Pensions crisis is back on the boardroom agenda
Shrinking credit, regulation and longer lives are seriously eroding pension returns, warns Alex Brummer. Forget the Riviera – it’s Worthing that awaits
When the credit crunch erupted on 9 August 2007, no one envisaged that nine months later the money markets, where banks lend to each other, would still be closed. The impact of that closure and the torrent of losses cascading through the financial system is having a dramatic impact on all of our lives.
Credit card limits have been slashed, mortgages for first time buyers have become all but extinct and pensions – already severely strained – have been skewered. A combination of turbulence on equity markets, the relatively low yields on gilt-edged stocks and constantly changing mortality assumptions and accounting rules mean a return of the pension fund deficits which have been the curse of corporate Britain since the turn of the 21st century.
Investment bankers Morgan Stanley estimate that falling asset prices alone, notably commercial property and equities, have added £40 billion to the deficits of the companies which make up the FTSE 350, the top 350 quoted enterprises. This worsening of the condition of corporate pensions is only partially offset by the surge in corporate bond yields, as markets have become increasingly distrustful of company debt. Rising corporate bond yields have allowed company pension funds to claw back £29 billion of value.
Even so, for many firms including BT (which has one of Britain’s largest pension funds), Northern Foods and AGA Foodservice, pension deficits are a liability that has now reached 7 per cent of market capitalisation or more.
This is not all. The regulatory environment for pensions is never at a standstill. Indeed, many people argue that ever-changing government regulation – which has required gold plating of occupational schemes to fund inflation adjustment and generous widows’ benefits – have proved as detrimental to pensions as the then chancellor Gordon Brown’s 1997 tax raid on dividend income.
The tax hike was estimated to have raised up to £6 billion a year for the Exchequer and back-of-the- envelope actuarial calculations put the total cost of that measure to occupational funds at £100 billion and climbing. At the time, Brown was warned by Treasury officials that the measure would have a detrimental effect on occupational schemes, which were in healthy surplus, but he chose to ignore it.
The latest regulatory assault is coming from two directions. Firstly, new, more conservative accounting regulations point to a switch from the current system under which the discount rate used to calculate liabilities is based on Double-A rated corporate debt. The whole ratings system has been thrown into disrepute by the subprime debacle under which toxic mortgages and other instruments, including private equity debt, was sliced and diced and given the top Triple-A rating by the main agencies Moody’s and Standard & Poor’s. As a result, there is a move among pensions regulators to rebase the discount rate on gilts or government bond rates – which are currently much lower yielding.
A second shift is changing mortality assumptions. Research by Pension Capital Strategies suggests that the life-span predictions among the FTSE 350 companies are understated by between one and three years. This is not surprising. We are all aware from our families how better lifestyles and health care have prolonged life, producing record numbers of people living into their late eighties and nineties. I personally have one parent and two parents-in-law, all hale and hearty, who fit into this category.
Longevity alone, Morgan Stanley forecasts, could add another £11 billion to the deficit. The credit crunch has proved a severe blow to New Labour’s reputation for economic competence and its fallacious boast to have abolished ‘boom and bust’. But it is the systematic destruction of Britain’s regime of defined benefit schemes that may be seen by economic and social historians as the most destructive outcome of its 11 years in Downing Street. In 1997 Frank Field MP, former minister for welfare reform, described the UK’s occupational pensions as ‘the envy of the world’. He was not alone. The right-wing Conservative John Redwood has used similar language.
The current picture is wholly different. The numbers of people in defined benefit pension schemes has collapsed to 8.5 million, or 29 per cent of the workforce, against 12.8 million, at its peak 30 years ago. But even this figure provides a distorted picture, since membership has been steadily climbing in the public sector, which grew sharply under New Labour, and falling in the private sector, where it is now just 15 per cent.
The corollary of this collapse in private sector membership of defined benefit schemes is that large parts of the workforce were transferred into defined contributions plans. The name is a misnomer designed to confuse members because of its use of the word ‘defined’. In fact these are ‘money purchase’ plans under which members’ returns are based on the contributions made. Worse, pensioners are entirely dependent on the state of financial markets in the period immediately ahead of retirement. If you were unfortunate enough to retire at the start of the credit crunch, when equity markets were in freefall, the very real promise of a comfortable retirement would be lost.
It is ironic that Labour, the party responsible for the universal state pension, has been responsible for the mass exodus of companies from defined benefits schemes and the transfer into much more volatile defined contribution schemes. Even worse, with the new Pensions Act, which has just cleared Parliament, the Brown government has created an opportunity for companies to lower the bill for retirement costs even further, just at the point that the pensions deficits are starting to rise again.
Under the Act, the government is creating a new ‘pensions account’ which automatically enrolls everyone in the workforce into a pensions scheme unless they actively opt out. But the obligation on employees is a contribution of just 3 per cent, with the government chipping in a 1 per cent tax break and employees asked for 4 per cent. The employer payment of 3 per cent is an open invitation for companies with pensions deficits and finance directors seeking to cut costs, to switch from defined benefit and contribution schemes into the personal account. This is a trend that in times of financial hardship like the present could accelerate.
The last decade saw companies frantically working to reduce their pensions deficits. This has been done by switching into cheaper-to-run schemes and by negotiating down benefits with the workforce. In exchange, firms like British Airways have agreed to make large one-off contributions to funds to restore them to balance.
This whole exercise now looks to have been fruitless. The credit crunch means that many schemes restored to good health are back in deficit. People in money purchase schemes are particularly harshly affected, as the value of their pensions pot and eventual payout goes up and down with volatile markets.
Even worse, the suspicion is that some of the more adventurous ‘alternative investments’ may be in subprime. Added to this, the switch from corporate bond yields to gilt-edge yields may reduce the risk but increases the liabilities by huge amounts.
The credit crunch will send pension fund trustees and finance directors back to the drawing board again. The objective will be to reduce their exposure to the gaping deficits which are again opening up. That cannot be welcome news to anyone looking forward to a romantic retirement on the Riviera, or for that matter more modest golden years in a sea-view bungalow in Worthing.
Alex Brummer is City Editor of the Daily Mail