Journalist Anthony Hilton's recent article on pension deficits has prompted a lot of debate. Dan Mikulskis puts forward his view.
Defined benefit (DB) pension schemes, and the trustees that steer them, face an unprecedentedly difficult macro-economic environment – challenging them to deliver promised benefits in an environment of low economic growth, low interest rates and low or highly uncertain future returns on assets.
Meanwhile, sponsoring companies face equally tough choices regarding the allocation of their resources.
This brings into sharp focus the question of how much can sponsoring employers realistically afford to contribute to pension schemes. It also raises the issue of what is the best way to track any gap between the value of the benefits promised, and the amount of assets held in the fund to meet them – a key question from the perspective of scheme members, many of whom rely on their DB pension for financial security in retirement.
His argument - that you could fund schemes based on the much higher expected returns on risky investments - might perhaps be justifiable in a world where all corporate sponsors were rock solid and would last forever (clearly we do not live in this world - and even then it would expose companies to some needless nasty surprises along the way).
In relation to these issues, leading city columnist Anthony Hilton recently wrote a piece making the case for an alternative approach to pension fund deficits; one where the liabilities are not calculated with reference to gilt yields (as has become standard practice) but with reference to the returns available on risky assets.
Here's one of the reasons why he's wrong
His argument – that you could fund schemes based on the much higher expected returns on risky investments – might perhaps be justifiable in a world where all corporate sponsors were rock solid and would last forever (clearly we do not live in this world – and even then it would expose companies to some needless nasty surprises along the way).
However, this completely misses the point that a major reason we fund pensions at all is precisely to provide security in a situation where the corporate sponsor ceases to be able to make payments itself.
The reason we need to measure deficits is to get a picture of how secure the benefits might be in the absence of the employer, and to take corrective action (e.g. topping up contributions) if the situation is off-track before it is too late.
In those situations of sponsor company failure, we would hit a major snag under Mr Hilton's approach: it's hard cash that must be used to secure the benefits – Mr Hilton's expected returns won't cut it I'm afraid.
Just ask the pensioners of BHS scheme, or indeed the Allied Steel and Wire groups, still campaigning for their pensions over a decade later. This second example pre-dates the Pension Protection Fund, so thankfully pensions today are better protected, but the conclusion for scheme funding – that you can't rely on high future expected returns to discount liabilities – remains valid.
If you include the PPF in the picture, then allowing some firms the scope to de-couple their liability funding measure from gilt rates would lead to the pension funds of weak firms landing in the PPF with larger deficits, and would create a transfer from strong to weak firms through increased PPF levies, which ought to also be an undesirable outcome.
Pensions need to be paid to members in real cash, and it flies in the face of both accepted theory and common sense that the amount of money needed to provide these benefits can be reduced depending on the assets held to deliver them.
Today's unfortunate reality is that the defined benefit system in the UK is on average chronically under-funded compared to the benefits it has promised. Undoubtedly firms and trustees face some tough decisions in the coming months and years. We recognise the difficulty faced and the careful balance that at some level might need to be struck between trying to ensure security for pensioners and sustainability for firms.
Indeed, the current regulatory environment does, in practice, afford firms quite some flexibility in incorporating an outperformance spread to gilts in discounting their liabilities. We firmly believe that changing the accepted liability discount basis beyond what currently exists is not the answer.
Dan Mikulskis is head of defined benefit at Redington
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