If you have a final salary workplace pension scheme, what happens to it if your employer goes into administration? The Pension Protection Fund exists to safeguard the benefits of members in these circumstances - but how reliable is it? Article by Nick Green.

When is a guaranteed pension not guaranteed? The cases of Carillion, BHS and Tata Steel in recent years have raised public awareness of pension security. When an employer runs into financial difficulties, there is an added complication if the company also runs a defined benefit pension scheme. If the company fails, what happens to everyone’s retirement income?

To answer this, we first need to be clear about the different kinds of workplace pension.

Understanding defined benefit schemes

Most pensions are defined contribution (or money purchase) schemes, where you save up a pot of money over time. However, some workplaces offer defined benefit (or final salary) schemes, which work differently. These pay you a guaranteed income for life once you pass a specified age, known as Normal Retirement Age (NRA). Such schemes depend on a central fund, which the employer has a duty to maintain in the interests of scheme members.

What does ‘in deficit’ mean?

You may read about some defined benefit (DB) pension schemes being ‘in deficit’. This is when the pension fund is judged to have insufficient money to pay its members their full contractual benefits, assuming the current rate of contributions, growth, NRA and various other factors. In short, the pension scheme is not on course to meet its obligations.

A scheme being in deficit is not itself a cause for concern. An employer who is aware of a deficit can take action to address the problem in good time. Unfortunately this does become problematic if the employer company is itself in poor health.

What if the company is failing?

If an employer that runs a DB scheme enters financial difficulties, it may not be able to address any pension scheme deficit. This is what has happened in the case of Carillion, Tata Steel and BHS. Fortunately, a safeguard exists to ensure that members of such pension schemes will still receive pensions even if their employer company fails. Some members may have to accept reduced payments, but no-one will miss out completely – thanks to the Pension Protection Fund.

Riding to the rescue: the Pension Protection Fund

The Pension Protection Fund (PPF) is known as the lifeboat for DB corporate pensions. It was set up to protect the benefits of scheme members if a sponsoring employer becomes insolvent and can no longer fund the scheme. An employer struggling to fund its pension scheme can apply to the PPF for compensation if they meet the PPF rules. Following the application, there is an assessment period of around two years, both to see if the scheme can be rescued and also to calculate whether the PPF compensation would be better than an insurance company could provide.

Will the PPF pay out my full pension?

Scheme members who are already at NRA or older (who in most cases will already be taking their pension) will continue to qualify for 100 per cent of their benefits. This also applies to those on ill-health early retirement pensions, and usually to anyone on a survivor’s pension (such as a widow or children).

However, those younger than NRA will usually qualify for 90 per cent of benefits (so will lose out on at least 10 per cent of the pension they may have expected). Furthermore, any increase in compensation will be in line with legislation, rather than with the rules of the former scheme.

How safe is the PPF?

The PPF currently has reserves of around £6.1 billion in excess of its current liabilities, which comes from a levy on all private sector employers with a DB pension fund. To date its reserves have been more than enough to cover the liabilities of rescued schemes. If the fund ever looks as if it may struggle to meet its obligations, then the government is likely to increase the levy on employers to make up any shortfall.

What if I want to transfer my DB pension out?

It is now possible to transfer a DB pension into a defined contribution (DC) scheme, to make use of the options available under pension freedom. However, if your scheme has entered the PPF assessment period then you cannot transfer out of it, unless you made the application before the period began, and the scheme’s trustees also agree to it. Even then, the scheme cannot pay out more to you than the PPF itself would pay.

Before considering a transfer out of a DB scheme, you should seek financial advice on whether it is the best option (this is required by law for pensions with a transfer value of £30,000 or more). In most cases you may be better off staying in the scheme – even allowing for reduced benefits under the PPF.

Historically, having a DB pension scheme was a major selling point for any employer – and these kinds of scheme remain very attractive. If you are looking for a relatively generous, guaranteed income for life, then you are usually better off staying with your DB scheme, even if the PPF has had to step in. However, everyone’s circumstances are different, so you should talk to a financial adviser before making any decisions.

Nick Green is communications manager at Unbiased, the UK's favourite place to find advice you can trust. He has been writing professionally on finance, business and many other topics for over 15 years.