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The Great British Pensions Scandal!

By Cliff D'Arcy
February 12, 2004

This is a long article, but I'd urge you to read it all.

The government is always harping on about how we all should be saving more for our retirement. One estimate of the so-called 'savings gap' is that we're saving 27 billion (PDF file) less than we need to enjoy a comfortable retirement. To encourage us to save more, the government released a new Pensions Bill today, which aims to improve our faith in pensions and make things fairer for everyone.

Saving for retirement is something we're very much in favour of here at the Fool. After all, the basic state pension is a little over 77 a week for a single person and almost 124 a week for a couple, which is barely enough to survive.

Ideally, if your employer operates a company pension scheme, you should join it. That's because firms usually make extra contributions on top of your payments, plus they pay the running costs. This means that you get more money invested, plus the overall charges are lower.

For example, many firms offer 'matched contributions', where they put in a pound for every pound you pay in. So, you might pay in 5% of your salary, with your employer adding a further 5%. However, thanks to tax relief, you don't pay the full 5%:

  • Basic-rate taxpayers get 22% relief, so their 5% costs them 5 x (1 - 0.22) = 3.9%.
  • Higher-rate taxpayers get 40% relief, so their 5% costs them 5 x (1 - 0.4) = 3%.

So, in this example, you put in just 3% or 3.9%, but you have 10% invested on your behalf. Not bad, eh? In theory, company pensions - especially guaranteed final-salary (or defined-benefit) schemes - are a sound investment. In fact, the government may decide to make joining them compulsory. However, when things go wrong, the results can be shocking!

Take Don Banham, for example, who joined me as a guest on the BBC Breakfast show this morning. Don worked for storage systems manufacturer Dexion in Hemel Hempstead for almost 39 years, having joined in 1964. Sadly, Don was one of around 180 Dexion staff who were made redundant last May and June, after financial difficulties forced the 56-year-old firm to call in the receivers.

That shouldn't have been a problem for Don, because he was only six months away from retirement and had been a member of Dexion's final-salary scheme from day one. In fact, Don's contract of employment obliged him to join the scheme, plus he had been paying in additional voluntary contributions (AVCs) for over twenty years.

However, all was not well inside the Dexion pension fund, as it didn't have enough money in the pot to meet all its obligations to pensioners, workers and former employees. What's more, workforces and their pension funds come way down the pecking order when a failed company's creditors are ranked.

A valuation of Don's company pension scheme showed that it had an estimated shortfall of 20m. This was to prove disastrous for Don and his colleagues, many of whom had been working hard for Dexion for their entire adult lives. Dexion's pension shortfall had grown ever larger during more than three years of falling stock markets between 2000 and early 2003. Over this period, pension funds saw the value of their assets crash, since they invest largely in shares.

As well as falling investment returns, longer life expectancy (leading to lower annuity rates) and Gordon Brown's withdrawal of tax credits on pension funds' income from shares (at an annual cost of 5bn) have led many businesses to conclude that final-salary schemes have become too expensive to run. Only 1 in 5 major employers allows new starters to join a final-salary pension scheme at present.

Also, during the boom years of the 1980s and 1990s, over-optimistic expectations of future stock-market returns led many firms to cut contributions or suspend payments completely (taking 'contributions holidays'), which made pension shortfalls more likely. Indeed, tax law penalises schemes that have assets significantly in excess of their liabilities, which means that running a healthy surplus is actively discouraged at present! Bonkers, isn't it?

Nevertheless, like many workers, Don assumed that after Robert Maxwell's theft of 440m, the government had tightened up the law enough to prevent future pensions disasters. However, the Pensions Act 1995 forces pension administrators (known as trustees) to put existing pensioners first when winding up a fund.

What this means is that existing pensioners have first claim on a fund's assets when it is wound up, so workers and ex-employees get nothing until 100% of existing pensions have been secured, including future increases. Note that Gordon Brown has relaxed this 'Minimum Funding Requirement' twice since Labour came to power in 1997!

To add insult to injury, Don's pension was contracted-out of the State Earnings Related Pension Scheme (known as SERPS), which means that he isn't entitled to any additional pension from the government. That's because there isn't enough money left to cover the Guaranteed Minimum Pension that Don's National Insurance rebates should have bought.

Alas, Don's bad luck doesn't end there: his AVCs were invested with - you guessed it - Equitable Life!

The independent trustee who is winding up the Dexion pension scheme has yet to produce a full valuation. As most wind-ups take two or three years to complete, Don is forced to wait and see what pension - if any - he will eventually receive.

Don was looking forward to a happy retirement, armed with a 25,000 tax-free lump sum, plus a pension of around 250 a week. However, he predicts that he will be lucky to get a fifth of this - a mere 50 a week, and no tax-free cash. What's more, Don is sixty, so he's got five years to wait before he receives his basic state pension.

Shockingly, even profitable employers can decide to wind up a scheme, so long as it meets the Minimum Funding Requirement. Danish shipping giant Maersk closed and wound up its under-funded Sea-Land Services pension fund, which threatened to halve employee and deferred members' benefits. However, it eventually backed down under pressure.

Some workers are pinning their hopes on private-sector union Amicus, which is taking the government to the European Court of Justice for failing to enact the little-known Insolvency Rights Directive, part of European law that EU governments should have enacted. This 1982 directive means that EU governments are required to provide greater protection for the pension rights of employees whose companies become insolvent. In Italy, a group of workers took their government to court in a similar case and won.

Clearly, adequate protection must be put in place to safeguard retirement benefits. The new Pensions Bill will introduce a Pensions Protection Fund, which will rescue under-funded schemes when companies go under. The PPF would cover up to, say, 90% of retirement benefits up to a certain ceiling, say, 10,000 a year - broadly similar to the Financial Services Compensation Scheme.

The PPF will be financed by a levy on all final-salary schemes and be collected by a new Pensions Regulator. The PPF levy will initially be a flat rate, but will move to contributions based on scheme and risk factors (size, riskiness and so on).

The Bill also proposes a fairer distribution of assets between pensioners, employees and deferred members. Furthermore, profitable companies that choose to wind up ailing pension schemes will have to meet pension costs in full. However, to help pay for these improvements, the government is lowering the cap on pension increases from 5% to 2.5%. This means that pensioners' incomes will rise more slowly than they have in the past.

Unfortunately, the Bill does will not improve pensioners' position in the pecking order of creditors (it goes without saying that banks always figure at the top), nor will it cap the fees charged by independent trustees that wind up funds, which can swallow up to a quarter of a fund's assets!

This new law will be introduced by April 2005, but will not cover current victims of pension wind-ups. This means that the 60,000 unfortunate victims of around 200 pension wind-ups - including Don - have had their lives stolen from them. My personal view is that the government should give these workers justice by organising a bail-out. If you agree, please sign the Financial Mail on Sunday's petition.

Frank Field MP tried - and failed - to introduce a Bill to pay compensation to existing victims last year, and over 200 MPs have signed a motion calling on the government to honour these pension promises. Surveys indicate strong public support for this measure.

Being a sensible man, Don followed the government's advice to the letter, and he's now paid the price of Dexion's mismanagement of its pension fund. In these circumstances, the government should not leave him high and dry. Take note, Andrew Smith, Work and Pensions Secretary, and Malcolm Wicks, Pensions Minister!

There are nearly thirty million workers in the UK, so pension wind-ups have affected only around 1 in 500 of us. But the number of victims will grow before the new Bill takes effect.

Up to now, pension wind-ups have been a private-sector problem, so MPs, civil servants, NHS and other government employees are unaffected. These workers all have risk-free pensions guaranteed by the government and, ultimately, the taxpayer. So, they should have no worries, right? Very, very wrong!

Estimates suggest the total shortfall across all government-run pension schemes is greater than the national debt, which is in itself a staggering 450 billion! In fact, it's more than the total income tax that the government will collect over the next four years. One day, this black hole will have to be plugged, either by closing these schemes to new members, reducing the pension benefits available to public-sector employees, or by substantial tax hikes.

Let's hope the government does something postive about the pension wind-up scandal soon, before we consumers completely lose faith in saving for retirement - or we have another major pension meltdown.

Finally, remember that final-salary pension schemes are only as secure as the employers running them!

More: Pressure group Pensions Theft | The Pension Service | Pensions and Equitable Life discussion boards.