How safe is your pension?

Final salary pensions rarely make the news, which makes the headlines of the past few weeks, with all their talk of insolvency and cash crunches, all the more alarming.

When planning for retirement, a final salary (or defined benefit) pension is typically something people spend little time worrying about – your final benefits are guaranteed, and no one will blame you for thinking that's all you need to know.

But, of course, things can go wrong at defined benefit (DB) schemes, too. One never likes to think about worst-case scenarios, but they do occasionally materialise. 

Additionally, other types of pensions such as defined contribution schemes and self-invested personal pensions (Sipps) offer less protection, especially from market movements. So how safe are your retirement plans?

Below we look at the risks and available protections for the key types of pensions – including those that arise during unpredictable market conditions.

DB schemes

Final salary pension schemes running out of cash was not a crisis that many people had predicted. On Friday 23 September, chancellor Kwasi Kwarteng announced a series of tax cuts in his 'mini' Budget, significantly increasing the UK’s borrowing levels. As a result, gilt yields skyrocketed, prices dropped, and by Wednesday the following week the Bank of England (BoE) had announced a £65bn gilt purchase programme in order to avoid a meltdown at pension funds. What had happened?

The problem originated from liability-driven strategies (LDI), a term that refers to investment strategies now commonly used by pensions to manage their liability risks. These typically include hedging against interest rate and inflation risks and use gilts as leverage.

As the value of their collateral fell, pension funds faced capital calls from their LDI managers. And as pension funds also began selling their most liquid holdings – including gilts – prices dropped even further, exacerbating the situation. The BoE stepped in to end this vicious cycle and stabilise the gilts market.

For a while, there was a concrete risk that some pension funds might run out of cash to top up their collateral. This would have been a technical default and risked contagion to other areas of the financial markets – but would probably not have affected the scheme members’ pensions.

“While a technical default would not have been a good outcome, it would not mean that pension schemes would be insolvent or forced into wind-up...It would, however, have led to some legal intervention being required,” says Ian Mills, head of DB endgame strategy at Barnett Waddingham. 

As at 4 October, the BoE had purchased £4bn-worth of long-dated gilts. The bank’s purchase programme is due to end on 14 October, and it is unclear what will happen then.

Pension funds have been trying to get their ducks in a row. Elaine Torry, co-head of trustee DB investment at Hymans Robertson, explains that while the BoE’s intervention has bought them some time, schemes still need to raise liquidity to meet their capital calls by selling assets, as well as to rebalance their asset allocation as needed for the longer term.

Over the past few years pension funds have been increasing their alternative allocations, in search of illiquidity premiums that could compensate for the low bond yields on the markets. Owning many illiquid assets increases a fund’s liquidity risk and makes things harder in a cash crunch.

Last week, the Financial Times reported that private equity funds stakes were on the market at significant discounts as pension funds sought to sell them to raise cash, with Goldman Sachs among the prospective buyers.

Ed Wilson, partner at pensions advisory firm Isio, says that in many cases sponsor companies (such as employers) have stepped in, accelerating contributions or providing short-term funding to pension schemes, helping them hold on to their illiquid investments.

Other DB risks

DB schemes are exposed to three key types of risks, notes Wilson: the aforementioned liquidity risk, which is about having enough cash available; a liability risk, which has to do with how pension liabilities change in time, mostly depending on interest rates; and a funding risk.

A scheme’s funding level is an important metric in gauging health. Expressed as a percentage, it will tell you how much of its liabilities are covered by its assets – if it is 100 per cent funded, it has enough money to pay all its pensions.

Funding levels can change quickly because of market movements. Many schemes are not fully funded, and rely on investment returns and contributions from sponsor companies to improve their funding position.

The LDI crisis was a cash crunch, rather than an affordability issue. In fact, many pension funds would have seen their funding levels increase (when gilt yields rise, pension fund liabilities decrease), Torry says. But there are other factors that can impact them negatively: pension schemes are exposed to a range of investment risks, including in many cases equity risks. Equities account for around 19 per cent of DB schemes' assets.

To ensure the best possible outcomes, they need to consider a number of things, from having an adequately diversified investment strategy, to choosing suitable managers to handle their assets (typically through dedicated mandates), to putting all the necessary investment monitoring procedures in place.

From a funding perspective, a worse situation for DB schemes would be one in which both equity market and gilt yields are falling, Torry says – like at the start of the Covid-19 pandemic. It would increase a scheme’s liabilities just when the value of its assets is going down.

Per se, a scheme’s funding level does not have a direct impact on pension payments – but it can become relevant. For example, one of the few DB schemes still accepting new members, the Universities Superannuation Scheme, last year made changes to the benefits its members accrue because it did not expect its projected investment returns and contributions levels to be able to sustain them.

You can learn more about how your DB pension is managing these risks by reading the annual newsletters prepared by trustees, which should include information on investments as well as at a statement of investment principles.

“But it's important to recognise that members in defined benefit schemes are largely protected from how markets go up and down,” notes Wilson.

Company failures

Final salary pension schemes are backed by their sponsor companies and sit on their balance sheets, which makes the company’s financial health a significant factor to consider. But if it fails, there is a contingency plan in place in the form of the Pension Protection Fund (PPF), which is partly funded through a levy system.

When a company sponsoring a DB scheme fails, the PPF starts an assessment period to determine whether it needs to step in. This might not be the case if, for example, the scheme is sufficiently funded to pay its members’ pensions autonomously.

The assessment period typically lasts 18 months to two years, during which the trustees will continue to manage the scheme. At the end of it, if the PPF does need to take responsibility for the scheme, it will offer 100 per cent of the benefits to pensioners, and 90 per cent to those who had not reached their retirement age at the point of insolvency.

To cite a somewhat infamous example, various pension schemes that were connected to failed construction company Carillion have been examined by, and in many cases transferred to, the PPF. One of them was the Carillion Rail Pension Scheme, whose 4,000 members would have received an estimated 55 per cent of their pensions without PPF intervention.

Some 1,088 schemes have been transferred to the PPF since it launched in 2005. The fund currently protects more than 5,200 schemes, a figure that has been decreasing over the years as DB schemes wind up or merge.

“It’s important that members of defined benefit schemes understand that we are ultimately here to protect them if we are needed to step in,” says PPF chief executive Oliver Morley.

The PPF was also caught up in the LDI crunch and faced significant capital calls at its peak, but told the FT it has been able to satisfy them thanks to abundant liquidity. Morley says the fund is “confident in the strength of our funding position”.

Defined contribution schemes

DC pension schemes have been spared the LDI troubles, because they do not typically use those strategies. They also invest very little in private markets and normally have plenty of liquidity.

But other risks that DC pensions face are similar in nature, and are borne by pensioners individually rather than by the schemes – an excellent reason to hold on tight to your final salary pension if you are lucky enough to have one.

The funding risk becomes an adequacy risk, Wilson explains – is your pension pot going to be enough to provide a comfortable retirement? The liability risk translates into having to decide what to do with your pension pot once you retire given the current market conditions (buying an annuity, using income drawdown, taking a lump sum, or a combination of those).

In some cases, people approaching retirement would have seen their DC pension pots drop in value significantly in the past few weeks.

Stephen Budge, partner at consulting firm LCP, explains that if you are in a default investment strategy and are approaching your set retirement age, your pension scheme is likely to have placed you in a low-risk fund in order to protect your pot, and this will typically be a fund with a high fixed income allocation. Pension funds cannot tell if you are intending to remain invested or to use your pot to buy an annuity, as was typically the case before the arrival of pensions freedoms in 2015.

Fixed income strategies have been heavily hit by the recent bonds sell-off. If you do end up buying an annuity, any reduction to your capital should be at least partially offset by the rises in annuity rates. But if you were planning to take your pension through income drawdown, you might find yourself with less than expected.

“Schemes should be proactively raising awareness of this issue with their members. They need to be reassuring those opting for an annuity that they are on the right track and checking with others that they are in the correct investment strategy in line with their retirement goals,” Budge says.

As at 4 October, the average annuity-hedging fund had fallen by 38 per cent in 2022, and by 5 per cent since the 'mini' Budget, according to AJ Bell. 

“Annuity rates have indeed shot up this year,” says Laith Khalaf, the platform’s head of investment analysis. “But since the pension freedoms were introduced in 2015, only about one-in-10 pension savers now buys an annuity...Many investors will therefore now simply be sitting on much smaller pensions than they were at the beginning of the year.”

DC scheme investors should check that their retirement age has not been set too early as being switched into a low-risk fund might clash with their own retirement strategy.

People who have not engaged with their DC pensions so far might want to look carefully at where they are at, and potentially speak to their provider. But it is a bad time to make significant changes.

“Our concern has been that members might just see they have got a massive loss and suddenly panic...You need to tread very carefully at this point if you are going to make a decision,” says Budge.

A small consolation for having to bear all the investment risk is that DC pensioners do not need to worry about their employer going bust, because DC pension schemes are separate from their companies.

If your DC pension provider fails, your pension should be protected by the Financial Services Compensation Scheme (FSCS). In rare cases, some DC pensions do not qualify so you may need to check with the provider to make sure that is indeed the case.

“FSCS can protect pensions that are provided by UK-regulated insurers, as long as they qualify as ‘contracts of long-term insurance’...Where FSCS can pay compensation, we will cover the pension at 100 per cent with no upper cap,” says the scheme.

Ssas and Sipps

As with DC pensions, people with small self-administered schemes (Ssas) or Sipps have no shield from market movements. But they have more control over their investment strategy, which should be carefully constructed in line with their overall retirement planning.

As you approach retirement or are in drawdown you might want to have a cash emergency fund in your pot in addition to your standard cash savings, to protect you if a crisis hits the markets, suggests Alice Haine at Bestinvest, but avoid holding too much cash if you are still far from retirement. 

In a market downturn or at times of high volatility, staying invested means there is time for markets to recover and drip feeding money in rather than investing a lump sum can smooth out the ups and downs. In turn, you should avoid checking your portfolio too often, trying to time the market (“unless you are an investment superstar this is unlikely to work”, Haine says) and drawing down too heavily.

Although seeing your income reduced can be difficult, especially during a cost of living squeeze, “eating into capital when valuations are down to fund your lifestyle risks cutting into the bone and potentially jeopardising your finances in the years to come,” Haine explains.

In terms of insolvency risks, a Sipp is held separately from the platform providing it, so if the platform fails, the Sipp is not impacted.

As for the cash and investments within the Sipp, as long as they are held in a product regulated by the Financial Conduct Authority, they are protected by the FSCS up to a value of £85,000 per firm. This is the level of protection that would apply if, for example, a fund you invest in becomes insolvent. But it does not protect you from bad investment performance.

Ssas, which are set up as trusts and controlled by their trustees and members, are in a similar situation.

“The trustees are individuals, perhaps with a non-trading professional trustee, and as a result cannot as a body become insolvent,” explains Martin Tilley, head of technical and director at WestBridge SSAS. 

Should the scheme’s administration, consultancy or practitioner firm become insolvent, they can be replaced with no impact on the scheme assets – although there may still be a cost.

The investments or cash within the scheme can also be protected by the FSCS up to a value of £85,000 if they are held in regulated products. However, one of the key reasons for setting up a Ssas is to have more flexibility with investments – for example, investing in a company’s trading premises or making a loan back to the business.

Unregulated investments come with a range of extra considerations and precautions to take. For example, Tilley says, any property should have a drawn up tenancy agreement and be insured, and any loans should be correctly documented.

Barry Foster, technical sales manager at Curtis Banks, adds that Ssas can create confusion because trustees are both the members and the sponsoring employer, with potential for conflicts of interest.

For example, in the case of a loan to the business, “the employer may be keen for the loan to progress but the trustees must act in the best interests of the Ssas members and not agree to the loan if they consider it is not for commercial purposes or it is too high risk”, he says.

Finally, both Sipps and Ssas can be vulnerable to scams, with fraudsters trying for example to persuade members to transfer their savings into schemes they control or to make high-risk investments.

For Sass in particular, “unregulated investments carry an inherent risk and it is quite likely that the trustees on their own will not hold sufficient expertise to determine whether some assets are suitable for their membership,” says Tilley. “In such instances, appropriate advice should be sought. The proliferation of investments offered to Ssas trustees which have turned out to be scams evidences this.”

More information on pension scams can be found on The Pensions Regulator’s website. https://www.thepensionsregulator.gov.uk/en/pension-scams