall off. Clearly there are questions concerning the long term sustainability of closed schemes because the contributions from current employees will eventually fall to zero. The next generation, our sons and daughters, will be very unlikely to afford comparable pensions unless some radical changes are made to the current pensions scene.