A Google search on ‘UK Pensions Time Bomb’ generated 160,000 results in less than 0.75 seconds. What is causing the concern over UK pensions? The concern expressed here is limited only to corporate defined benefit (DB) funds in the UK. The argument about the unsustainability of the government pension is for another day.
UK Pensions Time Bomb
The collapse of BHS and the publication of its £571m pension deficit served to highlight the parlous position in which DB funds in the UK find themselves. There are 11 million Britons in the UK’s DB funds. The UK has a government-sponsored (i.e. paid for by the taxpayer) Pension Protection Fund (PPF) which is designed to protect the pensioners of company pension funds when the company has gone bust. It monitors nearly 6,000 DB (or hybrid) pension funds, of which a staggering 5,020 are in deficit as at June 2016. A deficit in a DB fund means that, according to actuarial calculations, the fund cannot meet the liabilities it has promised to the members and pensioners and, if investment performance does not improve the situation, the company will have to pay in more to make the fund solvent, an event which could bankrupt the company. In the numbers above are FTSE100 companies (Sainsbury’s, BAE Systems, BT and Royal Bank of Scotland amongst others) whose total pension liabilities are larger than their market capitalisation. The average funding ratio (assets/liabilities) has fallen in the last five years, from a satisfactory average of 100% funded to 77% now. The deficit at BAE is more than a third of its market cap, while BT’s deficit is a quarter of its market cap. Post-Brexit, at the end of June 2016, the PPF estimated the aggregate deficits in UK DB funds at £408bn (see chart below).
How on earth have these pension funds lost the plot so badly?
One reason is the unintended consequence of the effects of central banks reducing interest rates so severely. Pension funds could bank on a return from 15-year government bonds of about 4.5% per annum five years ago. The equivalent bond now yields about 1%. Obviously, bonds in the portfolio then have appreciated in value as the yields have fallen but any new investments cannot fund the liabilities being created, especially when they’re being valued at such low interest rates. In the search for yield and protection against falling rates, some employers have taken to using their own stock to secure pensions. Dairy Crest has used its cheddar cheese stock as security as has Diageo, which used its whisky stock as collateral, for example.
As the FT said recently, a DB fund has long been regarded as “the gold-plated route to a comfortable retirement”. Now, companies are queueing up to offer prospective retirees the choice to opt out in exchange for a capital sum, instead of a lifetime pension the company has to fund. The company calculates your pension and then offers you a multiple of that pension in a lump sum to opt out. Up to about two years ago, the standard multiple was about 20. Post-Brexit, multiples of 40 are being offered! So, a prospective pensioner whose DB pension is calculated at £25,000 per year would have been offered £500,000 as a lump sum two years ago. Now that same retiree might be offered £1,000,000! Companies are desperately worried about the liability on their pension funds’ balance sheet, which is a contingent liability of the company, AND the fact that the pensioners are likely to live far longer than the actuarial assumptions allow.
The Office for National Statistics shows that the average life expectancy for a 65-year-old man has increased 29% over the last 20 years. The company and the pension fund are only too keen to give that longevity problem to the pensioner in exchange for a “Brexit bonus”.
The real solution to the pensions problem is for the Bank of England (and the other central banks) to stop interfering with interest rates and allow them to “normalise”, so that both assets and liabilities are valued appropriately and funds can forecast returns with confidence that will reduce the deficits over the time periods allowed by the Pensions Regulator.UK Pensions Time Bomb