Addressing The UK's Pension Crisis?
Britain's mammoth funding gap for gold-plated company pensions stands at nearly a third of the country's economic output despite a £50 billion boost in November.When I warn my readers that the ongoing global pension crisis is deflationary, this is exactly what I am alluding to. Not only is the shift from DB to DC pensions going to cause widespread pension poverty as it shifts retirement risk entirely on to employees, but persistent and chronic public and private pension deficits are diverting resources away from growing and hiring people which effectively exacerbates chronic unemployment which is itself very deflationary (limits aggregate demand).
A report by PricewaterhouseCoopers shows the deficit for so-called defined benefit pensions - such as final salary schemes, which guarantee an income in retirement - narrowed by £50 billion to £580 billion last month.
This marks the third month in a row that the funding gap has improved after hitting a record high of £710 billion in August.
But the pensions black hole is still £110 billion higher than it was at the start of the year and is equivalent to almost a third of the UK's entire gross domestic product (GDP).
PwC's Skyval Index gives a snapshot of the health of the UK's 6,000 defined benefit pension funds.
It reveals the battering that pension schemes have taken since the Brexit vote, with rock-bottom interest rates taking their toll after the Bank of England halved its base rate to 0.25% in August.
BT recently revealed its pension deficit surged to £9.5 billion at the end of September from £6.2 billion three months earlier.
Barclays has also seen its pension fund slip into the red by £1.1 billion from a surplus of £800 million last December, while Debenhams likewise suffered a reversal to a £4.1 million deficit in September against a surplus of £26.2 million in August last year.
Firms have blamed a sharp reduction in bond yields, which increases the pension liabilities, as a result of the Bank's economy-boosting action after the EU referendum vote.
This peaked in August, when the pension deficit shot up by £100 billion, with bond yields since having recovered a little.
Businesses are now under pressure to pump cash into their company schemes to address the shortfalls, especially after BHS's £571 million pension deficit contributed to its high profile collapse in April.
But Raj Mody, partner at PwC and global head of pensions, said companies should have realistic funding plans in place over longer timescales - up to 20 years rather than the nine or 10 year average.
He said: "Pension funding deficits are nearly a third of UK GDP. Trying to repair that in, say, 10 years could cause undue strain, akin to about 3% per year of potential GDP growth being redirected to put cash into pension funds.
"This would be like the UK economy running to stand still to remedy the pension deficit situation."
And while some think President-elect Trump and his new powerhouse economic cabinet members are going to trump the bond market and bond yields are going to rise sharply over the next four years, relieving pressure on pensions and savers, I remain highly skeptical that policymakers have conquered global deflation and would take Denmark's dire pension warning very seriously.
How are British policymakers responding to their pension crisis? Last month, I discussed the UK's draconian pension reforms, stating they would make the problem a lot bigger down the road.
This week, former pensions minister Steve Webb says the government is considering raising pension age sooner than previously planned, a proposal which has sparked outrage among citizens calling it a "huge tax increase".
In her comment to the Guardian, pension expert Ros Altmann writes, There are fairer ways to set the pension age – but politicians are ducking them:
Younger generations are being told to prepare to wait even longer for their pensions, with former minister Steve Webb suggesting that the retirement age for a state pension will rise to 70.In her insightful comment, Ros Altmann shows why raising the pension age, while politically expedient, can be detrimental and devastating to certain socioeconomic cohorts, including people suffering from an illness and many women relying on their state pension to survive in their golden years.
I can understand why some policymakers seeking to cut the costs of state support for pensioners are attracted to the idea of continually raising pension ages, but I believe this is potentially damaging to certain social groups.
The justification for such an increase is based on forecasts of rising average life expectancy. But just using average life expectancy as a yardstick ignores significant differences in longevity across British society. For example, people living in less affluent areas, or who had lower paid or more physically demanding careers, or started work straight from school, have a higher probability of dying younger. Continually increasing state pension ages, and making such workers wait longer for pension payments to start, prolongs significant social disadvantage.
The state pension qualification criteria depend on national insurance contributions. Normally, workers and their employers make contributions that can amount to around 25% of their earnings. Even now, a significant minority of the population does not live to state pension age, or dies very soon thereafter, despite having paid significant sums into the system. By raising the state pension age, based on rising average life expectancy, this social inequality is compounded.
Increasing the state pension age is a blunt instrument. A stark cutoff fails to recognise the needs of millions of people who will be physically unable to keep working to the age of 70, because of particular circumstances in their working life, their current health, or environmental and social factors that negatively impact on specific regions of the country.
State pension unfairness is even greater, because those who are healthy and wealthy enough can already get much larger state pensions than others who cannot afford to wait. If you can delay starting your state pension until 70 – assuming you either have a good private income or are able to keep working – the new state pension will pay over £200 a week. But if you are very ill, caring for relatives, or for whatever reason cannot keep working up to state pension age (now 65 for men and between 63 and 64 for women) you get nothing at all.
In fact, just reforming state pensions is not the best way to cope with an ageing population. It is important to rethink retirement too. Those who can and want to work longer could boost their own lifetime incomes and future pensions, and also the spending power of the economy and national output, if more were done to facilitate and encourage later life working. Having more older workers in the economy, especially given the demographics of the western world, is a win-win for all of us. Even a few years of part-time work, before full-time retirement, can benefit individuals and the economy. But this should not be achieved by forcing everyone to wait longer for a state pension and ignoring the needs of those groups who cannot do so.
There is no provision, for example, for an ill-health early state pension, or for people to start state pensions sooner at a reduced rate. Politicians have entirely ducked this question but such a system would acknowledge the differences across society. There are, surely, more creative and equitable ways of managing state pension costs for an increasingly ageing population, using parameters other than just the starting age.
Indeed, raising state pension ages has already caused huge hardship to many women born in the 1950s. These women believed their state pension would start at 60, but many discovered only recently they will need to wait until 66. Many women have no other later life income, therefore they are totally dependent on their state pension.
Rather than just considering increasing the pension age, the government could consider having a range of ages, instead of one stark chronological cutoff. Allowing people an early-access pension, possibly reflecting a longer working life or poorer health, could alleviate some of the unfairness inherent in the current system. Increasing the number of years required to qualify for full pensions could also help.
Raising the state pension age is rather a crude measure for managing old-age support in the 21st century.
There is a lot to think about in terms of pension policy not just in the UK, but here in Canada and across the world.
Also, remember how I keep telling you pension plans are about managing assets and liabilities. Clearly the backup in yields has helped many British and global pensions. Interest rates are the determining factor behind pension deficits. The lower yields go, the higher the pension deficits no matter how well assets perform because the duration of pension liabilities is a lot bigger than the duration of pension assets, so for any decrease or increase in the discount rate, pension liabilities will increase or decrease a lot faster than assets rise or decline.
In the UK, something happened earlier this year, a vote for Brexit which sent the British pound plummeting to multi decade lows relative to other currencies. Some think this is great for British exports and inflation expectations but I'm skeptical because a rise in exports and inflation expectations due to currency depreciation isn't sustainable and it's not the good type of inflation either (based on a rise in wages).
For UK pensions that fully hedged currency risk, they took a huge hit on their foreign bond, stock, real estate and other assets just on the devaluation of the British pound. So if interest rates didn't rise and instead declined, those pension deficits would have been far, far worse for these pensions.
Conversely, for UK pensions that didn't hedge currency risk, their foreign asset holdings rose as the pound took a beating. For these pensions, the gain in foreign assets would have dampened any losses on domestic assets and along with the rise in bond yields, helped their pension deficits.
And it's not just currency risk plaguing UK pensions. Cambridge Associates has come out with a new study which states many pension funds will struggle to close their funding gap unless they reduce their on public equities and other liquid assets:
Pension funds are too focused on holding liquid assets to the detriment of the long-term health of their investment portfolio, according to research by Cambridge Associates, the global provider of investment services. If they considered switching from liquid public equities to illiquid private investments, they could improve their chances of closing the funding gap and reduce the likelihood to requiring additional capital injections to honour their commitments to pension fund members.Obviously Cambridge Associates is talking up its business, after all, it is in the business of building customized portfolios for clients looking to allocate in alternative investments like private equity, real estate and hedge funds.
The average UK pension fund can have a staggering 90-95 per cent of their assets in liquid assets -- those easily convertible into cash. This amount is far more than they need in order to be able to pay pension fund members. "Many schemes do not need to set aside more than 5-10 per cent of assets for benefit payments in any given year for the next 20 years," according to Alex Koriath, head of Cambridge Associates' European pensions practice. "By having such liquid portfolios, they are giving up return opportunities and face having to deal with the risk of a widening funding gap."
Already, as of October 2016, the average UK pension scheme holds assets that cover just 77.5 per cent of their liabilities, according to data from the UK's Pension Protection Fund. Even though the value of "growth" assets -- such as equities -- has soared over the past 5 years, this funding gap has continued to widen because the dramatic fall in interest rates has increased the value of liabilities at an even faster rate.
For a typical scheme, some 40 per cent of the liquid assets is invested in "liability-matching" assets such as gilts, while around 60 per cent is held in growth assets such as equities, credit and other such asset classes. Of the 60 per cent, some 5-10 per cent is invested in illiquid assets such as real estate, private equity, private credit, venture capital and other less liquid investments.
But this allocation may need to change because many pension funds are facing difficult choices. As their member population ages, trustees understandably want to "de-risk" by buying more liability-matching assets and selling more volatile assets such as equities. However, de-risking also means that fewer assets can earn the higher return that is needed to plug the large funding gap. Even a pension scheme that hedges just 40 per cent of its liabilities faces a more than one third chance of seeing its funding level fall by 10 per cent at least once during the next 20 years. "In other words," said Mr Koriath, "the scheme could very well find itself needing a capital injection."
A New Solution: The "Barbell Approach"
To close the funding gap, Cambridge Associates proposes considering a "barbell approach". Here, trustees target substantially higher returns in a small part of the portfolio -- say, 20 per cent -- by focusing this portion on private investments. The rest of the portfolio -- as much as 80 per cent -- can then be focused on gilts and other liability-matching assets in order to reduce liability risk. Himanshu Chaturvedi, senior investment director at Cambridge Associates in London, said: "This approach to pension investing can deliver a hat-trick of benefits: plenty of liquidity, reduced volatility and appropriate rates of return to close the current funding gap."
The 80 per cent allocation to liability-matching assets should address the volatility and liquidity issues facing pension funds. The increased hedging reduces the risk of a slump in funding levels, while the large allocation to liquid assets should provide ample liquidity to pay benefits without needing any liquidity from the growth assets. According to Cambridge Associates, a representative scheme that is mature and closed to future accrual (say 70 per cent funded on a buyout basis with liabilities split 75 per cent/25 per cent between deferred members and pensioners) only has to make annual benefit payments of between 3 per cent to 7 per cent of assets in any given year for the next 10 years. Meanwhile, the 20 percent allocation to private investments should help address the return requirements of pension funds, allowing them to target higher return opportunities in return for accepting illiquidity in this small part of the overall portfolio.
Mr Chaturvedi said: "In our view, even a growth portfolio purely focused on public equities, typically the highest expected return option available in public markets, will not close the funding gap fast enough for most schemes." In the 10 years to September 2015, the MSCI World Index saw returns of 6.4 per cent. By contrast, the Cambridge Associates Private Equity and Venture Capital Index saw annualised returns of 13.4 per cent.
The Challenges of the Barbell Approach
In its analysis, Cambridge Associates found that there were two important requirements for successful implementation of the barbell approach. One is governance. As Mr Chaturvedi said: "A program of private investments takes years to put into place -- perhaps two cycles of trustees. So it can't be the passion of one group of trustees."
The other requirement is astute manager selection. "Finding high quality managers is not easy," said Mr Koriath. "At Cambridge Associates, we track more than 20,000 funds across all private investments and in any given year we only see about 200 that merit our clients' capital." But the benefits of getting it right in private investments are substantial. Over a 10-year time frame, the annual difference between the top and bottom quartile managers of public equities is about 2 per cent. By contrast, for private equity and venture capital managers, the annual difference is as large as 12-18 per cent.
But the recommendation for a "barbell approach" is sound and to be honest, even though most UK pensions are mature, I was surprised at how little illiquidity risk they are taking given they have a very long investment horizon and can afford to take on some illiquidity risk, especially since the average funded status of 77% is far from disastrous (I would be a lot more worried if Illinois Teachers' Retirement System or some other severely underfunded pensions were trying to close their funded gap by increasing their allocation to illiquid alternatives).
And Mr Chaturvedi is right, allocating more to illiquid alternatives will not work unless these UK pensions get the governance right and choose their partners wisely.
Lastly, one group that's not suffering from pension poverty in the UK is company directors. Carolyn Cohn of Reuters reports, Majority of UK pension funds say executive pay too high-survey:
Eighty-seven percent of UK pension funds say executives at UK listed companies are paid too much, a survey by the Pensions and Lifetime Savings Association said on Thursday, as Britain proposes changes to the way companies are run.What this article doesn't mention is that pension perks are increasingly a huge part of executive compensation in the UK, US and elsewhere. Corporate directors are padding the pensions of executives which are often based on their overall compensation, which is surging.
Britain began consultations on encouraging better corporate behaviour and curbing executive pay this week, part of Prime Minister Theresa May's campaign to help those who voted for Brexit in protest at "out of touch" elites.
"It's time companies got the message and started to reduce the size of the pay packages awarded to their top executives," said Luke Hildyard, policy lead for stewardship and corporate governance at the PLSA.
The number of shareholder revolts, defined as cases where more than 40 percent of shareholders voted against pay awards at FTSE 100 company annual meetings, rose to seven this year from two in 2015, the PLSA's analysis found.
The PLSA said it will publish guidelines encouraging pension funds to take a tougher line on the re-election of company directors responsible for setting company pay.
The average pay of bosses in Britain's FTSE 100 index rose more than 10 percent in 2015 to an average of 5.5 million pounds ($6.9 million), meaning CEOs now earn 140 times more than their employees on average, according to a survey by the High Pay Centre released in August.
The PLSA's members include more than 1,300 UK pensions schemes with 1 trillion pounds in assets.
And remember what I keep warning of, rising inequality is deflationary, so keep your eye on this trend too as it limits aggregate demand.
Below, a short Mirror clip on what is the new benefit cap and how it will affect UK citizens.
And former pensions minister Ros Altmann talked about changes to women's pension age - going upwards - to equalize with men back in February. Listen to her comments.
If you ask me, someone is getting the short end of the stick on these UK pension reforms and it isn't the corporate elites. I foresee a UK pension revolt in the not too distant future.