Firms commit to pensions, but will it just delay a costly time bomb?

A growing number of companies buck the trend to support their final-salary schemes

Standard Life, the mutual insurance company, will today reaffirm its commitment to offering a final-salary pension scheme for its staff, a pledge that flies in the face of prevailing corporate attitudes towards staff pension provision.

But Standard Life is not alone. After a long list of companies abandoned their final-salary pensions in favour of less costly schemes, some are now committing themselves to their existing arrangements.

Royal Bank of Scotland and MFI yesterday joined the ranks of committed final-salary pension employers. They follow RAC, the motor services group, which on Wednesday vowed to keep its final-salary scheme as long as its staff chipped in to cover some of the extra costs.

Centrica, Unilever and John Lewis are among the others who have promised workers they will provide them with a guaranteed level of pension when they retire, despite the rising costs of such benefits. "If everyone else around them is closing their scheme, being committed to one is a competitive advantage," Roger Key, a partner at Watson Wyatt, explains. "If a company is competing for labour against rivals that offer final-salary schemes, this may put pressure on them to keep schemes open."

This goes some way to explain RAC's move, which came a week after Centrica – owner of the AA – committed to its final-salary scheme. The RAC will now be contributing 19 per cent of salary to its fund, compared with a current norm of 10.5 per cent. Combined with increased staff contributions, some 30 per cent of salary is being put towards the scheme.

It was costs of this magnitude that have forced many companies, such as Big Food Group, British Airways and Marks & Spencer, to think again. "These are very bold statements for these companies to make," Peter Bowers, a partner at Mercer Human Resource Consulting, said yesterday. "They are making themselves hostages to fortune should the economic conditions continue on their present path. Salary inflation, low investment returns and an ageing population make these schemes costly to fund."

He estimates that companies will have to boost funding to their final-salary pension funds by 30 per cent over the next few years to match funding requirements. The average contribution by an employer to a money-purchase scheme, where pensions at retirement are determined by the returns contributions earned on the stock market, is only 6 per cent.

Some companies are now dwarfed by the size of their pension fund, which can outstrip the company's market capitalisation by some degree. This is particularly acute in former nationalised industries that have to honour pension commitments for thousands of former workers through the contributions of a now much-reduced workforce. This is not so for Corus, it should be pointed out, whose pension liabilities are curtailed by the low life expectancy of steelworkers.

But most companies are wrestling with unquantifiable liabilities on their balance sheets. With the onset of the accounting standard FRS 17, which gives a snapshot valuation of the fund's assets year by year, pension funds are now an unavoidable funding headache.

Ned Cazalet, an independent analyst, said: "These schemes are very onerous and there is a number of things that can go wrong. A small movement in interest rates will increase costs, as will a rise in inflation. These are very scary liabilities.

"And the only thing that is available to bail them out if things start to go wrong is the free cash flow a company has. Many companies do not have much of that and the numbers are terrifying in the context of the size of some funds."

Mr Cazalet believes ratings agencies are now firmly focusing on pension costs, and some companies may find themselves downgraded as a result of their pension liabilities.

Despite these factors, there are still many companies welcoming new members of staff in to their final-salary schemes. The National Association of Pension Funds said at the end of 2002 about 70 per cent of private-sector companies still have their final-salary schemes open for new employees.

David Yeandle, of the Engineering Employers' Federation, said: "Many firms do see final-salary schemes as an important recruitment tool. It can give them a competitive advantage if the company is human resource driven. Employers have been losing their schemes reluctantly."

MFI decided to retain its final-salary pension scheme despite announcing a £102m deficit yesterday, saying it was "part of being a good employer". Like RAC, it is increasing contributions and its payments will rise 0.4 per cent to 10 per cent. Staff payments will rise from 5 per cent of salary to 6.7 per cent. There is another potential downside for employers in retaining final-salary pension schemes, however. They can act as a drag on competitiveness in that ineffective staff who would otherwise leave the company stay put to retain their pension.

It seems likely that, despite the efforts of some employers, the trend towards closing final-salary schemes will continue. The number of companies that closed their final-salary schemes doubled in 2002, the NAPF said, and should closure numbers continue to accelerate, final-salary schemes will be a rarity.

An astonishing 24 per cent of companies were also still enjoying contribution holidays from their pension fund. But this surprising statistic is likely to be due to these funds not having had a three-yearly review during the worst of the bear market.

However, the pain does not necessarily stop with the closing of final-salary schemes and companies now will be looking at the next steps they can take to reduce costs. The inevitable result will be lower benefits. "Good pension provision does not come cheap, whatever your scheme type," Susan Anderson of the Confederation of British Industry, said. "Companies are now starting to realise that. Surpluses from stock market gains in the past have disguised pension costs, but the reality is now coming home to roost."

Additional reporting by Joe Bolger