Money news headlines often have 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, we explain what a pension deficit is, and why it doesn’t necessarily mean your pension scheme won’t be able to provide the pension you’ve been promised.
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 we mean final salary pensions, or career average pensions.
With a final salary pension, often known as a defined benefit 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. You can find out more about how these pensions work in our guide What is a defined benefit pension?
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.
The other main type of pension is either ‘defined contribution’ pensions or ‘money purchase’ pensions. With these types of pension, 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. Learn more about this type of pension in our article What is a defined contribution pension?
Why are more pension schemes in deficit?
Some 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. This is because we’re living longer on average and because investment returns may not have been as high as anticipated.
Why are different figures used to work out how much a pension scheme is in deficit by?
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.
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. It will usually pay you up to 100% of the value of your pension if you’ve reached the scheme’s retirement age, or 90% if you’re below the scheme’s retirement age.