Pensions: unrealistic assumptions for tomorrow cause real pain today

Pensions are long-term obligations. Falling interest rates have affected both the way that companies calculate the size of these liabilities, but also the assumed growth rates of the assets that they hold in order to pay those pensions.

What is quite extraordinary in my view is that QE, which now runs into hundreds of billions of pounds (over £600bn and counting), has been directly responsible for putting pressure on pension schemes. The deficit on defined benefit schemes is now nearly £900bn. The irony is that QE acts in precisely the opposite way from what is intended when pension funds are trying to defend their liabilities. These very pension funds are being forced to buy, by both the regulators and their own advisers, bonds that, in my humble opinion, are overvalued. I don’t think the Bank of England has done us any great favours and would respectfully suggest that interest rates should be going up rather than down to help beleaguered savers and pension schemes.

Unsurprisingly, the impact of all this has not been positive. Hardly a day goes by without a new headline about the latest pension ‘black hole’ opening up.

Today’s workers need to be able to rely on the benefits that have been promised to them. However, I would question the reality the regulations are creating. There are few parts of life where we are asked to put up money years ahead of actually having to pay – and there’s a reason for this; it’s impractical in life, and unbelievably difficult to calculate. Imagine that on the day you start your first job you’re asked to put aside a lump sum to pay for all your likely costs in the next 40+ years. This would include money for food, clothing, transport, housing, holidays, etc. We would find it almost impossible to work out how much we need and the vast majority of us would (a) struggle to pay it; (b) ask why it would be necessary. As an individual it is better to pay for things as they fall due. I earn money to pay for my various outgoings as I progress through my career.

In the US, there is a growing trend towards using very long-term interest rates to calculate pension costs. In Germany, corporate pension liabilities are often unfunded – they take the approach that we’d take as individuals and pay as liabilities come due. In the UK by contrast companies offering defined benefit pensions must fund their liabilities upfront. This latter approach may seem sensible to some, but UK pension funds are not suddenly developing big deficits, they are showing big (and increasing) deficits because of the rules being used to account for them. This is very different from a company suddenly taking on twice as many pensioners as before, or, in a fraudulent situation, seeing all of their assets disappear.

Nevertheless, the risk is that the regulatory and accounting treatment of pension assets and liabilities affects real world behaviour – increasing levels of cash get diverted to pension funds because the pension accounting rules require the assumption that interest rates stay low forever. Yes, it’s important to make sure that there are assets to back obligations, but let’s not panic. In robust, growing companies every penny put into the pension fund is a penny not invested in the business. If companies were to treat the pension issue as truly long term then alongside pension contributions, management could reinvest its cash and grow the business. A bigger business would be able to support a pension deficit more robustly. A company could grow its way out of a pension deficit to the benefit of all pensioners, employees, shareholders and indeed the wider economy.

In the first note to British Telecom’s 2016 accounts it says: “BT has a commitment to pay pension benefits to over 310,000 people over a period of more than 70 years…” This says it all. The provision of a pension is a long-term liability. Pension accounting rules at the level of interest rates we face today could result in short-term approaches to ‘fix’ problems that in reality won’t exist in the long-term. Many companies are to be lauded for the sensible approach they are taking but this needs to continue in the face of pressure from the media and politicians to come up with a quick solution that neatly solves all of the problems. This could be expensive, unnecessary, and ultimately will cost companies and stakeholders real money that doesn’t need to be spent.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.