What protection does my pension have?
"I've seen a lot of stories in the news about pension funds running into trouble. How worried do I need to be, and what protection do my savings have if something does go wrong?"
THE recent collapse of BHS and the struggles of Tata Steel have thrown into question the security of defined benefit (DB) pension schemes.
The good news is that should a company fail, any DB scheme it runs is protected by the Pension Protection Fund (PPF).
The bad news is that the protection isn't total - and the even worse news is that the PPF don't cover other types of pension - leaving many worrying about the safety of their retirement funds.
In this guide we'll look at the types of pension available, and the protection offered with each, should something go wrong.
Defined Benefit schemes
This type of scheme pays ex-employees a set annual income in retirement. There are two types - the increasingly rare Final Salary scheme, and the Career Average scheme.
The former pays an annual pension based on a person's salary in the final year of employment with their employer; the latter pays a sum based on their earnings over the duration of their employment.
The amount someone enrolled in either kind of these schemes receives as a pension can be calculated using the relevant salary figure (whether final or averaged over the career), the number of years they've been with that employer, and what's known as the accrual rate.
This final figure is a fraction, usually 1/60 or 1/80.
Multiplying the three figures together gives the total annual income we can expect from that employer.
So, for example, someone with a Final salary pension earning £30,000 when they retired after 40 years with the company, whose pension scheme has an accrual rate of 1/80, would receive:
- £30,000 x 40 x 1/80 = £15,000 a year
Final salary schemes have been popular with employees for years because of their fairly generous terms, but many have been closed or converted to career average schemes in recent years because they're simply too generous for employers to afford.
Of those that do continue to run the schemes, the PPF say that more than 80% are in deficit - that is, the funds held in the scheme as a whole fall short of what's needed to pay all the scheme's members in the coming years.
This figure has been rising over time, as a result of a combination of people living longer and higher administrative costs.
Being in deficit doesn't mean a scheme won't make good on payments - and as long as the company itself is in good shape there's usually not too much need to worry.
Even if a firm offering a DB scheme goes bust, the state-backed PPF will step in and make up a good part of the shortfall.
The PPF is funded through a levy on all companies who operate such pension schemes. In 2015, those companies were asked to pay a total of £574 million into the fund.
Since being established in 2005, the PPF have assisted with 800 failed schemes covering 222,000 members - at a cost of £1.8 billion.
However, although the PPF provide a lifeline to those with money invested in DB schemes, many members will see a reduction in the benefits they receive.
Yet to retire
Those who are still working when their pension scheme is taken on by the PPF will be in line to receive a "compensation" pension when they do retire.
This is generally 90% of what their pension would have been worth at the time the company failed - subject to a cap based on their age.
The caps are recalculated every year.
At the time of writing, someone aged 60 is subject to a cap of £32,277 - which with the 90% limit applied means they'll receive a maximum of £31,439 a year. Someone aged 65 will be subject to a £37,420 cap, which equates to receiving a maximum of £33,678 per year.
The PPF say the caps don't affect the vast majority of people - but higher earners and those who leave a company before retirement age are most likely to see their pensions decrease as a result.
Jon Hatchett, a partner at pensions consultancy Hymans Robertson, says that the worst affected are likely to be "executives who are close to normal retirement age, because they don't have much time to adjust".
The age-based caps do not apply to those who retired at their scheme's normal retirement age or who have already exceeded it.
Furthermore, any contributions made after April 5 1997 will rise with inflation. Anything before that date is not index-linked, meaning that, as prices go up, the value of this part of the pension will, in effect, go down.
Those who retire before their scheme's normal pension age are subject to caps based on how old they are when the scheme is taken on by the PPF.
So, while someone who retired at 55 might normally expect to receive £40,000 a year from their pension, if the scheme goes into the PPF when they're 59 their income will be capped at 90% of the level for 59-year-olds.
This would mean a drop in income to £28,270 a year.
Contributions to a defined contribution pension allow people to build up a pot of money that can be used to provide an income in retirement.
The amount of this income depends on the amount paid in and the performance of the fund the money is invested in.
The two main types of defined contribution pension are workplace pensions - arranged by an employer - and private pensions, arranged by the individual.
With a workplace DC scheme, members pay part of their salary into a fund, with their contributions matched (at the very least) by their employer.
This type of pension is becoming increasingly common - largely thanks to the Government's auto-enrolment scheme, which gives employers until 2018 to automatically enrol any eligible employees into a workplace pension scheme.
However, fears have been expressed that those who pay into some auto-enrolment pensions could lose out if their scheme collapses.
In February, a BBC investigation found that up to a quarter of a million people were at risk of losing their savings, because dozens of companies providing auto-enrolment pensions were "too small to survive".
Yvonne Braun, director of policy, long-term savings and protection at the Association of British Insurers (ABI) said that these trust-based schemes do not currently have to comply with insurers' strict requirements, "which means they can be set up far too easily".
Since then, the Government have proposed a new Bill giving the Pensions Regulator (TPR) greater powers to take action on smaller providers making unverifiable claims and deliberately misleading investors.
The Pensions Bill will help protect savings in these so-called "master trust" pensions favoured by around 1.8 million small employers.
Larger providers, offering what are known as contract-based schemes, are regulated by the Financial Conduct Authority (FCA).
Because defined contribution workplace pensions are normally looked after by a pension provider, it means that employees will still get their pension even if the employer goes bust.
If the pension provider goes bust, then compensation may be available from the FSCS (see below).
Personal pensions are just that - we choose a provider and make our own arrangements for contributions to be paid.
Personal pensions are protected by the Financial Services Compensation Scheme (FSCS), which can pay compensation to savers if a financial services firm is unable, or likely to be unable, to pay claims against it.
The amount of compensation depends again on whether we've retired or not - and if we have, on what we've used our pension savings for.
The usual level of protection offered by the FSCS is £75,000 per person per registered institution.
However, if we're saving into a pension fund that then collapses, we're protected up to 90% of the value of those savings.
Once we've accessed the money, it depends what we do with it as the level of protection we receive.
Funds placed directly in investments are protected up to £50,000 per person per firm, but annuities are protected by the FSCS for the whole amount should anything happen to the provider.
The FSCS say that they may also be "able to consider" claims made against products involved in Self-Invested Personal Pensions (SIPPs), such as investments, deposits or insurance.
The amount of compensation will depend on the type of product and would also require that the underlying product provider is authorised by the FCA or the Prudential Regulation Authority (PRA).
On the whole, we needn't worry unduly about our pensions. The Pensions Bill should overcome the teething troubles of auto-enrolment and see to it that trust pensions are better monitored by the Pensions Regulator.
Defined benefits schemes are still among the most generous pensions available, even with the shift from final salary to career average schemes.
Even when transferred to the PPF, and therefore becoming subject to caps and a 10% cut, they are still attractive for most of us, compared with defined contribution schemes.
Alan Higham, an independent retirement expert, says that "nobody should be scared into transferring out of a final salary pension over a fear that their company might go bust".