As final-salary plans retire, keep a close eye on the options

It's approaching zero hour for UK pensions. Last week, a survey from actuary consultants Lane, Clark & Peacock revealed that Britain's leading company pension funds are facing their largest ever collective shortfall. The deficit in FTSE 100 firms has more than doubled from £41bn last year, to a record £96bn, the survey revealed.

Scheme finances are being crushed by a combination of poor investment performance and the increased longevity of members. In short, schemes are earning less money than they expected, while at the same time their commitments are increasing.

And the signs of stress are palpable. High-profile companies such as Barclays have announced plans to shut their final-salary schemes. And last month, American Express went a step further and suspended all employer payments into its company schemes. Only three of the UK's biggest businesses allow new members to join their final-salary schemes – Cadbury, Diageo and Tesco.

"This closing down of final-salary schemes has been going on for a long, long time, but we are getting to the end of the chapter," says Danny Cox (far right), from advisers Hargreaves Lansdown. Final-salary schemes are often considered the most lucrative workplace pensions available, as workers are guaranteed a proportion of their final salary for each year of service.

Companies are also clawing back profits by capping pensionable pay rises and raising contribution rates. Other companies, such as Barclays, have prevented members from making any additional payments. Therefore, any workers fortunate still to benefit from such a scheme are likely to find that it is only a matter of time before their company follows suit. So it is vital for workers really to get to grips with their retirement plans now. So what should you do if your company pension, which you have been banking on throughout your career, suddenly becomes the subject of cuts?

When a final-salary scheme is frozen, members stop making contributions and the employer is obliged to offer a different type of scheme, usually one of two main alternatives – a money-purchase plan or a career-average scheme. Once a scheme has closed, the pension fund that has been built up is safe; only future benefits are affected. If in the future the company goes into administration, then the pension fund continues, and if it is in deficit – in other words it doesn't have enough assets to meet its liabilities – then it can call on the pension protection fund, which is a safety net for final- salary pension schemes. With such guarantees built in, pension experts generally advise employees to leave their pension rights in the scheme, unless they believe the company may go bust, at which point they should seek independent advice.

Nevertheless, several employers are currently trying to persuade existing members to transfer their final-salary pension to a defined-contribution plan, which could pose further problems. Generally speaking, there is little sense in transferring money out of a final-salary pension scheme, but as always, independent financial advice is essential. Even if there are incentives on offer to get members to move their pension, the long-term benefits of staying put will usually outweigh the short-term cash boost, and it's important to remember that even when frozen, final-salary-scheme benefits will keep up with inflation.

"You have to look at the numbers very carefully. If you're close to retirement and your earnings potential isn't great, you will almost certainly be better off sticking with the scheme, particularly if you have dependents," says Mark Ruse from financial advisers Fiducia Wealth Management.

There are many other issues for employees to consider if their final-salary scheme is to end. Crucially, they should make sure they take up the offer to join the new replacement pension plan, as not all companies will automatically enrol members.

A money-purchase, or defined contribution plan, is the most common alternative as it allows the employer to shift the risk on to their employees. With a money-purchase plan, the retirement fund is invested, typically, in the stock market, and therefore holds no element of guarantee. Upon retirement, the fund is used to purchase an annuity which provides a set income for life, the amount of which is heavily dependent on the performance of the investments and the annuity rates at the time of retiring. Of course, savers have the right to use their pension pot to buy an annuity from the best provider, not just the insurance company running the money-purchase pension in which they are a member. Shopping around on retirement for an annuity is a must, as annuity rates can vary a great deal; sometimes making a few phone calls to different providers can boost the annuity by anything up to 10 per cent.

The new scheme on offer may also have a matched contribution element. This means that up to a set level for every pound the employee pays in. the employer will match this.

"A lot of people join the scheme at the lowest level of contribution – the message is always try to take the free money on the table from the employer. If possible, try and pay up to the maximum; remember that employer pensions contributions are, in effect, deferred pay. If you don't make the most of them, they are gone for ever," says Julian Webb, from pensions and investment firm Fidelity.

As well as being higher risk than a final-salary scheme, a money-purchase scheme requires far more involvement from the employee. Many employees who cannot decide what to invest in may find themselves with default funds picked for them. While not necessarily a bad thing for those who do not want to manage their pension, it could mean that their money is invested inappropriately. Investment performance and contributions should be reviewed regularly to make sure that they are on course for the target outcome and prepared for retirement.

Similarly, as retirement age approaches, pension holders need to think about reducing the risk. "Ideally people should look at a range of funds that are open to them and take a keener interest in how their money is invested," says Mr Cox. "As a rule of thumb, people should look to move out of shares and into safer investments such as bonds and cash as they draw near to retirement. This minimises the risk that their hard-won gains will be damaged by a sudden downward move in the stock market," he says. According to Mr Webb, money-purchase pension funds often include a "lifestyle" option that savers can choose, which builds in an automatic switch out of shares and into bonds and cash as scheme members approach retirement.

Morrisons supermarket is one of several companies that transferred its final-salary scheme to a second alternative – a career-average scheme. With this plan, also taken on by Royal Mail and BT, payouts are based on average earnings during the employee's time with the company. These have the advantage over money-purchase schemes in that there is still a guaranteed pension but it will be a good deal lower than would have been available with a final-salary scheme.

There are also cash-balance schemes, where there is an element of protection because employers guarantee the size of the pension fund, but it must then be used to purchase an annuity at retirement. These hybrid schemes combine an element of guarantee with an element of risk.

The big problem for employers was that, by offering final-salary schemes, the risk lay entirely with them. Equally, with money-purchase schemes, the employee is taking on all of that risk, so these hybrid schemes offer a useful alternative.