EXECUTIVE PENSIONS

The Design of Executive Final Salary Schemes

Historically, most executive pensions in larger companies have been provided on a final salary basis. However, today, around a quarter of FTSE 100 provide their chief executives with defined contribution pensions.

In the private sector, final salary executive pensions have tended to involve accelerated accrual compared to that for other staff. Instead of providing a maximum two-thirds pension after 40 years of service (an accrual rate of 1/60th per year of service), a full pension is normally subject to just 20 or 30 years' service (equivalent to an accrual rate of 1/30th or 1/45th). The two-thirds pension provided is normally inclusive of any pensions from previous employments.

The theory behind accelerated accrual is that executives typically experience rapid salary growth throughout their careers and hence any job change would otherwise constrain their pensions expectations (expressed as a percentage of final salary). This issue is less of a problem in the public sector where the final salary link is often retained when transferring employment.

Recently, commentators have started to question the need to provide executives with a guaranteed pension of two-thirds of final salary because:

§  the final salary may be a short-term peak earned for just a few years;

§  since most executive pension schemes were set up, executive salaries have risen significantly in real terms, income tax rates have fallen and incentive opportunities have multiplied: hence executives now have more opportunities to save in other ways;

§  the cost of this type of provision can be very high indeed.

For these reasons and to limit the tax concessions available, successive governments have limited the amount of pension that may be delivered through tax-approved pension schemes.

Limits on Pension Provision

Traditionally, the pensions available from occupational schemes have been subject to complex limits on the benefits payable, proportional to service and earnings. For personal pensions, stakeholder schemes and some other defined contribution schemes, age-related limits on contributions have applied instead.

In 1989, the earnings cap was introduced. This applied to individuals joining tax-approved pension schemes after 1 June 1989. The cap limited the salary that could be taken into account for pension purposes to £60,000. This figure was indexed to RPI (only) and stands at £102,000 for tax year 2004/05. The earnings cap did not have a profound impact on the level of pension provided to executives, with most large private sector firms providing compensation in the form of one or more of the following ways:

§  funded unapproved pension schemes (FURBS) - a funded pension scheme that lacks most of the tax privileges of an approved scheme;

§  unfunded unapproved pension promises (UURBS) - effectively a promise from the employer to pay a particular level of pension;

§  cash allowances.

From 2006, the government will replace the cap with a 'lifetime limit' on tax-effective pension savings of £1,500,000 (equivalent to a retirement pension of £75,000 per annum). Unlike the earnings cap, this limit applies to everyone, but any existing accrued benefits above this figure will be protected.

There will also be a limit on the pension earned in any year of £215,000. Both the lifetime and annual limits will increase annually.

In future, where pensions exceed the lifetime limit, companies will be able to offer FURBS, UURBS or cash (as above). A further (new) option will be to provide a bigger pension in the tax-approved scheme but to pay a tax 'recovery charge' of 25 per cent on the excess funds: this levy is in addition to income tax, giving a composite rate of 55 per cent.

The Future of Executive Pensions

Executive final salary schemes have been very expensive to provide, particularly on an unapproved basis. Many investors and remuneration committees would now prefer a more modest, fixed-cost approach to be adopted. This might involve a pension allowance of perhaps 20–50 per cent of salary payable in cash or to a pension vehicle selected by the executive. There are signs of this happening, but the executive final salary scheme is unlikely to die completely for some decades.