Dashed: the last hope for final salary pensions

Britain's gold-plated final-salary schemes received the last rites this week following a partial U-turn by the Government on the rate used to set contribution levels.

The Government had been expected to allow private-sector pension schemes to follow public-sector pensions in switching from the higher Retail Price Index (RPI) to the lower Consumer Price Index (CPI) measure of inflation. But instead of forcing schemes to make the switch, the Government has passed the buck to pension trustees.

A move to CPI would have saved companies £75bn at a stroke and could have proved crucial in dealing with the massive pension deficits many firms face. But two-thirds of private schemes specify RPI as the measure of inflation in their rules, and the Pensions minister, Steve Webb, clearly decided that the legislation needed to change that would be too complex.

He explained the partial U-turn by saying: "We do not believe Government should intervene to give pension schemes powers to change their rules if they do not already have such powers. We need to ensure that people can have confidence in their pensions."

But confidence in UK company pension schemes has long drained away, after years in which they were first closed to new members, then to existing members, and then shut down altogether.

This year alone has seen Aviva, Asda and Alliance Boots announce plans to axe their final-salary pension schemes. In the last 18 months there has been a massive move towards shutting down final-salary schemes: DSG International, Vodafone, Whitbread, IBM, Royal Mail, Morrisons, Trinity Mirror, Barclays and BP have all gone down that route.

One notable exception has been British Airways which, despite an estimated deficit in its two staff pension schemes of £3.7bn, earlier this year agreed a recovery plan with trustees committing the airline to maintaining annual contributions at their current level for up to 16 years, plus agreed annual increases in line with inflation. However that move was to ensure the deficit didn't hit the airline's planned merger with Spain's Iberia, which is now expected to go ahead in January.

Pension experts say the fact that many firms may be unable to switch from RPI to CPI will prove costly.

"Many schemes have RPI 'hard-wired' into their rules, and without the statutory override, which many in the industry were asking for, schemes will not be able to adopt this lower indexation standard except for the future," says pensions lawyer Jennie Kreser, partner at City law firm Silverman Sherliker.

"Any significant savings to help them mend the massive deficits they are facing will not be as great as they may have hoped. This might be what pushes them over the edge to cease accrual of benefits for members."

The final-salary pensions crisis has been rumbling on for more than a decade now, with this week's move the latest in a long line of question marks over their future. At heart is the fact that pension schemes relied on unsustainable stock-market returns to provide future payouts for members. The technology crash of 2000 led to many schemes having assets that were worth less than their liabilities, forcing firms to prop up the schemes.

Pension schemes were already reeling from the 10 per cent tax on dividends imposed by Gordon Brown as Chancellor in 1997. With major deficits in schemes becoming apparent, the Government reacted with tougher regulation, which led to increased costs. At the same time, increased longevity meant the cash drain on pension funds has soared.

At the beginning of the last decade, major firms began closing schemes to new members in an attempt to cut costs. They switched workers into money-purchase schemes, also known as defined-contribution schemes. While a decade ago just over a third of employees were members of final-salary schemes, the latest figures suggest this has fallen below 15 per cent. Fewer than a fifth of the remaining final-salary schemes are open to new members.

"The combined weight of longevity improvements, mark to market accounting, well-meaning investor protection legislation, PPF levies, volatile markets and gender discrimination legislation have all driven defined-benefit schemes to the point where they simply aren't a commercially logical choice for any employer," says Tom McPhail of Hargreaves Lansdown. "The RPI to CPI move is good news for schemes that can make the switch, as it opens the possibility of reducing deficits slightly." Jennie Kreser says the Government has simply passed the buck on the issue to pension trustees. "In a sense, what the Government has done is to say to schemes and to the trustees who run them, 'Look, we think CPI is the way to go, and that's what the public sector will have, but for you, good luck, you're on your own.' Many of us suspect that the Government really had no idea just how complicated the issue truly was and when they realised, it went back into the 'it's-all-too-difficult' basket."

Pensions expert Ros Altmann says the latest move simply comfirms that the pensions crisis has hit. "Pensions are much more expensive than anybody realised, and 21st-century employers are simply not willing or able to underwrite these open-ended commitments," says the director general of Saga. "The question is how do they get out of past promises without bringing the company down?"

What the future could hold

*The huge deficits that many companies face mean they must find ways to reduce costs. That can be achieved by reducing what is on offer. The Government has helped towards this by plans to get rid of the default retirement age next year. If people work for longer, their cash demands on their pension scheme will be much less because the pension will be paid later.

Other solutions include reducing the rate of benefit accrual – which would have been achieved by the switch to linking to the CPI (Consumer Prices Index) measure rather than the RPI (Retail Prices Index) measure – or by increasing member contributions. The latter is problematic as it alienates employees, although it hasn't stopped some firms from going down the road.

Ros Altmann, a pensions expert, says the funding crisis will force firms to look at new solutions for dealing with their pensions. "Employers will be looking at ways to de-risk their payouts, perhaps by buying annuities," she says. "However that extra demand would push the price of annuities up, hitting those with private pension arrangements."

She says the Government should consider issuing gilts tied to life expectancy. "That would enable a market in longevity risk to be developed.

"It needs to be led by the Government to get some proper benchmarking. Such a move would help annuity pricing, and could help the Government fund the deficit."