House of Commons - Public Administration

Select Committee on Public Administration Fifth Report

Appendix 2: Note prepared by the House of Commons Library

I understand that in the light of the announcement in Budget 2007 of a further extension of the FAS,[24] you would like further information on the following questions:

1. The difference between benefits provided under PPF and what is now being proposed under the extended FAS.

2. An explanation of what £8bn figure referred to in the Budget amounts to and the difference between the figures presented in cash terms or net current value terms.

3. What it would cost to provide PPF level of benefits to those now eligible for FAS.

4. What it would cost to index-link payments under the extended FAS.

5. What it would cost to cover those who lost out when a solvent employer walked away from a scheme.

Scope of the FAS

To qualify for the FAS an occupational pension scheme must not be a money purchase scheme and must have commenced wind up between 1st January 1997 and 5th April 2005. Except in certain limited circumstances, the employer relating to the scheme must also experience an insolvency event (dealt with in more detail below).[25] Initially, eligibility for the FAS was restricted to those within three years of retirement age on 14 May 2004. In 2006, this was extended to those within fifteen years of retirement age on that date, with the amount of assistance depending on how far a person was from normal retirement age, up to a maximum of 80%, subject to a £12,000 cap.[26] In Budget 2007, the Chancellor announced a further extension of the FAS, so that all members of affected pension schemes would get:

80 per cent of the core pension rights accrued in their scheme. The cap on maximum assistance will be increased to £26,000 and the de minimus rule that excludes those whose FAS payment would be £10 or less a week will be removed.[27]

The FAS continues to be criticised as insufficiently generous. One of the reasons for this is that it provides 80% of "core pension rights," whereas the Ombudsman asked the Government to consider the replacement of the entirety of the pension which affected individuals would have received - non-core, as well as core benefits.[28] Ros Altmann argues that the 80% of core pension that the FAS provides "is not 80% of expected pension - it is worth around 60%."[29] "Core benefits" are, broadly speaking, the monthly payments individuals would have received from their pension on retirement. "Non-core benefits" include the option to take a proportion of the pension as a lump sum, survivor's benefits, and ill-health benefits (i.e. the ability to draw a full pension early on ill-health grounds).[30] The Department has estimated that implementing the Ombudsman's proposals would cost between £13 billion and £17 billion over 60 years in cash terms.[31]

How the costs are presented

Originally, the Government provided £400 million in cash terms (£243 million in net present value terms) for the FAS over 20 years.[32] The extension of the scheme announced in May 2006, to those within fifteen years of pension age on 14 May 2004, increased the commitment to £2.3 billion in cash terms (£830 million in net present value terms). The further extension announced in Budget 2007, increased the commitment to £8 billion in cash terms (£1.9 billion in net present value terms).[33]

The figures given in the breakdown DWP has provided for the Committee show the cost of the extended FAS announced in the 2007 Budget in cash over 55 years from £2007/08.[34] The annual amounts for all years to 2062/63 sum to £8 billion. DWP explains that:

Net present value is used to compare costs that occur in different time periods. It is a separate concept to inflation and is based on the principle of 'time preference', i.e. that people prefer to receive goods and services now rather than later. NPV costs discount cash costs by 2.5% per year to convert cash costs into real costs (to take account of inflation) and, in addition, by 3.5% a year in years 0-29, and by 3% a year in years 30 onwards to convert real costs into NPV costs (to take into account time preference.[35]

The effect of applying these figures to the cost of the extended FAS is to get a net present value of just under £2 billion. The main reason for such a big difference between the cash and net present value figures is the 55 years over which the scheme is costed. As an example, £100 in 2007/08 would have a purchasing power of around £25 by 2062 if inflation had been 2.5% on average a year. Applying a discount rate (the opportunity cost of capital) adds to the disparity.

Mr Justice Bean, in his decision on the application for judicial review of the Ombudsman's report on occupational pensions, said he considered the difference between the cash costs and net current value costs to be important as "a matter of presentation", although "not in truth a difference of substance." A more telling point, he said was that:

neither figure takes account of the tax that would be payable by the recipients of pensions if full payments are restored, nor the benefits that have to be paid to those who have lost all or most of their occupational pensions on winding-up.[36]

The Department has said that the increased tax revenue and reduced income-related benefit expenditure which would arise is "difficult to estimate precisely, over such a long period."[37]

Differences between Pension Protection Fund (PPF) and FAS

It should be noted that, like the FAS, the PPF does not compensate members for the full amount of their expected pension. However, it is more generous than the FAS. The main differences between the two schemes are, in broad terms, as follows:

PPF replaces 100% of the pension in payment to those of at least normal pension age for the scheme on the assessment date, and 90% of the expected core pension for those below normal pension age.[38] FAS will top up pension payment to 80% of expected core pension.[39]
For people below normal pension age, the 90% compensation provided under PPF is subject to a cap of £26,935.70 at age 65.[40] The amount of the cap is increased annually in line with earnings. FAS payments are subject to a cap of £26,000.[41]
Under both schemes, survivors are entitled to roughly half of what the scheme member would have been entitled to.[42] Survivors' benefits are therefore less generous in FAS than the PPF.
In the PPF, that part of compensation relating to pensionable service on or after 6 April 1997 is increased in line with the RPI, capped at 2.5%.[43] FAS payments are not index-linked "because many of the schemes involved were not index linked in the first place."[44]
Eligibility for the PPF starts from normal pension age for the scheme.[45] Eligibility for the FAS starts at age 65, (except where a person is terminally ill).[46]
Trustees can make pension payments at PPF levels (90% and 100%) during the assessment period.[47] The FAS scheme manager has the discretion to provide those eligible for FAS with "interim" payments, up to only 80% of the expected pension.[48]
PPF provides an option to draw up to 25% of the value of their compensation as a tax free lump sum.[49] There is no such option in the FAS.[50]

Additional costs of providing PPF level benefits to those eligible for the FAS

DWP estimates that the additional cost of providing people eligible for the extended FAS with PPF level benefits is £2.7 billion in cash terms (£640 million in net present value terms.) This assumes that people get PPF level of benefits (90% or 100%), the cap is set at PPF levels, and indexation is provided on benefits after 1997 (1% indexation across the board has been assumed). [51] It should be noted that this is the estimated cost of bringing FAS benefits up to PPF levels, rather than of bringing FAS into line with PPF in all respects.

Additional costs of indexing payments under the extended FAS

DWP was asked to provide an estimate of the additional cost of applying the same indexing rules to payments under the extended FAS as apply to the PPF. Instead, it has provided an estimate of indexing the full accrued pension. It explains that this is because the PPF provides indexation on the part of the pension that derives from pensionable service on or after 6 April 1997. Because individuals in FAS schemes are unlikely to have accrued much of their pension after 1997, providing indexation on those rights would provide them with little additional benefit.[52] For this reason, DWP says that:

We have instead estimated the costs of providing indexation in the individual's full accrued pension. We have assumed that the pension in payment would be increased each year in line with RPI capped at 2.5%. The additional cash cost, on top of the current FAS would be £3.5 billion (£530 million in NPV terms).[53]

Solvent employers

In order to qualify for the FAS the employer must usually have experienced an 'insolvency event' by 31 August 2007.[54] The date by which an insolvency event must have been experienced has recently been extended. The Pensions Reform Minister, James Purnell, said this was because he had received representations from trustees of a small number of pension schemes who were in negotiation with employers in relation to insolvency and would like further time to complete the process. He said he would consider whether a further extension beyond 31 August was required.[55] The definition of "employer insolvency" for FAS purposes is designed to be "sufficiently general … to capture schemes where the sponsoring employer no longer exists and also where insolvency may have occurred some time after scheme wind-up had started." The definition was extended by amending regulations which came into force in December 2006.[56] These allow the FAS to:

consider schemes where the employer has been subject to overseas insolvency proceedings, and further, they give a discretionary power to include schemes where the employer is unlikely to continue as a going concern but for whatever reason has not formally undergone a qualifying insolvency event.[57]

In debate in the House of Lords, Lord Hunt of King's Heath said that the amendments:

demonstrate our desire to define insolvency as widely as possible in order to bring schemes and their members into the FAS. They do not affect our oft-stated belief that ongoing solvent employers remain responsible for making good their pension promises to members.[58]

DWP was asked to estimate the cost of extending the FAS to people whose pension funds wound up before April 2005, where the sponsoring employer had not experienced an insolvency event. DWP says that there is limited data on the number and circumstances of schemes that have wound up under-funded with a solvent employer. It also argues that some will have suffered small losses (if any at all), for example where the wind up is due to the merger of schemes and members are transferred to a different scheme providing the same benefits. DWP has, however, provided an estimate of the cost of including a specific number of schemes where the debt has been compromised in order to avoid insolvency of the employer.[59] The context within which this would happen is set out below.

Where a decision is taken to wind up a pension fund, a valuation is made of the pension fund's assets and liabilities. Where the fund is found to be in deficit, any shortfall is treated as a debt due from the sponsoring employer to the trustees of the scheme under section 75 Pensions Act 1995.[60] Prior to June 2003, the valuation of the fund was done on a Minimum Funding Requirement (MFR) basis and non-pensioner members were required to be put in a position where they would receive the Cash Equivalent Transfer Values (CETV) that would normally be paid in the case of someone who left the company. DWP's 2003 Pensions White Paper commented that these CETVs were too low to provide people with the pensions they expected at retirement:

Companies that choose to wind up their schemes pass their investment risk on to non-pensioner members, as they transfer their money into money purchase arrangements. Moreover, because the actuarial assumptions underpinning the CETV calculation have become out of date, CETV levels are now providing less protection than was originally envisaged.[61]

For this reason, the Government introduced a requirement through Pensions Act 2004 to ensure that there were sufficient funds to meet the full costs of the rights accrued by scheme members. Since June 2003, any deficit is determined by valuing the benefits pension scheme members would get on a basis that they are bought out in full via immediate annuities (for pensioners) or deferred annuities (for non-pensioners).[62]

In some cases the employer is not in a position to meet its debt to the pension scheme. The courts have held that it can be permissible for the trustees, exercising their fiduciary duties, to agree a lower amount - or "compromise" the employer's debt to the scheme, if this is to the benefit of pension scheme members. In the case of the Bradstock Group Pension Scheme, for example, the scheme was in substantial deficit and the employers had no realistic prospect of being able to pay the instalments necessary to bring the funding up to the required level by the prescribed date. Unless the debt could be compromised, the employers would be forced into liquidation. The court held it was permissible to compromise a debt for the benefit of scheme members.[63]

DWP says it is aware of 15 schemes where the employer has compromised the debt on the pension scheme in order to avoid an insolvency event. It estimates that these schemes have around 8,000 members in total and that the cost of including them in the extended FAS would be £460 million in cash terms (£100 million in net present value terms).[64] Trustees should only agree to compromise a debt in the interests of scheme members. In the cases to which DWP refers, the decision would have been taken well before the recent extensions of the FAS. It is possible that had they been aware at the time of what would be available for pension scheme members under the FAS, they might have made a different decision. They might for example, have decided that it would be in the interests of scheme members for the employer to be forced into insolvency, bringing them within the scope of the FAS.

24 HM Treasury, Building Britain's long-term future: Prosperity and Fairness for Families, Budget 2007, para 5.65;http://www.hm-treasury.gov.uk/media/73B/6B/bud07_chapter5_320.pdf (retrieved 27 March 2007). See also, HC Deb, 28 March 2007, c113WS Back

25 DWP, The FAS, An in-depth guide for trustees and professionals, April 2007,http://www.dwp.gov.uk/lifeevent/penret/penreform/fas/fas-p2-apr-07.pdf Back

26 FAS Regulations 2005/1986, Schedule 2, para 3(3) and 4 Back

27 HM Treasury, Building Britain's long-term future: Prosperity and Fairness for Families, Budget 2007, para 5.65 Back

28 DWP, 'Response to the Report by the Parliamentary Ombudsman, Trusting in the pensions promise', June 2006 Back

29 Press release, 'More political spin - how mean-spirited can the Government be?', 21 March 2007. Her statements are based on detailed calculations of what individuals would get under FAS compared to the situation if their pension scheme had not wound up Back

30 DWP, 'Response to the Report by the Parliamentary Ombudsman, Trusting in the pensions promise', June 2006, Annex, page 40 Back

31 DWP, Response to the Report by the Parliamentary Ombudsman, 'Trusting in the Pensions Promise', June 2006 http://www.dwp.gov.uk/publications/dwp/2006/pensions/response-ombudsman.pdf Back

32 HC Deb, 14 May 2004, c32WS; SC Deb, 6 December 2006, c4 Back

33 HC Deb, 28 March 2007, c113WS Back

34 Paragraph 3, DWP letter to committee Back

35 DWP, Response to the Report by the Parliamentary Ombudsman, 'Trusting in the Pensions Promise', June 2006, p 44 http://www.dwp.gov.uk/publications/dwp/2006/pensions/response-ombudsman.pdf Back