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You may have come across the terms ‘pension deficit’ and ‘pension crisis’ in recent years. These terms are often used when referring to a growing problem for many final salary pension companies. But what exactly is a ‘pension deficit’ and how does it impact the financial security of members.
Large deficits have opened up on defined benefit pension schemes in the United Kingdom since 2007, and at the same time investment expenditure has been subdued; this is a common phenomenon in other countries too.
The most common form of defined benefit pension scheme is also known as a ‘final salary’ pension scheme. Under these schemes, employee members are entitled to a particular level of benefit depending on their length of service and the level of their salary when they retire. In a defined benefit pension scheme the pension benefit is defined by a formula linked to the member’s earnings and/or the length of their pensionable service. Those managing the scheme need to ensure that the contributions from both the employer and the employee are sufficient to provide the aggregate pension benefit.
A pension deficit is the gap between how much a pension scheme is required to pay out (it’s liabilities) vs how much money is available to payout (it’s assets). The deficit occurs when the scheme’s liabilities grow larger than the scheme’s assets.
Funding the deficit means that the sponsoring employer is likely to have its growth affected as it directs revenue and profit into closing the gap, which could also have an impact on employees salaries.
It is important to mention, that whilst some major employers have pension deficits, not all do. It goes without saying that “bad news” sensationalised headlines sell, so it can be easy to automatically think that there is an issue with all occupational, defined benefit and final salary schemes, but this is simply not the case, it just so happens that these are the ones that get news coverage.
We recommend that if you are unsure about the health of your scheme, you speak with a deVere financial adviser who will be happy to review your pension.
Historically, the average person would not live long past their retirement age. In the UK in 1961 the average life expectancy was 70.88, in 2017 that figure has risen to 81.16, which in just 56 years is a significant increase.
As such, pension schemes which promise an income for life in retirement are therefore required to pay out for a longer period – which often means that far more money is being paid out than was planned for.
It is also plausible that deficits have arisen as a result of a fall in the value of equity, bond and alternative asset yields, all which of which are commonly used as investment vehicles for pension funds. These decreases may be short or long term, but the impact is still the same – the real value of the whole pension fund is decreased.
Another common reason why deficits occur is simply that the company in question has been unable to fund their pension pot properly due to poor financial performance. This, of course, is likely to become more commonplace due to the current situation caused by COVID-19 with business revenues falling as a result of strict global lockdown measures.
On rare occasions, a pension deficit can occur due to mismanagement of the pension scheme itself, with corporate owners taking dividends out of profits, rather than funding the pension schemes.
For example, according to an analysis by AJ Bell, 35 companies in the FTSE 100 have paid out more in dividends to investors than the size of their pension deficit. However, it is often not as straight forward as this, but companies should always be trying to balance profitable growth and shareholder pay-outs.
If you are a member of a UK Pension Scheme you may wish to learn more about what you’re entitled to. By reviewing your pension you can be brought up to speed about your schemes health, the income you will be entitled to, your death benefits, your tax position and the charges you are currently paying.