Companies are only contributing the level minimum required by the minimum funding requirement (MFR) when it comes to paying off pension schemes in deficit.
According to consultancy First Actuarial, such companies should treat these schemes as they would their personal debt, where people pay above the monthly minimum for credit card debt to avoid high rates of interest as well as the time it takes to repay the balance.
Director of pension consultants at First Actuarial, Alan Smith says: “Finance directors are likely to be among those who act rationally when dealing with their personal finances, so why on earth do they throw these principles away when it comes to funding their company pension schemes”.
He says too many companies only agree to the minimum monthly payment when dealing with pension schemes, leaving consequences far worse than credit card repayment, as in most cases the deficit is likely to keep increasing and never extinguished.
In trying to account for a company’s minimum payment action, Smith says many adopt the ‘ostrich strategy,’ hoping that the problem will evaporate - perhaps because of a recovery in the investment markets.
He believes a more feasible answer is a shortage of cash flow to sustain the financial commitment needed to repay the deficit in the short to medium term.
At first glance, Smith's possible solution seems questionable, namely borrowing cash to return the deficit.
He provides a simplified example of a firm with a pension scheme in deficit of £500,000. To bring the deficit in line over 15 years (assuming all other assumptions are borne out in practice) would cost, after tax relief, around £36,000 a year.
Smith says by investing a £350,000 loan into a pension scheme and allowing for tax relief, would wipe out the deficit and result in (net of tax) loan repayments of £33,000 a year over the 15 year period - a £45,000 year saving over the term.
A further saving would occur, as the risk-based levy to the Pension Protection Fund should be lower with the scheme in a better position.
“As a possible final step: if the scheme is still open, closing it to future accrual would then be the corporate equivalent of cutting a credit card in half and throwing it away,” Smith concludes.IFAonline
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