Pensions on the brink

Defined-benefit pensions should pull back from bonds to avoid going the way of BHS, Pensions Minister Ros Altmann tells Merryn Somerset Webb.

The BHS pension debacle has made clear just how much trouble Britain’s defined-benefit (DB) pension system is in. BHS’s £571m deficit is only the tip of the iceberg: FTSE 350 firms alone have a combined deficit of around £84bn, and of the 6,000-odd funds covered by the Pension Protection Fund (PPF), around 80% run deficits (over £300bn in total). It’s scary stuff. But it also might not be quite as it seems.

A few weeks ago I visited the pensions minister, Baroness Ros Altmann, in Westminster. In 2009, Altmann, as she notes, was “one of the lone voices really standing up and saying we have no idea what this massive monetary experiment is going to do”. We know more now.

The “whole point” of quantitative easing (QE) was to affect the price of UK government bonds, and it did. But in doing so, it made annuities stunningly expensive (causing thousands of new pensioners a lot of pain) and it did something very nasty to DB schemes. When interest rates fall, pension funds benefit from the rise in bond prices. But overall they suffer because falling yields make it harder to meet their long-term liabilities (actually paying out the pensions!). Hence the huge rise in pension deficits since the introduction of QE.

Pension funds are now in a tricky situation. They know the market is distorted – that yields are lower than they should be. But they are constantly told by their advisers that the lowest-risk thing to do is to buy more bonds (the proportion of their portfolios in bonds has nearly doubled in the last decade). Altmann has noted in the past what a disaster this can turn into: the more gilts that funds buy to de-risk their portfolios, the greater their deficits and the more money their sponsoring firm has to add to the fund (limiting their own ability to invest and grow).

Altmann doesn’t approve. The real problem now is that what we think of as the risk-free rate “is no longer risk-free because the market has been distorted”. So we now have “no idea… what investment risk means”. Maybe bonds aren’t the least risky thing out there. “Maybe equities, on a relative basis, are less risky than they’ve ever been before” – maybe pension funds should in fact be selling bonds and buying equities.

“The more gilts that funds buy to de-risk their portfolios, the greater their deficits and the more money their sponsoring firm has to add to the fund”

And maybe there is no one-size-fits-all policy for pension schemes anyway. The pensions industry has a history of all investing in the same way. But different schemes have different needs: a mature scheme differs from an immature one. If you are deep in deficit, it’s very different from if you have a small deficit. “If you’ve got a strong employer, it’s different from if you’ve got a weak employer.” Say you have a big deficit and a weak sponsor (as BHS did). “Throwing money at the fixed-income market will never help… you’ve got to outperform the liabilities to make up the deficit” and you can’t do that with bonds today. “What you actually need to be doing is diversifying.” At least diversified funds wouldn’t all fail together.

I think she’s right: at these prices I’d take a long-term portfolio of equities over one of bonds any day. But if the pensions minister thinks that, why don’t pension trustees think this too? I talk to firms all the time who tell me that they can’t spend to expand – or to pay higher wages – because they are constantly pouring more cash into their pension funds at the insistence of their trustees.

There is, says Altmann, “an element of overcaution on the part of some”, who assume the regulator only wants them to “de-risk” (what the regulator really wants is for them to survive) and who can give the impression that they “would rather fail conventionally than try to succeed in an unconventional way”. Sounds like the financial industry in a nutshell. We leave it there, but the core point is made. Our DB pension funds are in a bad way. But they aren’t reacting to this in the right way: if they pulled back from the bond brink, their futures could well look brighter.

That brings me back to BHS: the 2015 pension fund accounts show it to have been 81% invested in bonds.

Hang onto your pension

At the end of my talk with Altmann, we moved on to pensions freedom. Altmann reckons we now have a “brilliant” system – one that gives us all very welcome choices in our retirement. She isn’t that keen on the complications introduced by the tapered allowance for the highly paid, or on the Lifetime Allowance. But that aside she is very happy – and she thinks we should all hang on to our pension funds for as long as we can.

“The best thing you can do with a pension, now, after the freedoms, is actually nothing. Don’t take your money out until you absolutely need it. Pensions are precious. They’re the last money you should ever spend. Spend your Isa. Downsize your house.” But if you can, hang on to your pension. Why? Because it just keeps growing tax-free forever – and when you don’t need it any more you can pass it on free of inheritance tax.