Pension problems
October 19th, 2010
One of the saddest features of the last decade has been the demise of the company pension scheme. Normally children look forward to their generation being better off than their parents. They are on the shoulders of the previous generations, and expect to keep the gains of the past and add their own advances. In the case of guaranteed income in retirement there is a danger we are going backwards.
Many final salary pension schemes have been killed or wounded by a lethal cocktail of higher taxes, more regulation, and poor investment returns. The decision to tax the funds did not help. It hit the funds directly, taking around £5 billion a year from them. It hit them indirectly, by making UK shares less valuable to pension fund holders, as the income came to be taxed, damaging capital values as well. Regulators made funds pay a levy to help bail out funds under financial pressure, adding to the costs of all funds. It also required more generous payments from some funds as various social policies were implemented in part by making claims on pension fund monies.
The third problem has been the poor returns from UK, US and European shares over the last decade. UK pension funds typically held two thirds of their investment money in shares, largely concentrated in the markets of the advanced western countries. These shares have produced virtually no return at all if held for the last ten years, undermining one of the main points of having a fund in the first place.
There have been various attempts to tackle these issues. Financial specialists have said that a pension fund runs three main types of risk. If wages and prices go up, the fund needs more money to pay the bigger sums. If people live longer, the fund needs more money to pay pensions for longer. If the investment returns are poor the fund needs more money. The search has been on for overlays or financial instruments which can match or limit the risk of inflation and mortality improvements.
It has proved difficult to find instruments which protect against wage inflation, as opposed to price inflation which is usually slower. Mortality is also a difficult risk to remove. Overlays might entail taking on new risks from the financial instruments that are meant to control the risks.
Pension liabilities also go up if interest rates fall. The way many actuaries calculate the liabilities, they say the cost rises because the bonds you would need to buy to pay out the required amounts for a specified set of pensions would become dearer in a low interest rate environment. For this reason some funds have been trying to buy financial instruments which pay out if interest rates do fall. The poor Trustee can become mesmerised by all these arguments. If interest rates rise that is often bad news for the investments in the pension fund. If they fall, that can also be bad news, as the actuary’s calculation of the liabilities will go up.
Sometimes it is best to keep things simple. The idea behind a pension fund is to create a pool of assets which can pay the future pensions, whatever happens to the company that sponsored the plan. It is meant to give members of the scheme reassurance that their pensions will be alright in due course. It also allows the fund Trustees to put the money to work to help meet the future bills through good investment performance. If the fund does not perform well the company and the members are expected to put more money in.
Many funds have disappointed the companies and Trustees by sticking to too big an investment in western equity for the last ten years. Instead of helping the company and members by adding good gains and strong income to the contributions, investment performance has been a drag. As a result more and more funds have closed their doors to new members, have stopped existing members making further contributions, or wound the whole operation up. If the funds had been more open to property, bonds and emerging market equities their story would have been very different. There was good money to be made in some of these. It is time for some new thinking on how to put the assets to work, to avoid more of the same in the next decade.
As Published in Investment Week
