Why pensions are bad news for investors

Pensions might seem boring to most investors, but now they are having a direct impact on returns, says Martin Spring in the On Target newsletter. In the US, some large companies such as General Motors face bankruptcy because of fund liabilities, while in the UK, companies are being forced to clear their deficits within a decade. And this is just the tip of the iceberg...

For most investors, pensions are a boring subject. If they're a problem, it's one that lies far in the future. Or it's someone else's problem. And in any case, it's too complex to make sense of (one example: when bonds, a major asset in pension funds, increase in value, that apparently makes the problem worse).

Yet it's a problem that's now lurking at the edge of our radar screen because it's starting to have an impact on investors.

In America, some large corporations face bankruptcy because of their pension fund liabilities in the case of General Motors these are three times the value of its shares. Congress is currently hammering out a new law to force companies to fund their pension promises and pay more in premiums to the Pension Benefit Guaranty Corporation, which has a $23 billion deficit.

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In Britain, companies are being forced to divert cashflow to clear the deficits in their funds within ten years the Pensions Regulator has started to use his new power to veto dividend increases.

But it's a problem that has much wider repercussions. It's starting to embrace all sectors of society and to trigger the first skirmishes in the coming pension wars.

In the US, New York City transit authority workers recently went on strike to block a move to increase compulsory pension contributions by new employees from 2% to 6%.

In the UK, a million local government workers went on strike to protest against plans to stop early retirements on full pensions. And the government has been castigated for giving bad advice to 85,000 workers about how secure their pension funds would be then refusing to compensate them when the funds went bust.

The scale of the emerging pensions problem is frightening.

In Europe, the Kok Report recently warned that by mid-century the ratio of pensioners to active workers will double. Broadly speaking, that means the burden on the working population of supporting those who have retired will also double.

In Britain, 97 of the hundred biggest listed companies have deficits in their pension funds, while the liabilities of unfunded schemes for public-sector employees, if taken into account, would more than double the national debt.

In America, the gap between the cost of Social Security pensions and Medicare and future tax revenues to pay for them has been estimated at $44 trillion, or four times GDP.

At the heart of the worsening pensions funding problem in the developed world is refusal to face up to the facts. There won't be a problem in future if it's tackled now. But doing so requires making substantial sacrifices now and for years to come.

Very few are willing to do that.

Individuals prefer "jam today" to "jam tomorrow." When the British supermarket chain Sainsbury gave its employees the choice of increasing their contributions to the pension fund from 4.25% to 7%, or switching to a cheaper scheme offering inferior benefits, two-thirds took the latter option.

"The situation is complicated by the emergence of a younger generation that lacks any sense of personal thrift," says one commentator.

Thrifty taxpayers resent the idea of having to pay for retirement benefits of the unthrifty.

Executives want to channel corporate resources into activities from which they can benefit personally, directly or indirectly, rather than contribute to workers' pension funds.

Bad news for employees of private-sector companies

Three-quarters of Britain's largest companies have closed their defined-benefit funds to newly-hired employees, offering instead the much inferior defined-contribution schemes.

This gives them a double benefit. It shifts the investment risk from the company to the employees, as the company is liable to cover any deficit in defined-benefit schemes, but not in defined-contribution ones. And it enables them to cut the level of their contributions in the UK, typically from 16% to 6% of the employee's pay.

However, the scale of this benefit shouldn't be exaggerated. The big liability problem relates to the bulk of work forces still covered by the schemes closed to new employees.

Politicians have seen no point in courting unpopularity with voters so as to address problems whose pain will be immediate, but whose gain will only become apparent long after they've retired. That's why they keep dodging the issue (although they do ensure that their own lavish pensions are adequately funded).

However, this attitude is starting to change. In the US, Congress is introducing reforms that seem sensible if timid.

The evolving long-term pensions funding problem in the developed world has several causes:

The ratio of working people to the aged they're called to support is declining.

The aged are becoming a bigger proportion of populations as people live longer because of advances in medical science, but also because of better nutrition and healthier lifestyles.

And because working people are becoming a smaller proportion, thanks to widespread use of birth control and better opportunities for women that have reduced the number of children, and therefore of youngsters entering the workforce.

In the world as a whole, the ranks of those aged 60 or older are growing 60% faster than the population as a whole. In 1950 there were 12 people aged 15 to 64 to support each person of retirement age. Now the global average is nine but by mid-century the figure will be down to four, the United Nations forecasts.

In some countries the situation will be much worse, and sooner. By 2025 less than 20 years away there will be only two workers for each retiree in Japan, just 2 in Italy and Germany, about 3 in the UK and fewer than 3 in the US.

The average number of years spent in retirement is growing. Not only because people stay alive longer, but also because many retire at an earlier age. Companies often consider it cheaper and less controversial to trim their labour force by offering early retirement than to retrench.

There is fierce resistance to raising retirement ages set by law, fund rules and labour contracts. In Britain last year the government reneged on its promise to start raising the retirement age of public-sector workers after labour unions threatened nationwide strikes. Most such workers can go on full pension at 60, though for some the retirement age is as low as 48.

In Europe, where most people depend on generous welfare-state pensions, there is strong public opposition to attempts to raise the age at which citizens can retire, even though the rules are absurdly generous. In Italy more than three-fifths of adults have taken retirement by the age of 55.

State and public-sector pensions are largely "unfunded" paid for out of current revenues instead of accumulated savings. This tends to hide the scale of the future problem, when there will be far fewer working taxpayers per retiree.

The two-decades-long bull market in equities encouraged companies to underfund their pension schemes by taking contribution holidays, and agree to over-generous retirement benefits as a cost-saving alternative to larger pay settlements.

It also removed the incentive for governments to address the problem, and even encouraged them to worsen it. In Britain one of the first measures taken by finance minister Gordon Brown when he came to power was to remove tax concessions on dividends, reducing the build-up of private pension funds by some £5 billion a year.

The collapse of stock markets and aggressive moves by central banks to flood the financial system with cheap credit to ward off a global recession have forced policymakers to start giving attention to the pensions problem.

The fall in share prices slashed the value of the assets of private-sector pension funds, which had seriously over-invested in equities in the biggest global equity bubble in history. Falling interest rates magnified their liabilities, by reducing the rates used to discount future obligations to pensioners.

Suddenly, black holes opened up. Many funds were found to have liabilities greatly in excess of their assets.

When actuaries, company sponsors, fund trustees and regulators looked closely, they uncovered another problem. In most cases, the mortality tables used to calculate the number of years future retirees would receive pensions were outdated. They under-estimated sharply rising life expectancy, and therefore both current cashflow needs to pay pensioners staying alive longer, and the scale of future liabilities.


Employers, the ultimate guarantors of corporate funds promising future pensions related to final salaries, acted to cap their liabilities and shift investment risk from themselves to employees.

Actuaries and regulators insisted on much more conservative accounting and adequate contributions out of company profits to reduce deficits and make prudent provision for future liabilities.

In Britain now accounting rule FRS17 requires that pension fund liabilities be measured by reference to the long-term yield on government bonds. A similar rule, IAS19, applies to private-sector funds in Europe.

One consequence is that pension fund trustees have been shifting out of equities into long-dated bonds, especially inflation-protected government securities. This is to avoid the risk in equities and to buy risk-free or lower-risk assets whose future capital values and income streams will closely matched pensions funding requirements.

It is starting to have some devastating effects. In Britain, for example, Barclays Capital says there has been "an undignified scramble" by an industry with £800 billion in assets to invest in a pool of just £41 billion of long-dated index-linked bonds, driving their prices up and their yields down to astonishing levels. At one point, a couple of months ago, the funds were investing in 50-year bonds offering a real annual yield of less than 0.4 per cent.

This "scramble" is highly controversial. Critics point out that "liability-driven investment" locks pension funds into very poor returns. Over the past 50 years equities have delivered a real average annual return of about 6% a year in both the US and the UK.

No risk of insolvency

Over the long periods that pension funds operate, the risk in equities is negligible. And as their liabilities are paid off over long periods the number of years their pensioners live there is no risk of insolvency from temporary collapses in share prices.

The driving down of bond yields to low levels has also an immediate adverse impact on people going into retirement, where their pensions are provided through purchase of annuities. In Britain annuity rates, which relate directly to long bond yields, are now less than half what they were 15 years ago.

If the regulatory and funding environment in the UK is now unduly conservative, in the US it's still undoubtedly too slack.

Under hopelessly outdated accounting rules, companies are still allowed to value their funds on such generous assumptions that they can assume non-existent and growing surpluses where realistic calculations would show increasing deficits.

Orin Kramer, chairman of the New Jersey state pension fund, castigates consultants and actuaries for using "artificial accounting constructs and generous investment returns (that) translate into economic fictions and highly optimistic visions of the future."

Worldwide, the long-term solution to the pensions problem would seem to lie in a combination of measures:

Raising the ages at which people can retire on full pension;

Reducing pension benefits for future retirees;

Switching state pension schemes from an unfunded to a funded basis (difficult, as this amounts to those actively employed being asked to simultaneously finance existing retirees as well as save for their own retirement);

Providing stronger tax and other incentives for individuals to save and thus accumulate resources for their own retirements;

Legislating formulae for calculating the future liabilities and assets of funds that are more realistic than those currently used (too generous in the US, too conservative in the UK, for instance); and

Increasing contributions to pension funds by the state, companies and individuals.

This last point may require compulsory saving, preferably in private retirement accounts. Many nations have introduced such compulsion, including Australia, Switzerland, Sweden, Chile and most Latin American countries, Poland and other Central and East European countries, Singapore and some other Asian countries.

All of these measures are likely to be highly unpopular politically. As retirees and near-retirees, who tend to be much more active in politics than younger age-groups, increase their relative importance, they are likely to be able to block or at least seriously retard measures to raise the retirement age and reduce benefits.

This will mean that the increasing burden of paying for retirement benefits will mainly fall on taxpayers and corporations particularly the latter, with their limited political clout in democracies.

Not good news for investors.

It means that you must give some attention to the pension and healthcare funding liabilities of companies when considering them as investments.

You also need to give attention to long-term structuring of your financial affairs to mitigate future tax liabilities. This may involve using offshore tax havens, especially those that have refused to be bullied into the European Union's information exchange system such as Singapore and Hong Kong, or continue to allow ownership to be hidden via anonymous bearer shares.

It may even involve planning to relocate to other, tax-friendlier countries. That's becoming increasingly possible as the internet makes it easier to work anywhere with a modern telecoms system, international aviation becomes ever-cheaper, developing countries modernize their legal and financial systems, and through travel we all become more used to and therefore comfortable with other cultures.

A final personal point about pensions.

I never liked the idea of depending on financial institutions to accumulate and build the capital I would need for retirement. OKas a financial journalist I was in an unusually fortunate position to take command of my own investment affairs. But everyone should seek to do as much of that as possible within the limitations of personal circumstances.

In a world that's become increasingly financially dangerous for retirees, personal financial planning with a global view is more important than it's ever been.

By Martin Spring in On Target, a private newsletter on global strategy