Deep impact

It started with US subprime mortgages in 2007 '“ and a year later the credit crunch had a tight grip on the UK economy with our newspapers awash with reports on how deep the recession is biting. We have seen countless reports of businesses failing, unemployment rising and savings suffering. But what will happen to our pensions? How will an individual's retirement be affected by the current economic crisis? And how will this impact on pension claims arising from a personal injury or fatal accident? Solicitors involved in pension claims need to be aware of how the downturn in the economy has, and will, impact on pension claims.

Pensions are a long-term investment and it is therefore assumed that any short-term 'blips' in the economy, and the effect on pension funds, will be resolved by the time retirement comes round. Comments in the press about the impact appear to be contradictory, ranging from pension funds bearing the brunt of the credit crunch losses to them being one of the few beneficiaries. Whether these comments are accurate depends on perspective and the type of pension scheme.

Defined Benefit Schemes

A Defined Benefit ('DB') Scheme is where benefits on retirement are largely provided by an employer and the employee may or may not make contributions into the scheme. Benefits payable are pre-defined by a formula set out in the scheme rules, incorporating number of years' service and final salary. It is the employer's responsibility to provide annual pension benefits on retirement and the employer bears the risk of investment.

DB schemes are becoming increasingly expensive to provide, due to increased administrative costs, increased life expectancy, and the valuation of pension fund assets in a company's accounts (FRS17). The increase in costs has driven the closure of many DB schemes for both new and existing employees. In 2008 only two per cent of DB schemes were open to new and existing members, compared to 35 per cent in 2006 (Pension Protection Fund '“ The Purple Book 2008)..

Despite the reduction in DB schemes, the financial crisis has led to some benefits for employers. Commonly, once in receipt of pension benefits, an individual will receive an annual increase in line with the Retail Price Index ('RPI') (up to a maximum percentage). The recent decline in the RPI has led to employers' future pension liabilities reducing. Furthermore, the recent increase in corporate bond yields (the returns of which are offset against pension liabilities) has reduced the pension deficit shown in the employer's accounts. It is the combination of these factors that has led to pension funds being portrayed in the press as the 'beneficiaries' of the credit crunch.

However, when looking at this from the DB members' perspective, those that are already retired will see a marked reduction in the annual increase they receive in their pension benefits, resulting from the falling RPI.

For those who are yet to retire, and are fortunate enough to retain DB scheme membership, their pension benefits will be secure by the formulaic rules of DB schemes and any impact to their benefits will be limited to the future performance of the RPI.

Defined Contributions Schemes

A Defined Contribution ('DC') Scheme is either an occupation scheme provided by an employer, where contributions are made by the employer and the individual, or a private scheme where contributions are made by the individual only. The risk of investment is always borne by the individual.

Typically, individuals will invest in a mixture of secure and more risky investments with the hope that they will receive year-on-year returns, building a pension fund which can be used to purchase an annual annuity on their retirement. However, the financial crisis has had a dramatic impact on the value of investments. Consequently, many DC scheme funds have reduced in value, lessening the funds available for purchase of an annuity, and leading to press coverage that pension funds are one of the many casualties of the credit crunch.

In combination with reducing fund values, individuals are finding it harder to maintain contributions due to financial pressures and job losses. Research carried out by Prudential last year found that voluntary contributions into DC schemes have almost halved (www.pru.co.uk) and this has contributed to depressed DC pension funds. Furthermore, the recent Budget has announced that tax relief on pension contributions for high earners will be reduced from 2011 '“ this will add to the reduction in funds contributed into DC pension schemes.

For DC members retiring in the next couple of years, there will be limited opportunities for them to recover from recent negative returns. Prudential's research tells us that those retiring in 2009 can expect to receive £884 per annum less than those who retired in 2008 (ibid).

For DC members retiring in the future, their fund value is still uncertain and will be largely driven by contributions made, future performance of the economy and investment returns. Regardless of the type of pension scheme an individual is a member of, they will be affected. The extent will depend on the recovery of the economy with DC members retiring in the short term hit the hardest.

Impact on pension claims

In claims arising from a personal injury or fatal accident claim, a loss of pension benefits can often form a material proportion of an individual's claim. For claimants who are members of DB schemes, the calculation and quantification of pension losses will remain largely unaffected because of the formulaic approach used. If, at the time of the incident, an individual was already in receipt of benefits, then the only situation where claimed losses would be affected would be in a loss of dependency, where there would be a reduction in the increase in annual pension benefits.

However, claimants who are members of DC schemes will suffer more as it is DC pension funds that have been hit hardest by the credit crunch. Due to the uncertainty of when the economy will recover, and its effect on contributions, the calculation of expected future benefits from DC schemes is speculative. To limit this speculation, losses from DC schemes can instead be quantified based on contributions that would have been made. In this way, claimants are reimbursed lost contributions, leaving them free to invest the money, and the speculation of future returns on those contributions is reduced.