How safe is your pension: a quick explanation


Current headlines in the media have led to us receiving a number of queries recently on the safety of clients’ pensions. We thought a quick explanation is worthwhile to clarify what is happening.

The terminology used in the financial world can easily be confusing. If only the media and the Bank of England could explain themselves a little better… 😤

Aside from the State Pension, there are two types of pensions you can accrue:

1. Final Salary pension (aka Defined Benefit)

These pensions are generally provided by larger companies that pay a proportion of your salary in retirement, increasing by inflation each year. For example, if you spent your entire working life at Shell, you might retire on two thirds of your salary and half this amount would be paid to your spouse after you die. This type of pension is now rare in the private sector as the promised income for life is so expensive to provide but are ever-present in the public sector.

The pension income is a promise by the employer who therefore takes all the investment risk. There is no such risk on the pension scheme member.

2. Personal Pension (aka Defined Contribution)

Contributions to these pensions are invested, often in the global stock markets, bond markets and property, in anticipation of their value increasing over time. At retirement, the accrued fund can be handed over to an annuity provider in exchange for an income for the rest of your life or can continue to be invested with money taken out as needed, often known as income drawdown.

The amount of pension income largely depends on how well the investments have performed. In contrast to Final Salary pensions, the pension scheme member takes all the risk. There is no such risk on the employer.

Yesterday’s media headlines had the following attention grabbers:

  • BBC – “Pound volatile after Bank says pension aid must end”
  • BBC – “UK economy shrinks and Bank warns help to end in days”
  • The Times – “Threat to pensions as Bank cuts its support”

What none of these articles even mention is that all the recent Bank of England interventions in the bond market are only to help Final Salary pensions.

Final salary pensions have to carefully match the value of their assets to the scheme’s obligation to pay an index-linked income for the rest of every member’s life. This is vastly complicated stuff and why actuaries get paid so much!

To do this they are required by the regulations to hold a lot of UK government gilts, i.e. money our government has borrowed with the promise of a regular income and that the debt will be repaid at the end of the term. These regulations exist as such investments are deemed safe so the investment risk to the pension scheme is low.

However, recent events have shown that even low-risk investments can quickly fall in value. Some government bonds fell so much that the final salary pension schemes no longer had sufficient assets to match their liabilities. They therefore needed to sell government bonds and hold more cash instead.

This was leading to a downward spiral with more sellers than buyers pushing down government bond values, hence the Bank of England buying up the bonds instead of them being sold on the open market.

What if a Final Salary pension scheme doesn’t have sufficient assets?

The investments of Final salary pension schemes are regularly valued and if they don’t have enough assets the trustees will demand money from the sponsoring employer. This can put a financial strain on the employer, hence why such schemes are now rare in the private sector.

If you are a member of a Final Salary scheme, don’t panic – you will not lose your pension and most schemes will have sufficient assets for the short to medium-term and can call on the employer for the longer-term.

There are also lots of regulations and protections around pensions. One of the biggest risks is if the employer goes bust and schemes are then covered by the Pension Protection Fund that pays 100% of pensions owed to retired members and 90% to those below pension age.

What is the impact on Personal Pensions?

The value of any government bonds held is likely to have fallen in recent months. However, don’t panic, such market movements have to be expected every now and again and this needs to be judged in the context of your overall financial circumstances.

As an example, if you are invested in a 60% equity, 40% fixed interest portfolio, about 95% of your investments will be outside the UK and your exposure to the UK government gilts the media are currently talking about is around 3%.

Again, regarding regulations and protection, these pensions are covered by the Financial Conduct Authority and the Financial Services Compensation Scheme.

Above all, if you are in any way concerned, please phone either Adrian or me so we can explain this in relation to your overall financial planning.