Extreme investment caution is killing off final salary pensions, believes Adrian Boulding – and, within that, there is a stark message too for the defined contribution saver.
Adrian is a long time friend of this blog and I’m pleased he’s happy for this fine piece to be published here (thanks to Dunstan Thomas and Retirement Planner too)
The strange and bizarre world of final salary pensions continues to throw up surprises. Open a newspaper at the City pages and you would think the schemes were in real trouble.
Talk of deficits abound. The government has consulted on a Green Paper that asked questions about the affordability of pension promises already made, while defined benefit (DB) workplace scheme closures continue to grab headlines. Just recently, while reporting their half-year company results, another great British engineering company, GKN, announced its final salary scheme was closing to future accrual.
Yet turn to the personal finance pages in the very same paper and you can find quite a different story. People are being offered very high transfer values to give up their DB pensions. It is regular to hear of transfer quotes of 40 times the pension being foregone, and recently I was shown one of 45 times.
Now, clients actually getting their hands on all that lovely lucre may currently be difficult – but the paralysis in the transfer market is caused by regulatory fear and that is a topic for a different column.
For now, let’s keep our eyes firmly focused on the final salary schemes and ask whether quantitative easing, or QE for short, really is the cause of the problem. Many will argue it is, and point to the very low returns available on gilts today. And it is certainly true these rates are lower than was foreseen when companies set up their final salary pensions a generation ago.
Around 30 years has passed since a formative day in my own actuarial training, when I asked questions about how the insurer that employed me was pricing its guaranteed annuity options and was told by a most eminent actuary: “Adrian, gilts will never go below 5%.” Today a 15-year fixed interest gilt offers 1.75% a year and the index-linked version a real return of 1.5% a year below inflation.
The mathematics is clear – if the pension has increases that are inflation-linked, or fixed increases of 2% or more, both of which are fairly common for DB, then gilts just do not keep up with the payments! Hence the reason surprised members are being offered a transfer value that is rather greater than their first year’s pension multiplied by their life expectancy.
And this is why so little of my own SIPP is invested in gilts. Or in a bank or building society account where, according to the Bank of England, most providers pay less than 1% and the average is just 0.15% a year. There are so many more exciting investment opportunities out there – as a quick glance at any financial magazine or website will show you – and yet final salary trustees, having taken professional investment advice, so often plump for the low-return options.
Again, we have to be careful not to confuse surface noise with the root cause. It is easy to attribute these ‘safe’ investments to the natural caution of trustees; or to The Pensions Regulator’s guidance the employer covenant needs to be carefully considered before trustees take any investment risks; or even accounting standards that encourage employers to seek liability-driven investment approaches to minimise year-on-year ‘shocks’ to the company balance sheet.
No longer friends
I have come to the conclusion the real cause is the pension fund is no longer part of the business – or even a friend of the business. It has become a rival, seeking to suck up as much resource as possible to bolster the security of the members’ pensions.
Three decades ago, when I gave actuarial advice to a portfolio of schemes, it was common to find the chief executive and finance director sat on the Trustee Board. They often viewed the pension scheme as an arm of the business, and we would discuss pace of funding alongside the firm’s other development priorities and cashflows.
To see how stark the difference has become, let’s look again at those GKN half-year results. The company is achieving a 15.8% annual return on capital employed, which is slightly down on last year’s figure of 16.6% a year.
Those sorts of returns are not particular to GKN – they are commonplace among FTSE 100 companies. No wonder shareholders are fed up with paying into final salary schemes then, when they see the funds invested by trustees earning so much less. Especially as the poor employer has been forced to take out and pay for an insurance policy too in the form of levies to the Pension Protection Fund that will pay benefits in the event of the employer’s insolvency.
There is a stark message in here for the defined contribution saver too. If you are too cautious in your investments, then achieving the sort of lifestyle you aspire to in retirement may well prove unaffordable.
Adrian Boulding is director of retirement strategy at Dunstan Thomas
For an opposite view – try this – the latest blog from Redington