The shocking truth about company pension funds

Lots of people will get a nasty shock when their next pension forecast comes through the letterbox.

Last week the Financial Services Authority (FSA) told personal pension providers that they had been misleading their customers.

The FSA reckons that telling people their pension pots will grow by 7% a year until they retire is a joke. They reckon 5% is more realistic.

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I suspect many of you worked this out for yourselves a long time ago. When you factor in the cost of investing, the rising cost of living and the fact that we are living a lot longer, the message is very clear. Most of us will have to save a lot more for a lot longer than we had thought.

But while everyone has been focusing on the implications of this pensions timebomb' for individual savers, it could be a disaster for big companies too.

And that's something investors need to be paying much more attention to

Company pension funds are in an appalling state

Final salary, or defined benefit', pension schemes where your employer guarantees to pay you a certain sum for the rest of your life, regardless of what happens to the stock market are practically a thing of the past in the private sector. Most of us now have defined contribution' schemes, where the level of our future pension depends entirely on how well we invest it today.

However, while most final salary schemes have been shut to new employees in recent years, many current and future pensioners still rely on them for an income. That's a problem for the companies who have committed to providing them, because they don't have enough in their pots.

According to pension consultancy firm Mercer, the final salary pension funds of FTSE 350 companies owed £42bn more than they owned at the end of September. But even this gap pales into insignificance when you take a wider look at the problem. The Pension Protection Fund has just published its Purple Book, which looks at the health of the nation's final salary pension schemes.

It makes for grim reading. At the end of March 2012, there were 6,316 schemes covering 11.7 million members. Between them they had a deficit of £204.2bn. That's up from just £1.2bn a year earlier. That's not a misprint. That really is a jump of more than £200bn in a year.

Blame it on the bond bubble

Why have things got so bad, so rapidly? Blame it on the Bank of England, and quantitative easing (QE). The Bank has tried to duck the blame. It argues that printing money to buy bonds has boosted the value of government bonds, and helped to prop up the stock market, and the wider economy. So it argues that it has avoided losses elsewhere.

This may be true. But the problem is, the Bank's new money has pushed yields on bonds down to record low levels. This is bad news for final salary pension funds, because their liabilities - what they'll owe in future - are calculated from the yields on corporate bonds with a AA' credit rating.

Think about it like this: as interest rates fall, you need more money to provide the same income. Say you need an income of £5,000 a year. If interest rates are 5%, you'll need a lump sum of £100,000 to get this. But if interest rates fall to 2.5%, you'll need £200,000 to get the same level of income.

In short, as yields fall, the value of the liabilities goes up. During the last four years, the average yield on AA-rated bonds has fallen from 7.7% to around 3.7%. Over the same period, pension fund liabilities have doubled.

It gets worse. Pension fund managers have piled into bonds to escape the volatility of the stock market, and to match the timing of when they have to pay pensions. Many now have nearly half of their money invested in bonds.

The trouble is, this has locked them into low-returning assets. The rush for bonds has helped to push yields down and driven liabilities up. In short, pension fund managers have shot themselves in the foot.

And even although money printing has boosted the price of bonds as the Bank of England is keen to point out - the value of pension fund assets has still gone up by less than the value of their liabilities. That's why the deficits are getting bigger.

We desperately need higher interest rates

This is storing up massive trouble for the future. We hear a great deal about the huge cash piles that companies have on their balance sheets. Many pundits especially those of a pseudo-Keynesian bent whine about companies failing to invest this money. Well, it might be because a lot of that cash could end up having to go into their pension funds.

Money invested in a pension scheme is money that isn't invested in new assets, creating extra jobs, profits and economic growth. Big companies with big pension liabilities, such as BT and BAE Systems, could see their dividends under threat as more cash is diverted to funding their pension schemes. And smaller, private companies could have their very survival brought into question.

What's the solution? Just as with the problem of high house prices, you can't help wondering whether the pension fund problem could be solved with higher, not lower, interest rates.

Higher rates would cause equity, bond and property prices to fall. But they would also reduce the value of pension fund liabilities. With the higher yields on most investment assets this would create, new pension fund contributions would have a good chance of providing a decent income, provided they were invested for long enough.

Getting to this scenario is messy, but so is staying with the status quo. Higher rates may in fact be exactly what the economy needs. They would encourage higher savings, which would be invested in lower-priced assets, to create jobs and growth.

Having impoverished savers and pension funds with low rates and money printing, perhaps it's time to try something else. Trouble is, we can't see the Bank changing its mind and embracing the short-term pain a rate hike would cause any time soon.

As for what you can do about it as an individual investor another side effect of the bond bubble is that it's hard to find any particular investment class right now that's cheap. What does seem sensible is to try to get as much of your investment return as possible from income - a return that you get regardless of what a market is doing.

When you get some income, reinvest it into more income-producing assets. Keep doing this for as long as you can. Let the power of compound interest work for you. This means looking for shares that pay decent dividends, and investments such as preference shares and real estate investment trusts (REITS).

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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