The end of history

For that minority, though, the future actually looks a little brighter than it has for some time. Not only have shares bounced back, with the FTSE hovering at about the level it was in 1999, but bond yields have also picked up slightly, helping to bolster pension funds’ assets and reduce the value of their liabilities. With most commentators agreeing that shares continue to look undervalued and with the government likely to increase its borrowing over the next few years, these trends are likely to continue.

Furthermore, many of those that still run final salary or other defined benefit (DB) schemes have by now made the adjustments they think necessary to tackle any shortfalls, such as increasing their or members’ contributions to the pension, cutting accrual rates or raising retirement ages. A survey in September by consultants First Actuarial found that although half those running DB schemes said the cost represented a serious problem for their charity, respondents were cautiously optimistic.

Eighty seven per cent, for instance, said that FRS17 (the accounting standard obliging organisations to include pension liabilities in their accounts) would not restrict their activities, and none of the respondents were considering closing their schemes to future accrual. Therefore existing members, at least, could continue paying into them. Most charities weren’t even drastically altering the terms of their scheme.

Citizens’ Advice is a good example. Faced with a £12 million deficit, the charity last year adjusted the benefits. Members were given the option of either paying more of their salary into the scheme or accepting a decrease in the accrual rate from one-sixtieth to one-eightieth per year (so that an employee with 40-years’ service, for instance, would collect a pension of half their final salary rather than the two-thirds they would have before). New staff also now have the option of joining a money purchase scheme instead, though they don’t have to.

According to the charity’s communications director Simon Bottery, the change should ensure the pension’s survival. “On our projections this solves the problem,” he says. “We’ve got no plans to revisit the scheme.”

And, for all the talk of deficits, James Smith, a consultant and one of the founders of First Actuarial, argues that the sector’s confidence is not entirely misplaced. “Final salary schemes look expensive at the moment, because people are living longer and because of the outlook for investment returns, but that could all change in five years’ time,” he says. “With a boom in the stock market, higher inflation and very different financial conditions we could start seeing schemes with big surpluses again.”

Other factors also argue for the schemes’ continuing survival. Take the Pension Protection Fund, for instance. Charities already paid a levy to the fund, which was set up to help provide for staff whose employers go bust and cannot meet their pension commitments. However, from April, charities faced also paying the new risk-based levy, which varies according to the credit rating of the organisation concerned.

There were worries this would hit charities unduly hard because they don’t tend to keep large reserves, but following pressure from a working party involving the CFDG and Charities Consortium, charities’ peculiar nature has been recognised in the credit ratings. Most have ended up in the higher bands, reducing their levy.

This is perhaps symptomatic of the attitude of the regulators. The Pensions Regulator, for instance, is also said by some to be sympathetic to charities when it comes to insisting that deficits be paid off within ten years, and may be more flexible, while the Charity Commission also seems to advocate a sober approach. In its 2005 guidance on Reserves and DB schemes it urged charities to exclude FRS17 liabilities in calculating free reserves while giving careful consideration to their possible effect on future cash flows.

All of this has led to suggestions that the dangers of DB schemes have sometimes been exaggerated. Rachael Maskell, national officer for the community and non-profit sector at Amicus, has argued that for some charities closing their schemes was a “knee-jerk reaction” that should be revisited. “What we’re concerned about is that some organisations are being overly cautious,” she says. Instead of just looking at the financial arguments, she urges charities to look at other implications of changing pension provision, such as its impact on employment and retention.

This is a particular worry for charities recruiting from the public sector, where final salary schemes remain the norm, and is the reason why the NSPCC, which closed its final salary scheme in 2002, maintained a new final salary scheme for those employees working with children who have joined from local government.

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Same old problem

However, according to Penny Cogher, head of charities at law firm Speechly Bircham, many charities are now revisiting their pension arrangements – but not in the way Maskell would like.

Cogher, who helped with the CFDG’s pensions report in 2004 and the Charity Commission’s 2005 guidance, says that some of her clients who made changes to their DB schemes in the past now have to address the issue again. “These are charities that bit the bullet a few years ago but are now coming back and absolutely agonising whether it’s right for them to continue offering a final salary scheme,” she explains.

This is certainly true for one major charity that is currently reviewing its pension. It made alterations some years ago but is now reconsidering its position in light of continuing deficits and uncertainty over future liabilities. The manager responsible says that although the charity is worried about the impact on recruitment, it is also worried about the signal its finances send to the public: “We rely on donors for a lot of our funds and, when our accounts are made public, the size of the deficit will be a worry for them.”

Even without the deficit, though, the manager says the charity would still be faced with the one disadvantage that DB schemes inevitably bring: uncertainty – and, in particular, the risk of increasing longevity, which threatens to increase pension liabilities exponentially if life expectancies increase significantly.

In fact, as the Children’s Society’s Nall explains, there are two distinct problems faced by charities with regard to their pensions: the present deficits and unknown future liabilities. And, while the first is now being successfully tackled by many charities (Nall reckons his charity’s scheme is now about 95 per cent funded), the last few years have made many realise they cannot take the risk of the second.

“Who’s to say that being cured of cancer in 20 years’ time isn’t an everyday occurrence for every man and woman in the UK?” he asks. “People are beginning to focus on that and say, ‘Yes, we have to remunerate our employees fairly, but we’re not here to carry the risk of national longevity rates.”

The future for final salary schemes therefore – as for those not in them – remains uncertain.

The alternatives

For those that feel they cannot bear the risk a DB scheme presents, the obvious choice is a money purchase scheme, such as a group personal pension or stakeholder. Structures vary, but the critical factor is that the income these defined contribution (DC) schemes will generate is not guaranteed and depends on the performance of the underlying investments. This effectively means the risk of providing an adequate pension is transferred from the employer to the employee.

There is little that can be done to avoid this. It’s true that there are hybrid schemes, which include both an element of guaranteed benefits and an element reliant on market performance.

However, while having the virtue of splitting the risk between employer and employee, these schemes tend to prove administratively cumbersome, and still leave employers with the uncertainty most want to eliminate. Consequently they are rare, even in the private sector.
Employers should not despair of providing their employees with a decent pension, however. As First Actuarial’s James Smith argues, although DC schemes have had a bad press, they can still act as a powerful recruitment tool if employers are willing to make a decent contribution towards them.

Many charities have followed his advice. The Children’s Society, for instance, puts in double whatever the employee contributes to its stakeholder scheme, up to a maximum of ten per cent of the employee’s salary, while Age Concern England, puts in nine per cent, against an average contribution across all organisations of seven per cent.

Age Concern also points out that in some ways the new scheme is better suited to modern employment patterns, because, while it doesn’t offer the certainty of a DB scheme, it is much more portable, making it better suited to the many employees who stay with the charity for under four years.

Even if encouraging long-term service is vital, DC schemes can be structured to encourage staff retention. The British Heart Foundation, for instance, uses an age related scale to determine its contribution to employees’ pensions. For those under 35-years old it puts in eight per cent and increases its contribution for older employees, up to 20 per cent for 56 to 65-year-olds.

“The intention was to reproduce the effect of a final salary scheme, where years earned towards the end of your career are worth a lot more than those at the beginning,” explains the charity’s finance director John Edwards. “What we wanted to do was offer something that would equal the generosity of the DB scheme, without exposing the foundation to unlimited risks.”

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