In the second of a three-part series on the sustainability of pensions in the UK, Con Keating, head of research at Brighton Rock Group, discusses the strength of private DB schemes
The first article in this series argued that occupational DB pensions, broadly as we knew them, are perfectly affordable for the UK economy. This article considers whether this is also true of the UK private sector and examines some of the fundamental problems faced.
If we begin by considering the relation between the profitability of the UK private sector and nominal and real GDP growth (Figure 1), we see that the private sector has earned, on average, more than 12% annually on its capital since the mid 1960s.
The variability or risk of private sector profitability is significantly less than that of economic production, or of the nominal gilt market. It is the high-inflation low-growth periods such as the 1970s which posed the greatest risk to private sector pension affordability rather than the low-inflation, low-return environment of recent times. It is clear that the private sector can collectively afford to provide pensions.
The problem is that these aggregates mask considerable disparity in the performance of individual companies; some companies can and will fail. The post-war rate of insolvency (shown since 1987 in Figure 2) among active companies averages just 0.6%; the Pension Protection Fund in 2010 reported the weighted average insolvency likelihood of the sponsors of its population of schemes at 0.4%.
It is evident that the new wave of pension regulation serves to protect only a small minority of schemes; the open question is why this minority should be so expensive to protect.
Pension contributions are large in absolute terms, and very large by comparison with firms’ net cash position; in the cash-heavy post-recession period, amounting to around 6% of balances. The increase in cost is pronounced. When measured as a proportion of private sector salaries and wages, it rises from 12% in 1989 to 16.5% in recent times, or as a proportion of the private sector’s gross surplus from 19% to 25%. These values are significant in terms of the operating efficiency and cost competitiveness of many of the companies involved, and sufficient to warrant the closure and cost limitation behaviour of many company sponsors observed over the post-Millennium period.
There is a material disconnect between the costs of scheme failures and the increase in sponsor expense. A simple calculation will illustrate this: with insolvency averaging 0.6% and total scheme liabilities at £1.1trn ($1.8trn) and an average scheme funding of, say, 50% at sponsor insolvency, the total loss faced in a year by the occupational DB pension system is just £3.75bn. The annuity cost of this annual loss, at the private sector’s average rate of return on capital employed, is just £28.1bn, a very small proportion of their capital resources. However, total special contributions, over the period 2000-2010, have amounted to £89.7bn. It appears that the scheme funding and related regulation has been very costly indeed.
The top stories this week were the High Court's decision to block the £12bn annuity transfer from Prudential to Rothesay Life, and a separate court ruling that 'raises the bar' for pension rectification exercises.
Guaranteed minimum pension (GMP) equalisation has soared to the top of pension schemes' to-do lists, with 58% stating it is a priority project, research from Equiniti has revealed.
Professional Pensions is holding its defined contribution (DC) conference on 4 September.