On the Money

Meddling has left us with defined liability schemes

Alan SteelWe keep reading that the Bhs pensions deficit is all down to former owner Sir Philip Green. Well, there’s always two sides to every story, so let’s dig deeper.

Back in 1972 after giving up on my actuarial career I began work in a pensions department. I was a lamb to the slaughter. These people spoke a language which appeared to be a cross between algebra and swahili.  Final Salary Pension Schemes, it seemed, were the most complex invention since feminine logic.

My manager drew a water tank with an inflow pipe at the top and a tap at the bottom, except it was money, not water, that flowed in and, supposedly, there was enough money in the tank to pay the pensions promised according to the “funding rate” when the scheme launched.

“Funding rate? What’s that and how’s it calculated?” I asked.  Apparently, you calculate how many workers there are, how many men or women, and salary details. Then you assume various things like an average rate of salary increase, future inflation rates, future investment returns and present mortality rates. Then you assume the oldest person retiring in future is replaced by someone the same age and sex as they were when they joined. And finally, that the whole thing lasts for infinity.

Chuck all this into the mincing machine and out pops a percentage of the total wage bill to be paid each year. Ta-daa..a funding rate!  Eh? I responded…that can’t work. “I know”, he sighed, “but dinnae tell anybody.”

By the way, these were halcyon days for Final salary Schemes. So, if they couldn’t work 44 years ago – considering the mad assumptions and the various hurdles imposed over the years by actuaries, bureaucrats and politicians – why do we think they should work now?

Here’s just a few gremlins thrown at pension scheme trustees.

From 1975 a law was passed that if you were over age 26 and had at least 5 years service with your employer, the Pension Scheme had to preserve a benefit for you at retirement.

Then in January 1986 some of that benefit had to be protected against inflation. Two years later a new law reduced the 5 years limit to only 2 years. Only 3 years later yet another law extended inflation proofing to leavers’ entire preserved benefits. Somewhere along the line it was decided that men and women were to be treated equally despite the fact women retired earlier and lived longer. All in all some hundreds of legislative changes were forced on schemes.

Astonishingly, most schemes in the 1980s were in surplus, so much so that Nigel Lawson in April 1986, decided companies must be avoiding taxes by continuing to pay in pension contributions, so he decided to impose taxes. Result? Companies stopped paying in. Another fine mess created by politicians.

While they and the bureaucrats were doing their best to destroy a benefit structure the envy of Europe, actuaries, accountants and regulators decided to throw in their tuppence worth. 2001 saw a new theoretical accounting standard introduced which brought about significant volatility in pension costs. Further legislation over the following four years imposed yet more constraints on companies and scheme trustees.

Despite this accumulated madness, schemes such as that run by Bhs remained in surplus until 2008. Then the great financial crisis hit, a crisis made far worse thanks to slack regulation on banks and financial institutions.  The UK reacted by dropping interest rates to historic low levels and holding them there ever since. Add up all the errors over the years, stir in almost zero interest rates and the result is widespread pension deficits.

And if that wasn’t enough, theorists in the shape of the Pensions Regulator have been doing their best to force Scheme Trustees to “de-risk” their portfolios by increasing exposure to Gilts and Absolute Return funds. Check out what is by far the biggest net inflows to Institutional  (Pension funds) since 2008/9. Five years ago I sat open mouthed at a pensions seminar when a consultant actuary said “because only 25% of active managed funds beat passive index trackers it makes sense to simply buy cheap passives.”

We act as advisers to a few final salary schemes and guide the trustees in asset allocation and fund selection. They have been under enormous pressure from regulators to “de-risk” by having the bulk of the portfolio in Bonds and Absolute Return funds, despite our consistent outperformance over accepted benchmarks for the last ten years. Indeed, had the trustees succumbed to that pressure 12 months ago , instead of a net 5.8% increase, they’d be looking at a 4.5% fall.

From my experience I’d say, not only are management and trustees bewildered by this absolute mess of regulation, there can be no doubt regulators and politicians are too. There are far too many vultures circling around pension schemes who prefer theory to practice and who seem oblivious to the fact that progress is cyclical not linear.

US analyst Rob Arnott many years ago calculated that if most passive and tracker funds were replaced by broader asset allocation funds, the world’s pensions deficits would disappear within 20 years. But few listened to him.

Alan Steel Asset Management is regulated by the Financial Conduct Authority. This article contains the personal views of Alan Steel and should not be construed as advice. Do check your individual circumstances with your advisers.

Visit the website at www.alansteel.com

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