What is a pension deficit? Should you be worried if you’re in a pension that has a deficit?

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The news headlines are regularly full of stories about pension schemes having a pension deficit. But what is a pension deficit? Should you be worried if you’re in a pension that has a deficit? Here’s my guide:

What is a pension deficit?

A pension scheme is in deficit if it doesn’t have enough money to pay the pensions of the people who are entitled to receive one. Only salary-related pension schemes can be in deficit. By salary-related schemes I mean final salary pensions, or career average pensions.

SAVVY TIP: With a final salary pension, the amount you retire on is based on the salary you earn before you retire and with a career average pension, it’s based on your salary throughout your time in that pension scheme.

With salary-related company pensions, it’s the responsibility of the pension scheme trustees – those who run the pension scheme, to make sure there is enough money in the pension scheme to pay everyone who is entitled to a pension.

SAVVY TIP: With pension ‘pot’ type of pensions (their official name is either ‘defined contribution’ pensions or ‘money purchase’ pensions), there’s no promise to pay you a certain amount when you retire. Instead, the amount you get at retirement will depend on how much money you and your employer pay in and how well the funds your money has been invested in perform.

Why are more pension schemes in deficit?

More company pension schemes are in deficit because it’s more expensive for them to pay the pensions they’re obliged to pay than it was in the past and more than they expected it to be. And that in turn is because we’re living longer and because investment returns are lower now than they have been for some time.

Why are different figures used to work out how much a pension scheme is in deficit by?

If a company pension scheme you belong to is in deficit, you may hear different figures being bandied around about how much it’s in deficit by. There are two main ways to work this out:

  • Buy out basis: this is the amount that a pension scheme would have to pay if it were to transfer its liabilities to an insurance company, which was then to pay the pensions as promised. It would effectively mean buying annuities for everyone as this would guarantee the pension would be paid until they die. It gives the biggest deficit figure – not least because – at the moment, government bond yields are low and this is what the insurance company would have to invest in to provide the pension payments.
  • Scheme specific basis: this is where a pension scheme works out the return it’s likely to get from the investments it actually holds and how this compares to the pensions it’s obliged to pay.

Should I worry if my pension scheme is in deficit?

It’s always concerning to hear the word ‘deficit’ – especially if you’re some way off retirement and/or the pension scheme in question is meant to pay most of your income when you retire.

But just because a scheme is in deficit does not necessarily mean it won’t be able to pay the pensions it’s committed to. It depends, in part, on the size of the deficit itself.

A scheme can:

  • Ask pension scheme members to pay more into the scheme;
  • Ask the employer to pay more into the scheme
  • Reduce the pension that’s paid when pension scheme members retire.

SAVVY TIP: If the deficit is really big and the pension scheme becomes unsustainable, it may have to be wound up. In that case, your pension would be likely to be paid by the Pension Protection Fund. You won’t necessarily get the pension you’re expecting, but you certainly won’t be left without a pension. You can read more about the Pension Protection Fund in my article How is your company pension protected by the Pension Protection Fund?

Related articles:

Understanding final salary pensions; how they work and how you’re protected

The pros and cons of transferring a final salary pension

What is the pensions dashboard? The pensions dashboard is due in 2019

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