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Long-term care needed for many pensions
By Philip Coggan , Financial
, Financial Times
March 1, 2003
The pensions industry is in a mess. In the UK, actuaries have been reduced to squabbling about the best method for calculating the funding position. In the US, excessively optimistic return assumptions have hidden the scale of the funding problem and have artificially boosted profits.
Members of defined benefit, or final salary, pension schemes are starting to realise that their retirement incomes are not as safe as they had previously assumed. And members of defined contribution, or money purchase, schemes, are worse off. In the UK, figures from Lipper show that investors in typical money purchase schemes would have lost money over 10 years were it not for the effects of tax relief; over five years, basic rate taxpayers have lost money, even with the tax boost.
Let us start with the actuarial debate. This can get a little confused because of the different methods for calculating a pension fund valuation. At the most extreme is the discontinuancevaluation, which would occur if the fund were wound up (normally because the company had ceased operating).
In such a case, an insurance company would acquire the assets of the fund and bear its responsibilities. Since the insurance company would have to put aside precious capital for this purpose and would face the risk of unanticipated longevity, it tends to charge a high price for this service. As a result, especially with few insurance companies competing to offer this service, not many pension funds are solvent on this basis. This is why scheme members are often disappointed when employers go bust.
The second valuation basis is the accounting one. Current systems in the US and the UK use a smoothed approach, on the basis that pension funds are a long-term liability and that market volatility should not distort company accounts.
In the US, this leads to the absurd position whereby companies are regularly assuming investment returns of 9 per cent to 10 per cent on their funds, even when a sizeable chunk of their portfolio is in government bonds. Even when returns fall short of the expected outcome, it is the forecast that is reflected in the accounts; any shortfall is amortised only slowly.
The UK's official accounting standard, SSAP 24, uses a similar approach, although UK companies have used less aggressive investment assumptions. But companies also have to show the position under a new, but not yet fully implemented, standard, FRS 17. This values assets at market prices and discounts liabilities at a conservative rate. The result, in current circumstances, is deficits far higher than seen under the old standard.
On an FRS 17 basis there is an enormous hole to fill. But one part of the actuarial profession, led by Watson Wyatt, argues there is no reason to panic. They use a third method of valuation to calculate how much money needs to be contributed to such schemes to fund the benefits.
This method explicitly allows for the excess returns investors can achieve through owning equities. Thus the contributions companies need to make are lower than they might seem from an FRS 17 basis.
To its detractors, the Watson Wyatt approach makes allowance for excess equity returns, without allowing for the risks involved. This creates perverse incentives. The more a fund invests in equities, the higher the returns it can assume and thus the lower the contribution the company needs to make. It is no surprise, therefore, that pension funds have held such big positions in equities.
But Watson Wyatt points to the alternatives. If one were to take a very conservative approach to asset allocation, funds would own conventional and index-linked bonds. But because of the low returns involved, this would involve high contributions from the company. Rather than pay such a cost, many companies might abandon their pension promise altogether.
In effect, the focus on equities is a risk worth taking. The pension promise is not guaranteed; few employers would guarantee it. Better for both employers and employees to pin their hopes on equities, and for the majority of schemes to deliver those promises, than for no promise to be made at all.
Whether or not that argument holds water, it is losing ground. The bear market of the last three years seems to have alerted many companies to the risks they were taking with pension schemes. Many have closed their schemes to new members.
As a result, it is unlikely that pension funds will ever take as big a gamble on equities as they did in the 1990s, when many funds had an 80 per cent weighting in shares. Kerrin Rosenberg of consultants Hewitt Associates says much of his time is spent advising schemes closed to new members. Eventually such schemes will consist entirely of pensioners and, to match those liabilities, funds will have to be invested in government bonds.
So the task over the longer term is how to manage the transition from the current portfolio mix (heavily into equities) into a bond-only allocation.
The final salary pension plan is thus facing a long, lingering death. Some will view this as a positive development. They think such pensions benefited a few - long servers, top executives - but delivered a poor deal for mobile workers and women with children. In a money purchase system, assets are protected so that monstrous injustices, such as workers in a bankrupt company losing all their pensions rights, are avoided.
But a look at the recent data on pension plan returns should give such people pause. To save for 10 years and get a negative return (save for the tax relief) is a dismal experience. When investors were sold pensions in early 1993, they would have seen illustrated returns of 8.5 per cent to 13 per cent. In theory, such investors should swallow their disappointment and save more. In practice, many will probably give up in disgust and rely on the state or the property market to provide for their retirement income.
It has always been hard, because of complexity and the limited appeal of deferred gratification, to get people interested in pensions; it is even harder now.