BHS and Tata Steel couldn’t be much more different, but there is one feature common to their respective collapses: their pension fund deficits. Each has its own special set of circumstances, but the problem of pension deficits is one that extends far beyond two struggling companies.
The ghost of funded occupational pensions is likely to stalk parts of British industry for years to come. There are lessons to be learnt from mistakes past. There are also policy responses that it is not yet too late to consider. How the government responds could be at least as important as any other element of industrial policy. It should also stand as the third leg of any serious attempt to tackle intergenerational inequality, with policies on state pensions and housing.
First, it is worth establishing a sense of scale. Funded defined benefit (DB) occupational pension schemes had assets of about £1.3 trillion at the last count — nearly three quarters of an entire year’s national income. It’s more difficult to say what assets are needed to cover future liabilities: that depends on future investment returns, longevity assumptions and so on. The Pension Protection Fund reckons that to buy out all the future promises would cost more than £2 trillion.
On this basis, the combined scheme deficits are in the order of £800 billion. The PPF can limit benefits if it has to take over a scheme but even on the basis of those more limited benefits, schemes are, on this measure, collectively underfunded by £250 billion.
That’s enough big numbers for now. The point is that, given current regulations, there are huge deficits to be filled. In part that reflects generous promises, increasing longevity and poor investment returns. But one big issue is simply measurement, and this is a form of measurement that matters not only because it produces big scary numbers but also because it drives behaviour.
How do we know what the deficits are? Well, we know what benefits current pensioners are receiving; we can work out the rights of current workers; and we can make assumptions about future longevity. Those are not easy things to do but they are not conceptually too demanding. What is more difficult is to know how to value these liabilities because they lie in the future. If returns on funds are assumed to be very high then the liabilities will look low: you don’t need so much in the way of current assets to cover future liabilities. For the purposes of measurement we could wipe out deficits simply by assuming that future returns will be high enough to cover them.
That obviously wouldn’t be terribly prudent. Broadly what happens instead is that pension fund liabilities are linked to gilt rates. As gilt rates have collapsed, measured liabilities have risen. Measured deficits are at their highest ever not because assets are low but because low gilt rates mean that future liabilities are discounted at very low rates.
There is no single right answer to the question “how should liabilities be measured?”. There is a series of trade-offs to be made. One really big effect of current practice has been to invest more and more pension fund assets in safe assets as a way of matching measured liabilities. Between 2006 and 2015 DB schemes moved from having more than 60 per cent of their assets invested in equities to 33 per cent, while investment in gilts and fixed interest rose from 28 per cent to nearly 50 per cent. That is perhaps a surprising choice for funds, which are by their nature long term and explicitly designed to share risk. It is a choice with big consequences in terms of the availability of funds for investment in productive activity.
The other big effect of the current situation relates directly to contributions into pension funds. Obviously the bigger the liabilities and deficits the more contributions are required. Employer annual contributions to DB schemes have more than tripled since the early 2000s and are now getting on for £50 billion a year.
That’s money that has to come from somewhere. That somewhere will be from current employees, current shareholders or current customers. There is good evidence emerging that employees are picking up a good share of that cost through lower earnings. At least part of the slowdown in earnings growth, which started well before the recession hit, can be put down to spiralling DB pension liabilities and the burden on employers of covering them.
Not only are younger workers not benefiting from generous DB pension provision — nearly all schemes are closed to new members — but they are paying the benefits of pensioners and older workers. This should always stand alongside the housing market and state pension policy when considering issues of intergenerational equity.
We are where we are through a combination of over-generous promises, over-prescriptive regulation, over-optimistic assumptions about returns and poor longevity forecasting. Whatever led us here though, what is perhaps most extraordinary is that while the scale of this issue has been increasingly clear for many years, the response has been negligible.
We need to start asking ourselves some very deep questions about these schemes: certainly about how to value their liabilities, but also about whether the current generation of workers should really be asked to bear the costs of copper-bottomed guarantees to a level of pension benefits they can never aspire to. That’s why I was delighted recently to be asked to join a new task force set up by the Pensions and Lifetime Savings Association (what was the National Association of Pensions Funds) to examine just these issues.
This article was first published by The Times and is reproduced here with permission.