What Futures for Pensions? A finance perspective

1. What Futures for Pensions?A finance perspective Ken Peasnell

2. Implications of resource constraints for actuaries • The Jones, Allen and Silver report is a timely input into one of the defining issues of our age. • I am going to accept, at least for argument’s sake, the macroeconomic implications of their modelling results. • I am going to focus instead on the risks facing private sector pension schemes. • Arguably, the risks will be greater for future retirees with the proposals in last week’s budget.

3. Private sector pension schemes • Pension schemes fall into 2 main categories: • Defined-benefit (final or average salary) pensions • Defined contribution (money purchase) pensions • Pension risks: • Longevity risk - uncertainty about life expectancy • Interest rate risk – uncertainty about future interest rates and hence of the value of future pensions • Inflation risk – uncertainty about future salaries • Investment return risk – uncertainty about how much needs to be invested. • Scheme default risk • DB schemes – employer bears 1st 4 risks; the 5th is borne employee and/or pension guarantor • DC schemes - employees bear all the risks except default

4. DB pension risks • How pension schemes work: • DC schemes – firm transfers promised cash to scheme • DB schemes – firm makes a pension promise backed up by transferring cash to scheme; but it is still liable for any deficit • The risks faced by employers are not trivial: • Barclays pension deficit increased 555% from £0.2bn to £1.2bn in 2012, mainly due to falls in corporate bond yields • FTSE 100 companies are on the hook for £0.5 trn in pension liabilities, even though most have now closed their DB plans • In the past, employees faced risks too: • Employment risk – dealt with by preserving benefits of early leavers and “portability” and introduction of indexation • Default risk – minimum funding and pension protection

5. DB pension risks • Question: If DB schemes are so risky, why were they once so common? • DB schemes have positive cash flow in their early years • Had features akin to a Ponzi scheme • Viewed as a specialist topic best left to the actuarial profession • Very different to now – many schemes are closed (so corporate payments are not made for current employee services but rather for past services) • When lay-offs took place during the Thatcher years, many firms had over-funded DB schemes and took “contribution holidays” – something they could not do with their DC schemes • Hidden from view - but not now • Liabilities, scheme assets and actuarial assumptions reported to investors – very little is now hidden from view

6. A simple example • A DB pension is currently very valuable: • A is 64-year-old employee with no dependents who is retiring next year with an inflation-protected DB pension starting at £15,000 para. • This is not going to lead to a luxurious retirement. Added to the basic state pension, A will have a future income substantially less than the median wage. • How much is the pension worth? • Currently quoted annuity rates indicate that an inflation-protected pension for A would cost about £470,000. Factored into that price will be the provider’s estimate of A’s life expectancy, current and future interest rates, and investment returns.

7. So how might the resource constraint risks identified in the report play out? • DC pensions: the employee gets cash salary plus money paid into a pension fund • A DC is simply a form of compulsory saving, to be weighed alongside other savings • Evidence suggests people tend to under-save • Risks: their DC assets might not grow enough (investment return risk) and they might live too long (longevity risk) • DB pensions: the employee gets cash salary plus a promise of a future “salary” • Deals with the under-saving problem • Risks will have to be addressed by employers (they have contractual obligations) & the pension protection scheme • They will be reflected in cash flow pressure on firms.

8. How and when will resource constraints affect pension calculations? • The risk that has received most attention is longevity risk • likely to be little affected by resource constraints? • Inflation risk is essentially an issue of political economy • Hard to say how it will be affected by resource constraints. • Interest rate risk and investment return risks • Resource constraints could have massive effects • But predicting how this will happen is very difficult • Shortages stimulate innovation • It might affect the propensity to borrow and save • Risk premia likely to increase

9. Impact on pension schemes • Employer DC schemes • The contribution rate is determined by the labour market • Pension managers therefore focus on balancing risks and returns • Resource constraints will affect these decisions through their impact on yields on equities, bonds and other investment asset classes • Are markets myopic? Probably less than are people, governments and organisations in general • But it is hard to bet against an over-optimistic market • All the risks of inadequate future retirement income levels are borne by the employees • DC pensions are not a promise of future retirement income but rather a tax-efficient savings vehicle (something now made explicit by Osborne) • AS DC pensions are becoming the norm, the real target for this report has to be in the political arena

10. Impact on pension schemes • Employer DB schemes • In the business world, DB schemes are now largely viewed as “legacy” commitments • But the legacy can be very large: General Motors has been described as being a hedge fund that makes cars on the side! • This sets a cap on the risks resource constraints pose via DB pensions • Resource constraints pose challenges (and opportunities) for all aspects of a firm’s business – not just its pension liabilities • How might quasi-public sector organisations like universities respond? • On the “plus” side, they are likely to be around long enough to honour their pension liabilities • They are probably better placed than employees to carry the risks – which is not necessarily the case with most businesses

11. Impact on pension schemes • Employer DB schemes • The essence of the problem for “continuing” DB schemes: • With a DC scheme it is obvious what the organisation is paying its employees (e.g. salary plus x% pension contribution) • With a DB scheme it is not obvious – how much is the extra 1/80th of DB pension entitlement you got this year worth? • The answer depends on interest rates and longevity estimates. • The answer will have to revised each year. • It therefore makes more sense to focus not on the size of any pension deficit, but rather to view DB pensions as they really are: • DB pensions are akin to the employer’s own debts • the fund’s assets are simply advance payments on those liabilities • What should a firm do that wants to get rid of the risk? • It should get the fund to invest in a portfolio of assets that hedge the liabilities, i.e. increase and decrease in step with the liabilities • Difficult to do in practice.

12. Conclusion • Resource constraints pose major challenges for our economy and society. • But the real problem facing occupational pension arrangements in the UK is that the switch from DB to DC is that it is resulting in reduced provision for future pensions • Employers and employees know the contribution made, but employees don’t know the income it is likely to produce • So uncertainties about future DC investment returns caused by future resource constraints could have a big impact on pensioner welfare. • Resource constraints pose risks for employers offering DB pensions, but these are really about the timing of cash flow demands.