A rosier view for pensions.


I’ve promised the guys (and it’s almost exclusively men) who’ve been involved in a week long debate on twitter, this article. I  have asked been asked for positive arguments for measuring pension liabilities against the cost of meeting them (rather than their present value).

I’m happy to do that , but not “peer-reviewed”, these thoughts are mine and mine only!

To meet this request would mean that I take the conversation away from ordinary people who are interested in this subject because it effects their retirements. Academics – whether economists or actuaries – need to understand how their ideas play with non-academics. Beside which I have two boat loads of people looking to have me skipper Lady Lucy on the Thames this weekend!

Proof of the pudding – we still have 6000 private DB plans

The proof of the value of the system of pension valuations that prevailed before the arrival of financial economics is still visible in the PPF 6000, there are 6000 private pension schemes in the UK that provide or will pensions to millions of people promised a wage for life. Some of the benefits will be paid from the PPF at lower rates than promised, but the vast majority will be paid in full.

The system that is in place, exists because it was relatively easy between 1960 and 2000 to set up a defined benefit plan for staff. If the liabilities of those schemes had been valued at mark to market from day one, it is extremely unlikely that any but a handful of those schemes would have ever been set up.

These schemes have collectively been called “Britain’s economic miracle” by Frank Field and their existence sets the standard of pension provision in the UK. We may moan about the dumbing down of pensions in the last fifteen years, but that is because we started from a very good place.

The proof of the value of using the system of smoothing future returns which made pensions affordable to employers, is all around us.

Where investment is not stymied, schemes prosper

The last ten years have been characterised in terms of the market, by consistent real returns for equities. The assets of schemes that have continued to invest for the future have prospered. As my recent report on the First Actuarial Best Estimates Index (FABI), shows,  British DB pensions are doing very well thank you, and its the ones that have continued to invest for growth that are in best shape.

Of course there will be market crashes in years to come and growth orientated schemes will not be immune from their impact, but we believe that over time schemes prosper from being invested in real assets.

It is also easy to see the social benefits of pension schemes investing long-term capital in infrastructure, in companies and in commercial property.

Where schemes have a long term strategy, people stay with them

We’ve found that transfers from our schemes are much lower than from schemes that adopt a mark to market approach and set about de-risking. This- in financial terms – is because transfer values are lower (the discount rates being higher). But I think it’s more than that. Where a scheme is properly promoted to its staff as wanting to pay pensions (rather than striving to be bought out by an insurer), members are reluctant to leave it.

There are exceptions (BSPS being the obvious one); but by and large where employers express a confidence in their ability and wish to retain the pension scheme, members are more likely to stay in the scheme.


Schemes which have an open strategy are more affordable to employers.

The more a scheme moves to de-risk , the more expensive the scheme becomes in terms of cash flow.  An obvious example is Royal Mail’s recently closed DB Scheme who’s funding rate – had it been kept open would have been more than 50% of payroll.

We can see how the cost of USS has rocketed as it moves towards a more conservative asset allocation. The ongoing cost of USS is estimated to be 38% of payroll. I’m grateful to this insight from Mike Otsuka correcting my original statement that the ongoing cost of USS would be 41% of payroll.

” You’re right that this is on account of movement “towards a more conservative asset allocation” — namely a 20 year shift towards bonds, which will result in expected returns on the portfolio being almost 1.5% lower in 20 year’s time than if they held onto their current growth-asset-weighted portfolio. Without the shift towards bonds, the contribution rate would be about 28% of payroll.”

These costs are based on the low discount rates caused by using gilts + valuation methodologies. Schemes which employ a discount rate that reflects the expected returns of the assets invested in use higher discount rates and don’t have to pay so much.

This may sound like munchkin economics to those in financial economics, but cash flow matters to small and medium sized businesses and it matters to members.

Simply driving up the cash contributions on DB schemes is not necessarily good. In extreme cases it can force employers into insolvency and schemes into the PPF. The Pensions Regulator has statutory duties to both employers and the PPF to stop this happening.  We argue that by staying open and adopting a long-term strategy to scheme funding, the risk of ruin is reduced leaving employers to invest in more than pensions!

The opportunity to keep pension promises still exists and it is evolving.

We have in the past months , seen the revival of interest in new open collective pension schemes. Not of the guaranteed variety – we now call DB – but of the non-guaranteed variety we call CDC.

The impact of closing DB has been to drive people into individual DC schemes which only offer an annuity for those who want to draw a “wage for life”. We think that most people, when they think of a DC pension pot, still want it to provide them with a wage that lasts as long as they do.

By adopting the principles that underpinned the original conception of DB all those years ago, we believe that we can offer many people who have DC pots , but problems spending them, a wage for life solution. Whether this be an employer sponsored scheme like that proposed for Royal Mail or a general purpose scheme (perhaps run by a master trust), the old methods of running pensions as open collective and pooled investment schemes, looks like returning.

So the old way of doing things may have a future as well as a past!

In summary

I could have written this piece another way, pointing to the ruination of our defined benefit schemes by the over-zealous adoption of the principles of financial economics.

Alternatively, I could have made arguments based on economic theory.

There are others much better placed to argue the economics. I’m arguing from what I see going on around me at First Actuarial, in the Friends of CDC and in my conversations with Government.

I am confident that “pensions” can break free from the pernicious embrace of financial economics and that we can return to a world where a “pension” meant a wage for life and not a pot of money.

For this to happen, we need to champion the advantages of open collective pensions and put to one side the argument that pension schemes cannot take “risk”.

We all live with risk in everything we do, it is by identifying the good risks which we should take, that we get stuff out of life. There are many bad risks which we should avoid, some of which I’ve talked about in this article.

But overall, the future for pensions looks bright and lets hope they look brighter still when we move back to being positive about their future.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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6 Responses to A rosier view for pensions.

  1. Re “The ongoing cost of USS is estimated to be 41% of payroll.”

    That should be 37%. You’re right that this is on account of movement “towards a more conservative asset allocation” — namely a 20 year shift towards bonds, which will result in expected returns on the portfolio being almost 1.5% lower in 20 year’s time than if they held onto their current growth-asset-weighted portfolio. Without the shift towards bonds, the contribution rate would be about 28% of payroll.

  2. Stuart Fowler says:

    ‘I am confident that “pensions” can break free from the pernicious embrace of financial economics and that we can return to a world where a “pension” meant a wage for life and not a pot of money.’

    I think you’re conflating a number of different pension-related issues Henry. When the new theory of DB schemes emerged in the 90s it was a reaction to the uncertainty of value of the ‘pot’ or fund and an interpretation of wage for life that was legally closer to contractual pay than an aspiration. The direction of travel did not depend on company finance theory. We could have got to the same outcome of hedging liabilities simply as a consequence of both a tougher replacement regime for MFR and international accounting standards.

    What finance theory does usefully add is the logic that made a distinction between a sponsoring company balance sheet on the one hand and both its shareholders and its pension scheme members. It therefore did not seek to impose a universal investment approach or imply nobody should engage in the harvesting of risk premiums. What was right for the company members or for scheme members was not necessarily right for the company.

    This is an important insight for your thinking about transfers. The theory makes it entirely logical that the risk should be transferred to those scheme members better able and willing to bear it. The only stipulation is that the terms are fair for those choosing to remain.

    The idea that members choosing to transfer from derisked schemes are motivated to any extent by some form of weakening of the scheme is both speculative and counter intuitive. The logic of company finance makes this plain. It is because of the difference in risk tolerance that has crystallised between the sponsor and members. This is the only insight you need to understand why transfers are occurring, are inevitable and (properly managed) improve individual welfare.

  3. henry tapper says:

    The phrase “The theory makes it entirely logical that the risk should be transferred to those scheme members better able and willing to bear it” – evinces a hollow laugh.

    • Yes, this is perhaps somewhat arresting, Henry. But what might the objections to such an attitude be? Do we believe it’s unlikely, or even self-evident, that there are no individuals who happens to members of a pension scheme who, given a sum of money calculated to provide a risk free income for life, would entirely rationally take the same sum and take risk with it? Obviously they wouldn’t if the sum in question was calculated based on the same risk approach, because the risk-return trade-off per pound invested would then be identical (except for costs and longevity cover). But if the sum was the ‘extravagant’ amount that either the scheme or the member would have to come up with to invest entirely in hedging assets then the trade off is different. This is what I think you may be overlooking in your comments on pension transfers.

      What’s changed is the utility definition of the scheme (loosely: how you define and measure success and how you make trade offs). It has changed because international accounting rules changed (and I would argue that would have happened without any overlay of corporate finance theories and indeed did so in other countries) so that avoiding an accounting mismatch (even if it is only a convention) became more important than the traditional trade off made between path variance and the range of probable outcomes at the point the money is consumed. Private individuals, nor being affected by accounting consequences, are free to think about risk in exactly the same terms as sponsors used to (and which you clearly favour). For me that has always been the penny-drop moment. But the difference in the way utility is defined, and success measured, is not alone a condition to justify transfers. It also requires the sum transferred to be as great as the same a private individual would need to avoid all risk and this is what the CETV rules ensure whenever a scheme has already derisked. Hence my firm’s preference in the past for outsourcing transfer advice: it rarely increased utility and then only for non-investment reasons, so it wasn’t worth it – even though we had that as a permitted business.

      This perspective on transfers makes it a kind of arbitrage opportunity created when market participants show different utility functions. But it is either a matter of contextual differences (e.g. steel workers versus bank employees) or random whether many or few, if presented with a certain amount, would in fact trade it for an uncertain amount based on the distribution of the latter relative to the former.

      The MPT acronym you pretended (?) on Twitter not to recognise refers inter alia to the choices portfolio investors make every day between accepting a bet and paying the price of avoiding the bet (i.e. between risky and risk free, or return-seeking and hedged). A transfer is only a logical extension of this practical exercise. Indeed the FCA rules make it explicit (although the probability distribution is not itself entirely prescribed – return models, including stochastic models, can within limits compete). The new rules even recognise that it would not be enough to identify a difference in the asset allocation of the scheme and that of the member’s own capital (assuming any is at risk in markets), because the outcomes or utility could in theory be increased by retaining the former and adjusting the riskiness of the latter. How logical and complete is that!

      Financial economics can also be seen to provide a conceptual justification for transfers, as I pointed out in my comment above (without need of a theory), by validating (without the need of a particular accounting convention) the distinction between the utility of the sponsor (particular if a company with shareholders) and the utility of its shareholders or its pension scheme members – both being individuals not corporates.

      So why a ‘hollow laugh’? Is it the logical argument itself we should reject? Is it the assumption that there will be individuals who will knowingly and rationally prefer to make the trade off themselves that companies used to make? Is it, in other words, because most members as unwilling or unsuited to such freedom? Alternatively, we might feel the vulnerabilities of some members should outweigh the freedom given to all. These are perfectly respectable and defensible points of view (indeed that are the vital focus of regulators and public policy makers) but we ought to be able to see them for what they represent: a view of human nature, not of finance. Our resistance to the logic may say more about us than about the logic!

      • Excuse my Trumpian double negative, Henry: the question is whether we believe there are no individuals who would rartionally take the bet.

  4. henry tapper says:

    I don’t understand a lot of this Stuart, but get the gist. i don’t think we need financial economics so much as common sense, international accounting standards have corroded the core of UK pensions, our DB system, to the point where it is in terminal decline. We have no replacement – unless CDC becomes common. People are driven towards DC pots and these seem attractive right now, but we are giving people minimal help in managing their pots and there are too few financial advisers to go round.

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