What is a pension deficit?
A deficit occurs when a pension scheme’s liabilities are larger than the assets they hold to provide for those liabilities. In the UK there are 5,422 final salary pensions with an overall deficit of around £136 billion. This works out at an average deficit of £28 million per scheme. In reality, it is far from an even spread with some schemes being in relatively good health, some with moderate deficits and others having deficits into the billions.
How does it work?
The deficit will change depending on the performance of the assets in the fund, the amount of contributions the company is making into the fund, and the outstanding liabilities the scheme has. The deficit calculation also factors in the life expectancy of a scheme’s members, which represents the amount of time a scheme will be paying out benefits for.
As the assets are invested, their value goes up and down in line with markets and interest rates. Typically, pension assets will be invested relatively cautiously, meaning a high weighting towards fixed interest investments such as government bonds. The yield on these investments is dependent on interest rates set by the Bank of England, which are currently at historic lows. Talks about negative interest rates are on the table, which would present a massive problem for pension funds and could result in them actually having to pay interest rather than receiving it.
The value of the scheme’s liabilities will also fluctuate, although to a far lesser degree. Since the overwhelming majority of defined benefit pensions are closed to new members, they are not increasing their liabilities by making new promises. However, the promised benefits they have already made to existing members is typically inflation linked, meaning it will increase in line with inflation. Their liabilities will also decrease as members pass away.
Interestingly, life expectancy seems to have plateaued in the UK and there has been a substantial rise in men remaining legally unmarried throughout their lives. This could lead to reduced liabilities for DB schemes as unmarried members will not require a spousal benefit after they pass.
How does this affect members?
The risk to members is that their pension scheme will end up in the Pension Protection Fund. This would result in them losing any flexibility they currently have with regards to the option of transferring out of the scheme and they could also see a reduction in the benefits they are expecting to receive.
The good news
As interest rates go down, transfer values go up. This means that people with defined benefit pensions are currently being offered large amounts to leave the scheme.
For more information regarding how this is calculated, read our article on CETV values here.
You can request a transfer value from your scheme free of charge and we would recommend anyone who is a member of a DB scheme to make this request. Typically, you can request a transfer value for free once every 6 or 12 months depending on your scheme. So, if you previously requested a valuation and did not transfer out of the scheme, it makes sense to request a new one as regularly as you are permitted to without incurring a charge. This way your decisions are always based on up to date data.
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