The debate at the CSFI mid week between Norma Cohen and John Ralfe on one side and Jon Spain and Dennis Leech on the other – seems to have focussed on the economics of pensions. I’d like to widen that debate to look at the social and moral impact of the changes to pensions in the past 20 years.
Firstly a statement of Norma Cohen and John Ralfe’s position. They argue that pension liabilities cannot be accounted for by using a discount rate based on “hoped for” returns . They should be marked to the risk free market return on market instruments able to secure the liabilities – AAA bonds.
Secondly the argument of Dennis and John which is that meeting liabilities and accounting for them are different things and that the investment strategy of a pension scheme should not be set by corporate accounting conventions but by what’s most efficient for the scheme itself. The Ralfe/Cohen paradigm sees pensions investing in low-risk matching assets – bonds, the Leech/Spain paradigm sees pensions investing in more volatile but ultimately higher returning equities.
I did not hear all the arguments, but I heard Norma’s – which was coherent if – to my mind- selective. She argued that the dilemma that DB pensions has got itself in has been of the actuaries making. The scheme actuaries in the latter decades of the 20th century ignored prudence and took cheap options to fund the scheme – typically over-relying on equity returns and offering sponsors the benefit of low or no contributions and distributing notional surpluses to members by way of perks such as high revaluations.
When the game of musical chairs ended it was because interest rates fell, equity growth hit a hiatus and the over-distribution of notional surpluses was exposed for what it was, reckless imprudence. So far , I have no issue with Norma Cohen.
But it’s what happened as a consequence that I take issue with. The moral and social consequence of mistakes in scheme funding should have been a proper debate on how to fund our DB plans and a recognition that many of the grants that had been made, needed to be retracted. Instead of looking again at the benefits and the guarantees on those benefits, the decision was taken to pass the buck to the employer. It was the employer who was forced to take the guarantees onto its balance sheet and the employer who was forced to meet the deficit repayments for the funding shortfalls that emerged from a mark to market approach to valuing liabilities.
The rest is (more recent) history. The impact on balance sheets rendered corporates incapable of operating freely in the capital markets and the impact on the profit and loss account caused cash flow problems for some employers – even leading in a few cases to insolvency. As a result, most corporates put pressure on trustees and the DB pensions were first closed to new entrants and then to future accrual. The drawbridge was pulled up on future service so that past service could be secured.
I see the acquiescence of advisers – especially the actuarial profession – to these closures as a failure of nerve. Closing good quality defined benefit schemes was the nuclear option and it was forced upon many companies without other options being explored.
There were three ways to have averted these closures which were missed.
- Legislation could have been passed to allow CDC schemes to take over the accrual of benefits limiting liabilities to companies to the contribution. This was firmly knocked on the head by the GAD report of 2009 which kicked CDC into the long-grass for a decade.
- Schemes could and should have reacted to the challenge of a mark to market approach by pulling in their horns and withdrawing some of the benefit promises and moving to more appropriate designs. Typically final salary schemes could have moved to a career average basis, voluntary cuts in indexation could have been negotiated and the hideously expensive early retirement options could have been withdrawn much quicker. It’s fair to say that trustees got little guidance on this from actuaries and little pressure from any regulator, what happened was too little too late.
- The actuarial profession should have taken the abolition of the MFR as an opportunity to keep collective schemes open. Instead it acquiesced to the new funding regime and turned its attention to the extinction of the 7000 or so schemes that it had helped established and had nurtured over the previous sixty years. The calamity of scheme closures is now clear. Millions of people have been moved from highly efficient DB plans that paid a wage in retirement to inefficient and hard to use DC plans which pay a capital sum.
The social and moral consequences
I shouldn’t paint an overly rosy picture of DB schemes in the last century. They were often massively unfair in their design, penalising low-earners by inflicting on them “offsets” relating to state benefits, giving nothing but a return of contributions to those who left within 5 (changed to 2) years of joining and excluding large parts of the workforce who weren’t deemed worth a pension. Socially and morally defined benefit schemes were often far from perfect.
But they were infinitely better than DC plans. They invested more efficiently, they were managed more efficiently and they were not subject to the costs of intermediation attending on retail products. All this is reflected now in the massive transfer values available to people who have DB benefits but have been taught to think of retirement in terms of “wealth” not income.
There being currently no efficient way to turn wealth into income, the further ruination of DB schemes by the taking of over £36bn in transfers last year, is a second body blow to the pension fabric built up in the past century. Not only has future accrual ceased, but past accrual is flying out of the window into wealth management schemes designed by the rich for the rich and totally inappropriate for the needs of those for whom a pension meant a wage for life.
Where I take issue with Norma Cohen and John Ralfe is not in their analysis of the problem created by lax accounting in the 20th century, but in their failure to put forward a 21st century alternative. To take away the defined benefit accrual and put nothing in its place than individual DC is socially and morally irresponsible.
The social and moral consequence of a move to mark to market accounting was that schemes closed to future accrual and to buy-out -with sky high transfer values resulting from a shift in scheme assets to nil-risk matching bonds. This has deprived a good part of the UK workforce who are and will be approaching retirement in the next 20 years of proper pensions.
Nothing has been done to replace DB with another form of open collective scheme and actuaries and economists have fought against innovation , preferring to keep benefits at a high water line rather than admit mistakes had been made. This is a different but no less heinous example of social and moral irresponsibility.
Government has been led by those who have shouted loudest and these have been those on the side of corporate finance. Whether left right or centre, Government has failed to avert the social consequences of the closure of defined benefit schemes and support any of the three remedies mentioned above. Instead it has been left to the unions and a few outstanding actuaries, to reassert the importance of open collective pension schemes in the private sector.
Thankfully, we have deep thinkers – Norma Cohen among them – who also have a social conscience and a moral compass. I hope that those thinkers will continue to wake from their slumbers and rise up against the lunacy of requiring wealth management to manage the pitiful DC pots that most people will have to eke out a long and financially impecunious retirement.