Monday, November 22, 2010

Slashing UK Public Pensions?

The FT reports, Value of public pensions falls by quarter:
Reforms to public-sector pensions have already cut their value to the typical employee by 25 per cent, according to a study by the Pensions Policy Institute.

Further changes being considered by Lord Hutton, the former Labour cabinet minister, in his review of public-sector pensions could reduce the cost to the taxpayer by a third during the next 40 years.

That would come at the price, however, of making the schemes appreciably less generous, the institute said in a study funded by the Nuffield Foundation, which is to be published on Tuesday.

Under the most radical potential reform, the average earner would get just over 40 per cent of their pay in retirement, against a current replacement rate of 64 per cent.

“Changes that Labour and the coalition government have announced will already reduce the cost of public-sector pensions from 1.2 per cent of GDP [gross domestic product] today to 1 per cent by 2050, even if the government undertakes no further reform,” said Niki Cleal, the institute’s director.

A large part of the saving comes from the decision to increase the pensions in future using the consumer price index rather than the retail price index.

“That has a really quite radical effect, which I am not sure most people have fully understood,” said Ms Cleal. While the 0.2 per cent reduction in GDP might not sound much, in today’s money it is £3bn.

The changes already make public-sector pensions more affordable. That will lead some people to argue that there is no need to do more,” she said.

“But as Lord Hutton has said, there are arguments for making the present system fairer, both between the public and the private sectors – where public-sector pensions still remain more generous – and between staff within public-sector schemes.

“Under the current final salary arrangements, high fliers do much better than lower earners.”

The PPI has modelled a range of potential reforms. These include a switch to career average pensions, which Lord Hutton has said he favours, and other options he is considering such as providing a career average pension up to a specified salary cap, and then a form of unfunded direct contribution on top.

The PPI said the results depend on the assumptions used, but give a good guide to the potential impact of further reform.

And things are not much better at private pension plans. Insurance ERM reports, Pension deficits reduced but not the risk outlook:

While October was positive for FTSE 100 UK pension schemes, with the overall deficit reducing by £11.0bn to £43.5bn, it did little to improve the risk picture, according to the first issue of PF Risk Report.

The new publication from PensionsFirst, which provides advanced risk management and advisory services to the defined-benefit pensions industry, said that at the end of October, the one-month 95% value-at-risk figure on an IAS19 basis was £25.4bn.

This means that in November there was a 1-in-20 chance that the IAS19 deficit could increase by £25.4bn or more - and the expectation that in one of the next twenty months it will. "The corresponding VAR figure at September month-end was £26.6bn, so the improved deficit position changed little from a risk perspective," commented the report.

The PF Risk Report breaks down pension risk into its key components. On an uncorrelated basis, interest-rate risk is the largest risk factor, contributing £17.8bn to the VAR, closely followed by equity risk, which contributes £15.7bn. The report also focuses on inflation, FX, credit and property risk exposures, while ignoring longevity, which is a genuine long-term risk exposure but has negligible volatility in the short term.

The report illustrates the impact of the key factors that could cause variation in deficits. For example, a 20% decrease in equities would increase the aggregate deficit by £34.2bn and a 1% increase in long-term inflation would increase the deficit by £60.8bn. The two events combined would increase the deficit by almost £100bn.

"The simple fact is that many UK companies (not just those in the FTSE 100) have significant unhedged exposure to financial market volatility through their pensions schemes", the report stated.

The report puts into context the expectation that the monthly accounting deficits of the FTSE 100's UK pension schemes will move by £25.4bn at least once in a two-year period by underlining the fact that in August 2010 the accounting deficits increased by £20.8bn, driven primarily by a 60bp fall in interest rates. "And it is important to note that while...such large monthly movements can be reasonably anticipated, there is also the potential for much more extreme outcomes," the PF Risk Report concluded.

It's not just UK companies that have significant unhedged exposure to financial market volatility through their pensions schemes. The problem is widespread and as the report concludes, there is also potential for much more extreme outcomes.

Finally, take the time to listen to this CBC interview with three experts discussing CPP reforms. Pensions are a big issue everywhere right now, including here in Canada. The discussion highlights important issues and is well worth listening to.

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