Lightening the Load
How do you close a final salary pension scheme without alienating the workforce? David Prosser has some suggestionsThe pensions industry is in crisis. One company, the Big Food Group (BFG), says that continuing its staff pension scheme in its present form would be commercial suicide. Keeping the scheme open would cost 10 million a year half its annual profits, says BFGs board. Now the company is facing legal action from staff who dont want to lose pension rights.
But BFG isnt alone. A string of companies, from British Airways to Marks & Spencer, have announced changes to their pension schemes over the past 12 months. Some companies are closing the most generous types of plan altogether others have decided to bar new workers from their schemes.
The schemes affected are final salary pension plans, where the employer guarantees that members pensions in retirement will be a specific percentage of their pre-retirement earnings staff get more pension the longer they are members of the scheme.
Instead, many employers are switching to money purchase alternatives. They still contribute to staff pensions, but benefits are not guaranteed what employees get in retirement depends on the performance of the stock market.
Although companies have been worried about the cost of pension provision for some time, it is plans for a new accounting standard that have brought matters to a head over the past year.
The Accounting Standards Boards FRS 17 standard will, for the first time, force companies to include on their balance sheets the money needed to pay staff pensions and many companies liabilities are massive. The standard had been due to come into force next year, though its launch has now been delayed until 2005.
The effect of the new standard has been devastating because it reveals to shareholders the parlous state of many companies pension schemes. A recent report from consultants Hewitt Bacon & Woodrow concluded that the typical large company scheme does not now have enough assets to cover its liabilities.
Hewitt looked at 69 of Britains largest 100 companies on the calculation method used by the FRS 17 standard, the average pension scheme was 100% funded at the end of last year, but since then, tumbling share prices have had a devastating effect on assets.
Stock-market changes are likely to have moved the average funding level of 100% to about 87%, says Hewitt spokesman Brian Wilson, who warned that some companies would be substantially worse off than the average.
The figures do not mean companies are unable to pay workers pensions, because FRS 17 measures future liabilities as well as current outgoings. But companies will have to make up these deficits over the coming years or renege on the pensions promises they have made.
Some companies have massive problems. Investment bank Goldman Sachs calculates that BT, for example, has a 5.6 billion deficit in its pension scheme, though the telecoms company disputes these figures.
But it isnt only FRS 17 that is forcing companies to re-examine their pensions provision. Plunging stock markets over the past three years have sharply reduced the value of many pension schemes assets.
And chancellor of the exchequer Gordon Brown has not helped matters. In 1997, he abolished pension funds right to reclaim the tax that is deducted from share dividends before they are paid. The decision cost pension funds 5 billion a year.
The closure of final salary pension schemes is a last resort for firms, says a spokesman for the Confederation of British Industry. Many companies have been forced to take this decision given the volatility of the stock market and the rise in the complexity of occupational pension provision.
And although the Government has pledged to cut red tape in pensions regulation, this wont solve perhaps the biggest problem of all facing employers: Britons are living longer than ever before.
When companies first set up pension schemes, they expected to have to pay retirement benefits to employees for a few years. Now many people live 20 or 30 years in retirement. The final salary model cannot cope despite the various tax breaks that pension schemes continue to enjoy.
Nevertheless, many employees are angry about the way their pensions are being changed, which means that trade unions and HR departments are increasingly getting involved.
Roger Lyons, general secretary of Amicus, says too many employers are taking knee-jerk actions. Pensions are the biggest issue for employees today not pay and not conditions for the first time in more than 30 years, he says. Lyons believes some companies have been too quick to shut down schemes.
With confrontation ahead, employers now face a massive challenge on pensions. Many have no choice but to cut the cost or at least the future potential cost of providing staff with retirement benefits. But they also have to manage change so that benefits can be adjusted without alienating staff.
Six ways to manage change effectively
Call in the legal eagles
Employers duties to pension scheme members are very clearly set out in law, says a spokeswoman for the National Association of Pension Funds. Employers cannot change a pension scheme in any way they see fit there are things you can and cant do, she points out.
In addition to statute, every occupational pension scheme has its own set of rules and these may further limit an employers ability to make changes to workers pension rights.
Above all, employers need to prove theres no alternative to what they are suggesting. Theres a big difference between an employer who cant afford to pay for staffs pension benefits and one who saves costs to guarantee a boost in company profits, says one pensions lawyer.
HR departments play a key role in ensuring that companies follow a legal checklist before implementing changes to their pension schemes. First, they have to check that the rules of the scheme allow the changes proposed. Next, they must look at staff contracts do they give the employer the right to withdraw pensions?
Also, pensions may have become a contractual right even if the details arent specified in workers contracts through subsequent correspondence between employer and employee, for example.
It is for alleged breach of contract that 900 staff are suing BFG. The legal firm BFG employees have instructed has reportedly told its clients that they have a better than 50:50 chance of winning the case, even though such a claim is unprecedented.
BFGs spokesman says: We are assured that the changes do not contravene pension or employment laws. However, other employers are watching the case with great interest.
Communication is crucial
Just unilaterally announcing that you are changing your pension scheme is a recipe for disaster, says Mike Fosberry, head of pensions at employee benefits consultancy Smith & Williamson.
Fosberry says companies that feel the need to change their pension provision should start by talking to the trustees of the scheme, who are responsible for safeguarding the interests of members.
The employer and trustees should between them co-ordinate consultation with staff discussing the options with employees representatives, and listening to their views. Proposals presented as a fait accompli are unlikely to go down well.
Its up to HR departments to ensure employers find a way to explain the importance of changes to the pension scheme, says Fosberry. Many companies have altered their schemes in order to secure future jobs, he says, so try to leave staff in no doubt about what the implications of making no changes might be for their current financial security.
As Britains chief City watchdog, the Financial Services Authority (FSA) tries to practise what it preaches, and pension experts say its approach is a good model.
The FSAs 149 million fund is already closed to new members but had a shortfall of 31.5 million at the end of March. Stock-market failures since then recently forced the regulator to warn staff that it was considering closing its final-salary fund to existing staff.
Crucially, the FSA has not yet finalised plans and has told staff that closure is only one of a range of options. A spokesman says there is no particular urgency since most scheme members are a long way from retirement. Talks are continuing.
Since it is the potential future cost of pensions that worries most companies, rather than the current cost, there may be scope for HR departments to offer staff other benefits in place of pensions.
In March, for example, the BBC announced that the surplus in its 6.5 billion fund had fallen 60% over the previous two years. But the organisation has already taken steps to cut the cost of pensions. It runs a flexible benefits scheme that enables staff to allocate their remuneration in different ways to suit their circumstances accepting less pension in return for more salary, for instance.
Graham Mitchell, a pensions specialist at consultants Watson Wyatt Worldwide, says, Different people value different types of reward using flexible benefits it may be possible to manage people out of major pension commitments.
A 25 year-old man with a wife and three children, for example, is more likely to be concerned about life insurance and private medical insurance than a large pension. Other staff may be happy to accept less valuable pensions in return for, say, extra holiday.
Think about the broad rewards package offered to staff, says Carol Hathaway, Watson Wyatts human resources specialist. Pensions are a paternalistic type of benefit and if you treat people like adults by giving them more choice, they are more likely to accept difficult decisions.
Flexible packages may not reduce a companys remuneration bill immediately but they can take many people out of the pension scheme which will steadily reduce the cost of pensions.
The simplest option is to offer staff extra salary but explore other benefits too.
Timing is everything
Mike Fosberry of Smith & Williamson has advice for HR directors: Try to set up consultation exercises well ahead of changes actually being implemented. Otherwise staff will feel as if the decision to shift away from final salary pension provision has already been made.
Companies also need to be sensitive. Many employers will want to retain superior pension benefits for senior staff, particularly where the recruitment market is very competitive. But that can add to resentment on the shop floor remember that pension payments to directors have to be declared in the annual report and accounts, so staff will find out about them one way or another.
Announcing the closure of a final salary pension scheme shortly after the company has announced big profits or pay increases for directors is also a bad idea.
You have to be very careful about the way in which these changes are presented to staff, says Graham Mitchell of Watson Wyatt. For example, one reason why workers and unions at steel firm Caparo are so angry is that the company is run by Lord Paul of Marylebone, a wealthy Labour peer whose family fortune was estimated at 280 million in the last Sunday Times Rich List.
The workers also point out that Caparo has taken a 12-year holiday from making contributions to the pension scheme. And their union has discovered that Paul is a non-domiciled resident for tax purposes, which saves him millions of pounds in income tax.
Helping staff face up to risk
Moving from final salary pension provision to money purchase is effectively a transfer of risk. In a final salary scheme, the employer bears all the risk if markets disappoint it has to top up the pension fund in order to pay guaranteed pensions.
However, in a money purchase scheme it is the members who are the risk-takers if the funds investments prove a let-down, it is their pensions that suffer.
Matthew Demwell, European partner of Mercer Human Resource Consulting, says employers have a responsibility to help employees face up to this risk. Staff joining money purchase plans have more decisions to make, particularly about investment options, and they need help.
Employers arent professional financial advisers, says Demwell, but HR departments can ensure that generic help is at hand. Booklets that explain exactly how the new pension arrangements work, what employees have to do, and what the consequences of their decisions might be, are a must. Paying for employees to see an independent adviser, or at least sharing the cost with them can also be a good idea, Demwell adds.
The key for employers, Demwell says, is honesty. Be above board at all times and explain what you are doing, he advises.
Accountants Ernst & Young, for example, had to reconsider plans to scrap its final salary scheme for existing members a legal challenge from a group of employees unhappy with the proposals forced the rethink. The company has accepted criticisms from staff and is now promising a better offer.
Mercers Demwell says employers cannot afford to forget their final salary commitments once they have implemented changes to the pension scheme. Even if the scheme is closed to both existing and new members, promises made in the past will still have to be honoured.
The worst-case scenario if an employer fails to manage its legacy final salary commitments properly is that it will have to go back to employees with proposals for a further downgrading of their benefits, he says.
Employers also have a responsibility to fund pension schemes properly so that there are sufficient assets to provide staff with the pensions they have been promised.
Official compensation schemes do not protect employees of companies that go bust and leave a hole in the pension scheme. Thousands of people lose out in this way every year.