Pensions and the Recession
Article, The Barrister – October 2009
Insurance / Legal / Liability / Casualty
Amanda Fyffe examines how pensions claims arising from personal injury/fatal accident will be impacted by the recession.
It started with US subprime mortgages in 2007 - a year later the credit crunch had a tight grip on the UK economy, with newspapers awash with articles on how deep the recession is biting. We have seen countless reports of businesses failing, unemployment rising and our savings suffering. But what will happen to our pensions? How will an individual be impacted on retirement as a result of the current economic crisis? And how will this impact on pension claims arising from a personal injury/fatal accident? Lawyers involved in pension claims need to be aware of how the downturn in the economic climate has, and will continue to, impact pension claims.
Pensions are a long-term investment and it is therefore assumed that any short-term ‘blips’ in the economy, and the impact to pension funds, will be resolved by the time retirement comes around. However, comments in the press about the impact on pension funds appear to be contradictory, ranging from pension funds bearing the brunt of the credit crunch losses to pension funds being one of the few beneficiaries. These comments add to the uncertainty of what has really happened to pensions following the financial crisis and whether they are accurate depends on perspective and the type of pension scheme.
Defined benefit schemes
A defined benefit (“DB”) scheme is where the benefits on retirement are largely provided by an employer and the employee may or may not make personal contributions into the scheme. The benefits payable on retirement are pre-defined by a formula set out in the scheme rules which include the number of years’ service and final salary of each individual. It is the responsibility of the employer to provide individuals with annual pension benefits on their retirement and the risk of investment is borne by the employer.
DB schemes are becoming increasingly more expensive to provide, due to a variety of factors such as increased administrative costs, an increase in life expectancy, and the valuation of pension fund assets in a company’s accounts (FRS17). The increase in costs has driven the closure of many DB schemes to both new and existing employees. In 2008 only 26% of DB schemes were open to new and existing members, compared to 35% in 2006.
Despite the reduction in DB schemes, the financial crisis has led to some benefits for employers providing these schemes. Commonly, once in receipt of annual pension benefits, an individual will receive an annual increase in line with the Retail Price Index (“RPI”) . Therefore, the recent decline in the RPI has led to employers’ future pension liabilities reducing. Furthermore, the recent increase in corporate bond yields, the returns from which are off-set against pension liabilities, has led to a reduction in the pension deficit shown in the employer’s accounts. It is the combination of these factors that have led to pension funds being portrayed in the press as the ‘beneficiaries’ of the credit crunch.
However, when looking at this from the DB members’ perspective, those that are already retired will see a marked reduction in the annual increase they receive in their pension benefits, resulting from the falling RPI.
For those who are yet to retire, and are fortunate enough to retain DB scheme membership, their pension benefits will be secure by the formulaic rules of DB schemes and any impact to their benefits will be limited to the future performance of the RPI.
Defined contributions schemes
A defined contribution (“DC”) scheme can be either an occupation scheme provided by an employer, where contributions are made by the employer and the individual, or a private scheme where contributions are made by the individual only. However, the risk of investment is always borne by the individual.
Typically, individuals will invest in a mixture of secure and more risky investments with the hope that they will receive year-on-year returns, building a pension fund which can be used to purchase an annual annuity on their retirement. However, the financial crisis has had a dramatic impact on the stock exchange and the value of securities. Many DC scheme funds have dropped in value, thereby reducing funds available for the purchase of an annuity, and leading to press coverage that pension funds are one of the many casualties of the credit crunch.
In combination with reducing fund values, individuals are finding it harder to maintain contributions into their DC schemes due to financial pressures and job losses. Research carried out by Prudential last year found that voluntary contributions into DC schemes have almost halved , which will contribute to depressed DC pension funds on retirement. Furthermore, the Budget earlier this year announced that tax relief on pension contributions for high earners will be reduced from 2011 - which will also contribute to the reduction in funds contributed into DC pension schemes.
For DC members retiring in the next couple of years, there will be limited opportunities for them to recover from recent negative returns and, on retirement, individuals will receive a lower annual pension. Prudential’s research tells us that those retiring in 2009 can expect to receive £884pa less than those who retired in 2008 . This situation will also lead to individuals delaying retirement to try and recoup lost fund values.
For DC members retiring in the future their fund value is still uncertain and will be largely driven by the investments of their scheme, the future performance of the economy and any contributions they are able to make. Regardless of the type of pension scheme an individual is a member of, they will be impacted - the extent of this impact will depend on the recovery of the economy, with DC members retiring in the short term hit the hardest.
State pension benefits
The State pension celebrates its centenary this year after the introduction of Pension Day on 1 January 1909. Over the years the State pension has changed and the introduction of SERPS, and later the State Second Pension (“S2P”), has enabled people to ‘top up’ their State pension to provide them with greater benefits on retirement.
The rules governing the calculation of an individual’s basic State pension are dependent on the number of qualifying years a person has built up during their working life. Currently, the full basic State pension of £4,953 (2009/10) is only payable with 44 qualifying years for men (39 years for women).
Eligibility for the S2P and the value of payments depends on a person’s earnings and whether they are contracted out of the S2P. However, there are proposals to reform the S2P, abolishing the ability to contract out for DC scheme members and introducing a flat rate S2P. Furthermore, the Pensions Act 2008 puts into law an automatic enrolment in the Personal Account scheme for eligible workers from 2012. This scheme is aimed at those who do not have access to an occupational pension scheme and individuals are required to make a minimum contribution of 4% to supplement their State pension.
American Express announced that from 1 July they are temporarily ceasing payments into employee pension schemes until 1 January 2011 to cut costs. However, under the new legislation employers will no longer be able to adopt this cost cutting measure and will be obligated to contribute 3% into individuals’ Personal Accounts unless employees elect to opt out.
Aside from legislative reforms, many believe the State pension, even including a S2P, does not provide sufficient income for retirement and should not be relied upon as a person’s sole source of income after they stop working. But what are the implications for the State pension following the downturn in the economy?
The UK’s ageing population has been putting pressure on the State purse for a number of years, with the 2006 announcement to increase State retirement age to 68 years from 2044 intending to ease the strain of future State pension liabilities. However, the recession has now added to this burden by causing a rise in unemployment, with many high earners now out of work. An increase in unemployment results in a loss of National Insurance contributions (“NIC”) and tax receipts for the Treasury creating an even greater challenge for the Government to provide for future State pension costs.
For those who are eligible for the basic State pension/S2P, the benefits received are largely unaffected, regardless of the decline in the economy. However, the decline in the RPI, to which State pension benefit increases are linked, will affect future annual pension payments. Another repercussion of the recession could be further reform or even the demise of the State pension system altogether, brought about by escalating administration costs and future liabilities.
Impact for pension claims
In claims arising from a personal injury/fatal accident, a loss of pension benefits can often form a material proportion of an individual’s claim. For claimants who are members of DB schemes the calculation and quantification of pension losses will remain largely unaffected because of the formulaic approach of calculating pension benefits from DB schemes.
However, claimants who are members of DC schemes will suffer more since it is DC pension funds that have been hit hardest by the recession. Due to the uncertainty of when the economy will recover, and the insecurity of individuals being able to continue to make pension contributions, the calculation of expected future benefits from DC schemes is speculative. To limit speculation, losses from DC schemes can instead be quantified on the basis of contributions that would have been made into the scheme. In this way, claimants are reimbursed their lost contributions, leaving them free to invest the money, and the speculation of future returns on those contributions is removed.
For State pensions, the impact to personal injury claims is less profound. Often there is no loss of basic State pension as receipt of other State benefits, such as incapacity benefit, generally count towards an individual’s qualifying years. However, if a claimant is contracted into the S2P then there could be a loss arising due to a reduction in earnings, and consequently, a reduction in the NICs they would have paid towards their S2P.
The calculation of State pension benefits is intricate, requiring detailed records of life long NICs made. Therefore, in personal injury/fatal accident claims, where a loss of state pension is anticipated or claimed, the most cost effective and accurate method of calculating the loss is to obtain pension forecasts from the Department for Work & Pensions (The Pension Service).
The recession has had a significant impact on our pensions and the fallout will be felt for several years to come. Consequently, Lawyers will need to keep abreast of both economic and legislative changes to ensure pension loss claims accurately reflect the changing future of pension funds and the State pension system.
As appeared in The Barrister, October 2009.