The great pensions disaster
Martin Jacomb says a series of catastrophic decisions have wrecked Britain’s once-proud retirement savings system
Britain’s private sector pension provisions used to be something we were proud of, the envy of less fortunate nations. Our public sector pensions, on the other hand, have never been backed with full cash contributions. Pensions provided for government servants are paid month by month by the Treasury as though they were Civil Service salaries, with no funds set aside for future liability. Even though the capital value of this ‘debt’ (which is just as real as borrowing) is absolutely gigantic, it is disregarded by the Treasury when it presents our national balance sheet.
The public sector pension situation is deadly serious, with retirement at 60 and longevity still rising. The liability is thought to be worth somewhere between £500 billion and £800 billion, while more than a fifth of council tax now goes on local authority pensions. All that is bad enough; but on top of it, in just a few years, decisions taken in the public sector, by politicians and bureaucrats, and also by the accounting and actuarial professions, have managed to destroy the private sector pension structure which used to work so well, and a crisis has been created instead.
Until recently most companies ran pension schemes which paid you a pension based on your final or average salary, called ‘defined benefits schemes’. Employer, and usually employee as well, contributed to pay for this; and these contributions were the most important element in the personal savings of our nation.
The first decision in this catastrophic series was the Inland Revenue rule, introduced in the late 1980s, that, if a pension fund built up a surplus of more than 5 per cent over the assessed value of future pension liabilities, the company lost its tax privileges on the excess. Since pension funds did well with their stock exchange investments during the 1990s, this limit was frequently hit, and companies cut their contributions. The concept of building a surplus in the good years was thus deliberately sti fled by the Inland Revenue, and a good flow of savings for investment was cut off. The extra tax fell back into the Treasury. Savings for investment were effectively diverted to government consumption.
Then came Gordon Brown’s tax on pension fund dividend income in 1997, turning the screw and making pension funds a much less favourable form of rewarding employees and providing for their retirement. The effect was to interrupt the continuous flow of income into pension fund investment. The extra tax was about £5 billion a year. Equity shares were, at a stroke, made less attractive and stock exchange values inevitably suffered accordingly. The decision contributed directly to the stock market downturn in 2000–02. This, together with increasing longevity, opened up deficits in pension funds. The value of their investments became less than the capital value of the liability to pay future pensions.
At this point the actuarial profession, following pressure from the Financial Services Authority on some mutual life assurance companies (which cannot raise capital on the stock market like a nonmutual) to rebalance their portfolios, started advising pension fund trustees to sell equities and buy gilt-edged government bonds, in order, so they said, to minimise risk. This does not, however, necessarily reduce the risk at all. Long-term funds invested in equities over the years tend to do better than bonds. As a temporary switch to guard against a decline in equity values, this may have been a good idea for the early movers. But if everyone sells equities and buys bonds, the bonds go up in price and the equities go down; later switchers sell at the bottom and buy at the top. Why this was thought to be a sensible long-term investment policy for the whole sector is a mystery.
But it gets more absurd still. The way pension fund liabilities are valued is by reference to the long-term yield on bonds; so that if bonds go up in price, they yield less, and the officially assessed capital value of the future pension liabilities goes up. This is indeed as ridiculous as it sounds.
The absurdity is at last becoming obvious. The price of long-term government bonds has gone up enormously, out of line with government bonds abroad, partly because pension funds are buying all they can. They feel (wrongly) obliged by the regulatory regime to do so. But as they do, the calculated value of the future pension liability also goes up. Thus a vicious circle is created. This is serious because everyone can see that the price of long-term bonds today is virtually a ‘bubble price’ and can not last long. Even the authorities are concerned that long-term bond prices are too high, and more long-term gilts are being sold to create more supply and bring the price down. But the correction has been small.
The net result of all this is that over 90 per cent of FTSE 100 companies have a pension fund deficit according to this compulsory calculation of their future liabilities.
And the Pensions Regulator, a new figure who has entered this Alice in Wonderland world, wants these deficits eliminated. So companies are diverting cash into their pension funds to close the deficits instead of investing in new plant and modernising their equipment. No wonder our economy is losing its dynamism.
The result is a serious misallocation of resources on a grand scale. As a company manager, you do not invest in the future of your business; you lend the money to the government instead. And your focus of attention is directed from your business to managing the obligations to the pension fund.
The Pensions Regulator has come on the scene as a result of new legislation introduced to try and prevent people suffering too much when their pension funds become insolvent. The way this works is that pension funds have to pay a premium into the new Pension Protection Fund and this insurance pool is there to pick up some of the liability when a fund goes bust.
This is a tax whose constitutional legality may one day be tested. But in the meantime the premium is set so that it is lowest if the sponsor company is in good order, its fund is solvent, and the investments in it not particularly risky. As the fund gets shakier and the investments more risky, so the premium goes up. So those least able to do so pay the most.
The Pensions Regulator is a powerful person, and the new law which empowered him prevents a company that has a pension fund with a deficit from doing anything which might reduce its ability to pay off the deficit unless it gets his permission. This obviously includes making acquisitions, being taken over by a company with debt, buying back shares, or even paying a dividend. Why the Pensions Regulator should be in any position to judge whether these moves are good or bad for the company and its pension fund is a mystery.
The obligation of policing all this is, in practice, imposed on the pension fund trustees. They effectively stand between the company and the Regulator. So that now, when the board of directors wants to do any major transaction, if their pension fund is not fully solvent, they must get the pension fund trustees’ prior approval. If directors get this seriously wrong, they can be made personally liable. They can apply for a clearance from the Regulator, but they may well decide that the risk of getting a red or amber light is too real to warrant going for a clearance.
This amounts, in fact, to a massive shift of corporate power away from the boardroom to the pension fund trustees, whose experience and knowledge do not usually qualify them for this role. And their primary focus is pensioners, present and future, and not the wealth-creating sponsor company.
These changes spell the end for defined benefit schemes. Some people say that they are not needed now anyway and are out of date, because people don’t stay in the same job for a lifetime. But maybe, if there were proper pensions, as there used to be, more people would like to stay loyally put, and they would then become more productive, thus helping to remedy the UK’s pathetic productivity record.
Anyway, nothing now can save defined benefit pension schemes for the future. This important savings habit is gone. Perhaps it is all part of a plan to insure that we have inadequate savings for retirement and become dependent on the state.