Bill Robinson: Would you still give to charity if half your cash went to cover a pensions deficit?

These are not good times for charities. One perverse effect of the 2p cut in the standard rate of tax announced by Gordon Brown a fortnight ago is that they will get less in gift aid from the Treasury.

The recent stock market turbulence is also hitting charities hard. They tend to pay their staff poorly and make up for that with generous non-contributory pensions. Some have been known to award 5 per cent annual increases in pensions to compensate for inflation, now running at less than 3 per cent.

These promised real increases in pensions are a huge burden on those schemes. Deficits could become serious enough to cause the collapse of a big UK charity within the next few years.

The pension fund deficits have arisen because (a) legislation over many years has made pension promises much more onerous; (b) the assets set aside to pay the pensions now deliver less income because long-term interest rates have fallen while the scheme members are likely to live longer; (c) that income is more heavily taxed; and (d) the resulting deficits are now more stringently measured.

The requirement to pay off these deficits threatens the financial viability of charities that sponsor pension schemes. How did we get in this position?

Legislation now requires firms to provide inflation-linked increases in the pensions of employees who stay in the scheme until retirement, and to provide a guaranteed pension for those who leave the scheme before retirement. In the old days, the pension was a fixed monetary amount and early leavers were heavily penalised. Successive government actions to protect pensioners have thus gradually transformed an affordable promise into one that many schemes now struggle to meet.

These long-term changes are often overlooked in the drama that surrounds stock market crashes and steep falls in annuity rates. The pension-fund deficit hit the front pages after the dot-com crash. Then, as the market recovered, long-term bond rates fell. Against this backdrop, life expectancy continued to rise.

The cost of buying £1,000 per annum of income from retirement until death rose dramatically because the pension was payable for longer, the rate of return on assets was lower and that return was more highly taxed (the corporation tax cut of 1997 was funded by a £5bn-a-year rise in the tax on dividend income held by pension funds).

The increase in the deficits resulting from these changes affects the bottom line of companies and charities because they are required to come to an arrangement with their trustees to pay off the deficits within a reasonable period, usually taken as five to 10 years. And the deficits must now be measured on a conservative basis, by assuming that the assets in the scheme earn only a corporate bond rate of return.

What this means for the average charity can be illustrated with some stylised numbers. Paying a pension of £1,000 a year for 15 years costs £15,000. But through the magic of compound interest, it only needs a capital sum of around £9,000 invested at 7 per cent (a reasonable guess at the long-term rate of return on equities) to deliver this income. However, if the money is invested in corporate bonds yielding 5 per cent, the cost goes up to over £10,000. If the income rises by 2.5 per cent each year to compensate for inflation, the cost goes up to over £12,000.

What these numbers tell us is that requiring charities to pay inflation-linked pensions that rise as prices rise, and to assume no more than a bond rate of return on their assets, can easily increase the costs of pension provision by over 30 per cent. These changes, together with the fall in bond rates and the increase in life expectancy, have turned pension-fund surpluses into deficits which threaten their viability. Deficits are no longer just accounting numbers; tThey represent an annual cash drain.

The Charities Commission recommends that charities hold reserves which are equal to one year of income. The minimum recommended reserves are a half year of income. For many charities, the pension fund deficit dwarfs these figures. Their assets are much less than their long-term liabilities.

They may have no immediate cash-flow crisis but they are, on some definitions of the term, technically insolvent. And if their pension-fund trustees insist on the deficit being paid off within the recommended five- to 10-year period, the annual cost can range from a quarter to a half of annual income.

This places them in an invidious position. People donate to charities because they approve of their purposes - for example, nursing cancer patients. They understand that their money goes to pay people to carry out these socially desirable tasks. But how would they feel if they were told that 25p to 50p in every pound they gave was earmarked for the pension-fund deficit?

How will the situation be resolved? At one level, it is simple. If people who work for a charity care about its viability, they may be persuaded to accept a lower pension. If the promise is unaffordable, the scheme members will not get what they have been promised whatever they do.

If they accept a lower, affordable, pension, the charity will be saved. If they insist on their rights, the charity will be bankrupted - and they will still only get what is affordable. So in the end, the only meaningful choice the pension-fund members have is whether or not to save the charity they work for, or once worked for.

I believe that scheme members, when they understand this, will want to save their charities. The trustees will also want to help. But the duty of trustees is to secure the maximum pensions for scheme members. Unless there is good communication, a high level of understanding of the issues and a lot of trust between the charity, its employees and the trustees, the resolution of the pension-deficit problem can all too easily lead to a wind-up of the charity.

I am afraid that this will be the outcome in one or two high-profile cases within the next few years. But the public outcry that will follow the disappearance of a much-loved charity will probably be sufficient to raise public consciousness of the problem and save the rest.

Bill Robinson is head of economics, forensic at KPMG

Hamish McRae is away