Britain’s pensions crisis

Crossrail engineers © Crossrail
We need more infrastructure in our pensions

The headlines are full of alarming stories about deficits. Should you be worried about your pension? Simon Wilson reports.

Is the pensions crisis a myth?

No. Lots of Britons can expect lower pensions and a less comfortable retirement as a result of economic and demographic trends. The fact that the stockmarket is still about where it was at the turn of the century, together with the long-term fall in bond yields that started in the early 1980s, mean that the assumptions behind many pension funds’ strategies have been thrown into chaos – and that’s before you factor in the rise in life expectancy and falling birth rate.

If someone invested £100,000 in a balanced portfolio of stocks and bonds, they could expect a total return of £21,800 after costs over the next two decades, according to Andrew Lapthorne of Societe Generale. Ten years ago, that same investor could have expected to make about £60,000, and three decades ago £150,000. That’s a gigantic shift.

What’s the core issue?

Lower yields make it more expensive to buy a guaranteed stream of income from bonds. Thus companies who have promised their employees a defined-benefit (DB) pension – such as a proportion of final salary, index-linked to inflation for life – face a shortfall that must be filled without threatening the ongoing business. Such schemes pay out £81bn a year to about 4.3 million people, but another 27 million are due to receive DB pensions in the future.

Equally, savers in modern defined-contribution (DC) plans, where there are no guarantees about what the pension will ultimately pay out, are at risk of not saving enough to avoid poverty in old age. Indeed, they may see their own investments grow more slowly as the direct result of listed companies needing to meet their increased DB obligations.

Why’s that?

If interest rates and yields remain at their historic lows, there will be more pressure for firms to tackle their deficits – and thus more pressure on the cash available for either reinvestment in the business or for distribution to shareholders in the form of dividends.

Fund managers including George Luckraft of Axa Framlington have cited pension liabilities as factors in their reasoning behind investment decisions. However, as Luckraft noted, the present situation in terms of deficits is down to current market conditions that could reverse. “When the consensus is so strong that the situation can’t change,” he says, “that’s often a sign that it’s about to.”

How might it change?

Yields might recover to such an extent that today’s deficit forecasts will look bizarrely pessimistic. Pensions deficits are, after all, estimates of notional future liabilities based on current assumptions. They are not statements of exact, known, sums. Moreover, some analysts think even today’s situation isn’t as bad as it’s painted. Since 2007, the Pension Protection Fund has been publishing monthly figures showing its estimates of the total assets and liabilities of the 6,000 or so UK DB schemes.

At the end of September 2016 its “PPF7800 index” data show total assets of £1,449.5bn and total liabilities of £1,869.3bn – making an overall deficit of £419.7bn and a “funding ratio” (how much of the liability is covered by the assets) of 77.5%. So on official figures, the UK’s 5,945 remaining DB schemes are in deficit by about £420bn. But a recently launched rival index thinks that’s nonsense.

On what grounds?

On the grounds that the PPF’s calculation of liabilities is far too high, because its assumptions about future investment returns are far too cautiously pessimistic. First Actuarial, a pensions consultancy, launched its own index this month (the First Actuarial Best estimate index, or FAB), which it says is intended to combat “scaremongering” in the industry, and which is based on assumptions that reflect the actual investments within schemes, rather than on a basis that assumes gilt investments match liabilities.

On these FAB figures, the same 5,945 schemes’ liabilities are much lower, at £1,092bn, meaning that their assets are in surplus to the tune of £358bn and the overall funding ratio is a healthy 133%.

So we can all relax?

Probably not. However, several influential voices – from Old Mutual’s Richard Buxton to the pensions regulator’s Andrew Warwick-Thompson – have warned that we need to be wary of panicking too much, lest overblown projections of doom end up having real economy impacts that damage businesses and limit investment opportunities. At the same time, calls are growing for action to head off the threat of a future funding crisis.

That may well involve easing the requirements governing the types of assets pension funds are required to hold to offset future liabilities, encouraging a higher-growth approach (albeit with the higher investment risks this entails), and encouraging greater consolidation bringing advantages of scale. A further option, says Ed Monk in The Daily Telegraph, would be to encourage pension funds to invest in infrastructure projects, with the long-term returns from roads, tunnels and commercial properties taking the place of bonds.

How to fix DC pensions

DC pensions are the future, and they need to be “rethought totally”, says John Authers in the FT. First, they must become more flexible and friendly to illiquid assets. “There is no reason why young investors’ long-term savings should not go into funding infrastructure, or clean energy” and so on. Second, the whole “decumulation” phase must be reworked.

Rather than buying low-yield bonds, the withdrawal phase will need to be about selling assets gradually, with lots of guidance based on life expectancies and “maximum” annual withdrawals. As such, the UK’s reform allowing savers to take bigger lump sums on retirement – introduced in April last year – is “a confident and irresponsible step in exactly the wrong direction”.