Inside investment: We need to talk about pensions

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By:
Andrew Capon
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If you want to kill the conversation at a dinner party, one sure-fire winner is pensions, but it is the $25.2 trillion in pension assets that fuel global capital markets and there needs to be some serious thinking on how they will work in the future.

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There were very few LOL moments in 2016. So, thank goodness for Philip Green.

Watching the copper-toned tax dodger squirm in front of the joint business and work & pensions committee in June almost merited a full ROFL. He was so far out of his depth that a superyacht speeding up the Thames from Monaco with a cadre of crack ex-special forces mercenaries on board would have struggled to rescue him.

On reflection, though, this is no laughing matter: certainly, not for those in the BHS pension scheme who worked loyally for years only to see a £571 million deficit develop through the toxic combination of cupidity and stupidity. Sadly, for other members of UK defined benefit (DB) pension schemes, the parlous situation at BHS is far from being exceptional.

In July 2007, the Pension Protection Fund (PPF), the UK’s lifeboat for ailing DB schemes, first published its 7800 index. It measures the broad health of the sector.

Today the 5800 Index would be a better name. That, approximately, is how many are left. Among those schemes the PPF says a further 600 are unlikely to “ever” meet their obligations. A further 1,000 are subject to “unmanageable stresses”.

The same pattern is repeated in the US. In 2015, 118 of Fortune 500 companies offered a DB pension scheme to new employees, down from more than 60% just 15 years earlier. In their stead employers on both sides of Atlantic have offered defined contribution (DC) plans.

Road to perdition

The oft-cited explanation for the demise of DB is that the plan sponsors did not understand the risks they were taking when they set up DB schemes, particularly the welter burden of greater longevity.

However, another perhaps equally important influence in the UK, Netherlands and elsewhere has been accounting standards and regulation.

Though they differ in nuance, many regulators have adopted a similar standard which mandate that pension funds need to put a present value on their future liabilities by applying a market discount rate, typically an inflation-linked government bond. The gap between those assets and liabilities is the deficit.

As yields fall, liabilities rise in a mechanistic fashion. This hit the headlines in the summer after the Brexit vote. As gilt yields fell, the aggregate deficit of UK DB schemes shot up from £295 billion ($369 billion) at the end of May to £384 billion ($480 billion) at the end of June. After the Bank of England cut rates in August that deficit ballooned to £459 billion ($574 billion). It was enough to give even the most sanguine of finance directors palpitations.

It is also largely meaningless. The true financial position of pension funds depends on asset market returns and inflation over multi-decade time horizons.

The PPF calculations are also based on iffy data. The figures are derived from the triennial actuarial valuation of schemes, which it then takes the PPF nine months to interpolate into its aggregate reading, return assumptions and what in polite circles are known as heuristics and are more commonly thought of as rules of thumb.

Sadly, these meaningless statistics and wrongheaded regulations are dictating investment behaviour, hence the headlong rush into de-risking. This, as the recent sell-off in bond markets demonstrates, might have involved buying extremely expensive assets, such as gilts, linkers or swaps, at precisely the wrong time. No wonder sponsors are giving up on DB.

Next misselling scandal

They have shifted the burden of risk from their balance sheets via DC pensions. The onus is on the employee to both take the risk and investment decisions. Joe Sixpack and the man on the Clapham omnibus, who voted for Trump and Brexit respectively, must assume the mantle of asset allocation experts in the DC world.

As an academic will tell you, asset allocation is by far the most important driver of investment returns and it is being left to the least qualified. That is absurd.

There is advice on offer, but that does not mean it is comprehensible or that plan members will bother listening.

However, the real pachyderm in the DC pensions room is fees. As well as frequently high management charges, there are often fees on the way in, fees on the way out, fees for switching – fees, layered on fees, on fees. Big DB schemes have buying power. The little man does not and is all too often getting ripped off.

Last year, employees of Delta Air Lines and a few other notable US companies began class action suits regarding their 401(k) plans. My prediction is that this is just the tip of the iceberg. DC is a huge misselling scandal waiting to happen. The fund managers will have collected their fees so they won’t especially care. It will be the plan sponsor that has to pick up the pieces.

They might stoically conclude risk comes in myriad forms. Getting rid of DB might have solved one problem, only to spawn an even bigger one.

On both sides of the Atlantic, pensions systems are in a mess. A hybrid approach to risk sharing is essential. This might not make for compelling dinner-party conversation, but should be high up the policy agenda.

Andrew Capon has worked as an analyst, strategist, communications specialist, financial journalist and author for more than 20 years. He has won multiple awards for commentary on markets, investment and asset management.