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!
That will be a start, but please tell us the foundations of the non-FE approach, or at least point us to works that do, preferably peer-reviewed by respected actuaries and economists.
— John Kiff (@Kiffmeister) July 27, 2018
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.