Pension funds falling short

Thousands of members of final-salary schemes could end up in the same position as Rover staff over the next 10 years. They could lose up to a fifth of their retirement benefits as their employers go into liquidation, leaving vast deficits in their pension schemes.

The shortfalls on the largest 342 'defined benefit' schemes (as final salary schemes are sometimes called) run by UK private sector employers are estimated at £85 billion by credit rating agency Standard & Poor's. In six out of 10 of these schemes, the future pension liabilities amount to more than the current net assets of the employer.

If historic default rates are repeated, at least 25 of these 342 big employers (with B credit ratings and above) could go out of business in the next decade, as well as up to 1,000 smaller businesses. In most cases, there will be a shortfall on the final salary pension scheme - if the current deficits are not reduced - which will usually mean scheme members will end up getting a smaller pension than promised.

In most cases, the new Pension Protection Fund (PPF) will step in to pay the pensions, but these will be capped and many will end up with smaller pensions than they had expected. Pensions paid out by the PPF might be just 70 or 80 per cent of what people would get if their pension scheme had stayed the course.

S&P argues that the writing on the wall is very clear for some defined benefit schemes in some sectors and in some businesses. Bankruptcy should be rare among companies with a credit rating of AAA, AA and A.

Only one or two of the 163 A-rated companies that support the largest 342 defined benefit schemes are statistically likely to fold in the next decade. But as many as six out of 100 BBB-rated companies in the study could default, as well as 11 out of 60 BBs and six out of 19 Bs. Roughly another 5,000 smaller private sector employers also run these schemes, and the failure rate will be higher here, suggesting that about 1,000 companies could go under, leaving their schemes in deficit. Danger signals are the usual ones of impending insolvency: a poor credit rating, cash flow problems and weak trading.

If a pension scheme has a surplus, then members of the scheme do not have to worry as much, as there would appear to be enough money to pay out their pensions. But most defined benefit schemes are now in deficit as a result of poor investment returns in recent years, low real interest rates and the fact that people are living longer and are therefore having to pay out pensions for greater periods.

The fact that an employer has a deficit is not an immediate cause for alarm. The accounting rules used to calculate the deficit are conservative and assume that all liabilities have to be met now. But, in reality, many of the liabilities are very distant - such as pension payments due in 40 years to employees now in their twenties - and schemes have decades in which to generate the cash.

Both General Motors and Ford were recently downgraded by S&P from BBB to BB, partly because of the deficits on their pension schemes. But if they achieve healthy trading records and get adequate returns on their pension fund investments then all will be well.

Defaults on pension schemes are less likely in energy companies, pharmaceuticals and banking than in commercial service.