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Editor's letter

Good news for defined-benefits pensions

A rate rise or two could make the defined-benefits pensions deficit simply disappear, says Merryn Somerset Webb. In the meantime, there are a couple of things pension fund managers could do to help things along.

If the huge deficits in the UK's defined-benefit (DB) pension schemes have kept you awake at night in recent years, I have some good news. The overall deficit appears to be falling very fast. In August 2016, according to the Pension Protection Fund's 7800 index (which covers most DB funds in the UK), pension funds were short by £459bn. In February 2017, it was £196bn. This February? A mere £71bn.

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How did this happen? It isn't what you think. It's true that longevity in the UK is levelling off (for now), and that companies have been holding off on investment and wage rises in favour of topping up pension funds. But the real difference is UK gilt yields. As the PPF 7800 monthly reports make clear, pension "liabilities are sensitive to the yields available on a range of conventional and index-linked gilts". Thanks to silly assumptions and actuarial fiddles, when yields fall, deficits rise. When yields rise, deficits fall. It is that simple.

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In August 2016, after the Bank of England's ill-advised interest-rate cut, 15-year gilt yields fell to 0.90%. Today they are 1.67%. That has made all the difference. This suggestion that the pension problem is in large part illusory might make you lose interest in the deficits. Even if it doesn't, you can at least stop worrying: a couple more interest-rate rises and the deficit problem could just vanish.

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In the meantime, there are many things pension fund managers could do to help things along. They might look to Japan, where the $1.4trn Government Pension Investment Fund (GPIF) has declared that it has had it with the fund-management industry. It is fed up with them getting paid the same percentage fee on their assets, regardless of whether they beat the market or not; fed up with them focusing more on gathering assets (on which to be paid fees) than taking the risks required to do well (and justify those fees); and fed up with the "lack of alignment of interest" between the GPIF and its managers. So it now intends to pay active managers the equivalent of passive fees (very little), unless they outperform, in which case they will get more.

Big managers will hate this: their business plans rely on being able to overcharge and underperform over the long run. But for the rest of us, it's very exciting. First, because we can (I hope) look forward to our own pension providers taking the same stand on our behalf; second, because it will then boost pension-fund returns (the less you pay the industry, the more you get); and third, because we now get the fun of seeing if managers on the GPIF payroll can outperform and of seeing what happens to their margins if they do not. We'll offer them a few pointers. Maybe cool it with the FANGs; think about valuations in general; and perhaps look at UK firms whose share prices have been hit hard by large-looking pension deficits. They'll start to look cheap when rates rise again.

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