Pension Scheme Deficits - FT Analysis
I hope that nobody minds my posting this full story, as I cannot link into it, however if provides a strong rundown of all the factors behind the current DB pension scheme farcicle from the Financial Times. I think that is relevant to many in various companies at the moment, so have posted a new thread rather than attached to the bottom of some rather long BA ones for example.
Pension funds' flight to gilts is a tragic farce
By Martin Jacomb
Published: March 13 2006 02:00 | Last updated: March 13 2006 02:00
At long last the debacle that has befallen the nation's pensions provision has become apparent. Even now, however, the scale of the disaster and the damage it is doing to our economy is not fully appreciated.
The liability for unfunded publicsector pensions is gigantic. Government and private sector estimates put its capital value at between £500bn and £750bn, bigger than the national debt. Others have put it even higher. And it is a real liability: everyone knows that if you live longer you have to work longer; denying this and keeping the public sector retirement age at 60 is a scandal. Yet the government deliberately shies away from facing it, judging that the beneficiaries' votes are important while the rest of us will not notice. But the longer the inevitable is delayed, the worse the problem gets, and it will not be long before mere arithmetic erupts into social trouble.
Alongside this, the private sector "defined benefit" (ie final or average salary) system has been killed off and most existing schemes are being closed. People say it is no longer needed because lifetime jobs are a thing of the past. This is at best only half true; if defined benefit pensions were still provided, maybe more people would stay loyal to lifetime employment and perhaps a sorely needed productivity improvement would follow.
The first blow came nearly 20 years ago when the Inland Revenue cracked down on pension funds building up surpluses. This was when the pension contribution holidays began. The Treasury justified the change by saying it would otherwise be permitting a distorting tax-free subsidy; although many think that encouraging cash flows into savings, rather than non-productive government spending, is sensible. But the damage done was not mortal.
The killer blow came with Gordon Brown's imposition of tax on pension funds' dividend income in 1997. Equities at a stroke became much less attractive. When equity markets declined in 2000-2002, with no surpluses to fall back on, pension fund deficits soon opened up.
The actuarial profession then started propagating the view that safety required a higher proportion of funds to be invested in gilts rather thanequities. This was always a doubtful proposition, since the history ofmarkets shows that well managed equities always outperform fixed-interest bonds in the long run, and the essence of pension funds is that they are there to provide for long-term liabilities.
The accounting profession has compounded the problem. The accounting rule FRS 17 requires that pension fund deficits be measured by reference to the yield on long-term gilts. It is easy to see why those setting standards opted for something precise and easily ascertainable but conceptually the proposition is seriously doubtful, if not actually wrong. If you invest to secure on a long-term basis a higher return than is obtainable with gilts, then the discount rate used for valuing the corresponding liability should reflect this.
However, FRS 17 prevails; and with the advent of the Pensions Regulator and legislation creating it, pension fund trustees are investing heavily in long-dated bonds. The regulator obviously wants deficits eliminated rapidly but with the boom in the price of long gilts due to foreign buying, as well as pension fund buying, yields have sunk and the FRS 17 deficit calculations have risen sharply as a result. This looks like a vicious circle. There is no actual requirement for trustees with a deficit to buy gilts in this way but the surrounding regulatory requirements leave them with little alternative.
The result is a serious misallocation of resources and it is occurring on a massive scale. Hundreds of healthy companies (more than 90 per cent of FTSE 100 companies) have defined benefit pension scheme deficits and they are currently diverting substantial proportions of cash flow into their pension funds with which the trustees then buy gilts. This money would otherwise be available to invest in the sponsoring companies' own businesses. To anyone keen on the health of the economy, this distortion is a tragic farce.
At the same time, the new legislation as operated by the regulator gives pension fund trustees the duty and the power to see that the deficit is eliminated over, say, a 10-year period. With this goes the power to object to corporate transactions that might jeopardise that aim. Change of control, share buybacks and sometimes even dividends come within the scope of this. As a result there is an unprecedented shift of power away from company boards to their pension fund trustees, most of whom are not trained for this role.
The result is a serious self-inflicted wound. It needs immediate and radical attention. Obviously, the 1997 tax imposition should be reversed; but chancellors do not like admitting mistakes. There is, however, one simple thing that could be done to mitigate the damage. The accounting profession can find plenty of reasons for not reversing FRS 17. It only became mandatory for accounting periods ending after 2004. However, company accounts could be permitted to contain, as well as the FRS 17 figures, a full explanation of the pension fund's condition, thus enabling boards to explain that the FRS 17 calculation does not necessarily represent the true and fair view.
A small step, perhaps - and no one should think it is anywhere near a full remedy for this awful mess.
Sir Martin Jacomb, who was chairman of Prudential until 2000, writes in apersonal capacity