Pensions in peril

Pension schemes are currently a big issue in the UK. British Airways is the latest company to have closed its scheme, following the lead of other household name companies – Iceland, Marks and Spencer, ICI, Abbey National, BT, Lloyds TSB.

As a result, a pensions debate has kicked off among companies and in the mainstream media.

To understand what’s going on, you might need a brief explanation of the current pensions system. Most employed people in the UK have traditionally belonged to final salary pension schemes (also known as defined benefit schemes), where your pension is a certain proportion of your salary at retirement.

In final salary pensions, the amount of pension coming out of the scheme is guaranteed. But it is never possible to say in advance how much these benefits will cost – most obviously because nobody can know in advance how long the pension scheme members will live for. And there are other unknowns, including investment returns. The only way to balance a final salary pension scheme is to make the contributions going into the scheme (from the employer and the members) variable.

If the amount in the scheme is estimated to be insufficient to pay the benefits promised, employer contributions rise. Usually, if the amount in the scheme is more than the estimate of that required to pay the benefits, the surplus is used to reduce (or suspend) employer contributions.

Final salary schemes were historically a perk of public sector employees. They appeared in the private sector partly due to paternalism and partly to attract staff in periods of labour shortages.

But final salary schemes became widespread in response to forces from outside the workplace. Social security changes in the mid-1970s effectively offered a bribe to employers to move people out of the second tier of state pension provision (known as SERPS: the State Earnings Related Pension Scheme). Introducing and improving pension schemes were seen as a good way around wage restraint in the late 1970s.

So what has happened now?

The cost of final salary schemes has risen substantially in recent years, for three reasons.

The most often-cited reason is that older people now live longer: the longer pensioners live, the higher the cost of pension benefits. Improvements in mortality are no doubt a good thing, but it is important to consider how they impact financially on pension schemes. Increased mortality has already raised pension costs – and costs are rising further because actuaries, who
advise on the financial position of pension schemes, anticipate further improvements in mortality.

The graph below shows the probability of death at each year of age on both the bases in use now and on the bases being introduced to allow for future improvements. It shows that people are living longer – and the longer people live for, the more it costs to provide the same amount of pension (1).

The second major reason for rising costs is a reduction in future investment returns. When investment returns are low, more money needs to be reserved to pay the same future benefits, as less of the money required can be generated from future investment returns. The move to low inflation, low interest rate economies is viewed by many as a permanent change. The graph below shows the relative cost of buying an annuity, based only on changes in interest rates. (It does not show the increased costs associated with mortality improvements) (2).

The third reason for increased costs is that benefit levels have generally risen – firstly as a result of legislative changes (for example, pensions now generally have to increase each year once they come into payment), and because members have negotiated benefit improvements, particularly at times when schemes have been in surplus. Also, employers have become used to relying on pension schemes as a human resources tool – especially to help ease out older employees.

It is the increased costs associated with these pension schemes, as reflected in higher employer contributions, which are seen as driving the move away from final salary schemes.

There is some truth to this. But the removal of final salary schemes is also a cost-cutting measure. Most of the employers who are withdrawing final salary schemes are replacing them with money purchase schemes, which have a much lower employer contribution. In money purchase (or defined contribution) schemes, employers and scheme members pay a fixed percentage of earnings into the scheme. The benefits at the end are unknown, and will depend on the investment returns generated and the expenses taken out of the scheme.

The average employer contribution to a money purchase scheme is around six percent, compared to an average long-term employer contribution of 13 to 15 percent for a final salary scheme (3). So withdrawing final salary schemes is one way to reduce payroll costs significantly.

The need to reduce costs is crucial for some companies, as for many years employers have been paying reduced contributions or no contributions at all. When a pension scheme is valued, the actuary estimates whether there is enough money in the scheme to pay all the benefits that have been promised so far. They also advise what contributions need to be paid in the future. For the past 20 years, many schemes have been in surplus, where the money already in the scheme is more than the actuary expects will be needed to pay for the benefits promised. Often in these circumstances, the employer can suspend or reduce their contributions to the scheme. In reality, what usually happens is that the employer uses the surplus in the scheme to pay their contributions for them.

Employers justify ‘contribution holidays’ by claiming that they will make up any shortfall in schemes by benefiting from any surplus. But this argument seems to have vanished recently, after employers have taken the surpluses and no longer feel like making up deficits.

But the other big factor encouraging the move is risk (4).

As I explained, the way final salary schemes work means that employers take on most of the financial risks. Poor investment performance is reflected in higher employer contributions, as are increased costs arising from improved mortality.

The need to consider risk has been magnified by two recent requirements on schemes. First, the minimum funding requirement introduced by the Pensions Act 1995 required schemes to hold a certain level of assets to cover the benefits promised. A new accounting standard, Financial Reporting Standard 17 (FRS17), requires companies to show the effect of their pension schemes in both the company’s profit and loss account and balance sheet.

In both cases, the requirements place values on the scheme’s liabilities (the benefits it has promised) based on the returns available from risk-free investments (gilts issued by the government or bonds issued by companies with good credit ratings). If a scheme is invested largely in equities, there is a risk of a large deficit appearing in the scheme – if equities fall in value and risk-free assets rise in value. The fall in equity values would reduce the value of the scheme’s assets, while the rise in the value of risk-free investments would reduce the return on these assets. The value of the scheme’s liabilities under the requirements is then based on a lower rate of return, and the liabilities rise. The possibility of large deficits in these circumstances has become a spectre haunting pension schemes.

Companies blame the increased perceptions of risk on these new requirements, but in reality there is something of a vicious circle. New legislative and accounting requirements are largely framed by pensions professionals and politicians – whose fears are reflected in new requirements which seek to control risk – and these requirements then further increase companies’ sensitivity to risk.

Moves away from final salary schemes seem to be as much the result of increased perceptions of risk as of increased costs. This hasn’t always been the case. In the 1980s, companies generated large surpluses from pension schemes – with some companies believing that generating a surplus from pensions was probably easier than generating profits from manufacturing goods. The pension scheme was seen as an important generator of profits.

Since then, fear of taking risks has permeated the world of pension schemes. The impact has been greatest in the sphere of investments. Traditionally, schemes were invested heavily in equity type investments, where the risks involved were accepted as a legitimate business risk and vindicated by the large surpluses generated by good investment returns. But as risk moves from being a blessing to a curse, employers, consultants and fund managers have sought to control it. Sometimes, this is understandable. The decimation of some industries leaves behind a pension scheme whose size dwarfs the value of the company itself. In such cases, a small deficit in the pension scheme could easily plunge the company into bankruptcy.

Controlling investment risk has meant changing investment strategy. So there has been a major switch from equity investments to more secure assets. The most extreme case was Boots, which has switched all its assets into gilts and corporate bonds with no equity element to its portfolio. As low-risk investments are expected to produce a lower return, this has increased the cost of providing the benefits. But Boots is willing to accept this cost increase as an inevitable consequence of its desire to control risk.

Risk aversion is also evident in schemes that retain some of their equity portfolios. Gone are the days when fund managers were expected to take bold decisions and buy only shares that are expected to perform well. Pension scheme trustees now dictate the amount that risk fund managers are allowed to take. At the extreme, some trustees have eliminated the risk of wrong investment decisions altogether by opting for passive management. Using a tracker fund, which just invests in all the shares in a market index, means the scheme is insulated against the risks of underperforming (or outperforming) the market.

Even active managers who are expected to outperform the market start by investing in the index against which they are judged. They then make small adjustments to the portfolio, slightly under- or over-weighting one company, industry or sector against the index to achieve some outperformance without risking large deviations from the market.

In many ways, money purchase schemes are more suited to the individualised climate of the noughties. Each member has his or her own individual pot – in stark contrast to the collective nature of final salary schemes, where there are major cross subsidies between members. But the drift away from final salary schemes is likely to continue, and this will almost certainly result in a poorer retirement for most future pensioners.

Hilary Salt is a pensions actuary who runs her own consultancy in Manchester, England.

(1) The bases shown are PA(90) rated down 2 years and PMA92C20 – the latter allows for improvements projected to the year 2020.

(2) Costs shown are the pure costs of the benefits – the actual costs would include the expenses and profit margins added on by the financial services provider.

(3) See 26th NAPF Survey 2000

(4) See Minister wades into pensions row, Guardian, 15 March 2002