The turmoil that has surrounded British Home Stores throughout 2016 has highlighted a deeper concern about UK firms’ pension funds that is more serious and complex than may seem on the surface. The BHS example has gained significant media coverage because of the conflict between management parties after Sir Philip Green sold the struggling company to three-time bankrupt ex race-car driver Dominic Chappell, and its subsequent descent into administration. The £571 million deficit (difference between the money set aside for the pension fund and the eventual pension obligation) that BHS faces is only a fraction of the £800 billion in pension deficits[1] that UK firms must account for. Redundancies at BHS and PPF (Pension Protection Fund) funding for its pension fund simply force the issue. Whilst hope remains that Mike Ashley’s Sports Direct will save some jobs, the issue of BHS’s underfunded pension remains open. £800 billion is a lot of money, and we have to hope that fortunes turn before too many firms seek help from the PPF and create a nationwide problem.
To be precise, we are talking about defined benefit pension schemes, i.e. pension schemes that promise an income at your age of retirement. To fulfil this promise employers contribute to a pension fund which will invest its capital, often in stocks, bonds and infrastructure projects. Unlike defined contribution schemes, the employer holds the risk that these investments fail to perform sufficiently well to provide the promised retirement income. DB schemes are often ‘index-linked’ meaning that your pension income goes up in line with the rising price level, i.e. in real terms your income from you pension is the same since it is adjusted for inflation. Every year pension funds have to declare their performance, and their ability to meet their estimated liabilities. If a defined benefit pension scheme is failing to meet its statutory funding target, the employer will be forced to agree a recovery plan with the regulator often involving additional short-to-medium term contributions[2]. The subtlety of how these schemes work and what they are affected by are important to consider before we conclude on who is to blame and the magnitude of the potential effects.
So what has gone wrong; how has the UK pension deficit doubled in less than 10 years? What are the social, political and economic implications of this? Are there any solutions?
Life expectancy has gone up, and therefore pension schemes’ liabilities have risen accordingly in order to account for people needing more money to sustain the same standard of living for longer. One of the most significant factors however has been the low interest rates post-crash, and the effect they have on the discount rate applied to future liabilities. By convention, the interest rates on corporate bonds are used to determine the pension’s risk free return. This rate is incorporated into the discount rate calculation that establishes the present value of future cash flow pension liabilities. The ‘prudence’ needed in recording accounts means that firms have to recognise all future liabilities and quantify them in the present day, implying any changes in the interest rate (and thus the discount rate) will affect the present value of these future pension liabilities. The present value of cash flows (like pension liabilities) is particularly sensitive to the discount rate over long periods of time. The magnitude of pension fund deficits could, therefore, be a result of the IAS19 accounting standards used. So does this imply that accounting conventions have created an artificial crisis?
After the financial crash of 2008, interest rates dropped from 5% to 0.5% (a record low in the UK), decreasing the discount rate and increasing the present value of pension liability cash flows. At the same time; stocks, which these funds are invested in, are more volatile in the post-crash scenario conveying an element of risk for firms making speculative investments with their pension funds. Not only do such schemes see smaller returns on the investments, the drying up of liquidity post-crash means that the very businesses backing these schemes had less cash to invest in the first place. This essentially means firms have to inject a lot more money to get the necessary returns they need to cover their obligations. Times have been like this for almost 7 years now, which can account for UK firms’ pension deficit quickly spiralling upwards. The reaction of pension funds in response to interest rates and stock prices shows the dependency of such funds on the nuances of macroeconomic policy just as much as the fluctuations caused from microeconomic uncertainty and speculation.
So, firstly, Mark Carney may choose to increase the base rate from 0.5%, which may distil confidence in the markets and thus boost stock prices, but will certainly affect pension fund deficits through the discount rate mechanism discussed above. Having said this, interest rates affect more than just the present value of pension liabilities, so this option is less viable. We should consider it this way; when interest rates are raised, the pension deficit will slowly correct itself, rather than we should raise interest rates because of the growing pension deficit. A more practical option would be for the government to issue long term interest bearing assets, which have a similar maturity to when the pension liabilities are due, showing that firms can purchase these to match their pension liabilities with. Currently, issuance of such long dated assets does not seem to be possible. Matching the duration of the portfolio of assets will immunise the pension fund to changes in interest rates by ensuring the present value of assets and liabilities move in tandem, reducing the risk and scale of future changes.
According to Con Keating[3], the market pricing of assets in the short term is highly volatile, “with the majority of this volatility arising from the inside game among intermediaries rather than the fundamentals that drive productive investment returns”. Consequently he argues that there is a need for an asset pricing mechanism that eliminates this short term volatility for these long-term funds, if half time measures of the adequacy of pension scheme funding are to be meaningful. Since the pensions themselves are index-linked, maybe making such long term government bonds index-linked too will achieve a higher level of stability and mitigate risk from market and economic uncertainty.
A stronger regulatory framework has seen pension legislation increase considerably since the ‘90’s with more regulation causing more complexity for firms, and this complexity has driven up the cost of administration and compliance, lowering investment returns. Alan Pickering’s report in 2002 (“A Simpler Way to Better Pensions”) identified complexity as a chief reason for under provision in funds, backed by 71% of employer respondents. Some argue that the low interest rates do not reflect the expected risk free returns, but are more aligned to suit the relatively extreme measures taken by central banks, and firms find this too hard to overcome with regards to managing pension funds. The complexity in deriving an appropriate discount rate from this misrepresentative interest rate has thus led some to believe that the present value of pension liability cash flows should be calculated with a more accurate discount equivalent, like the Internal Growth Rate[3] (IGR – the growth rate achievable for a firm without external financing).
The effects that the recession has had on pension funds highlight the vulnerability of such schemes, and Con Keating’s report in 2013 (Keep Your Lid On[3]) suggests that using the IGR is a better way to discount future cash flows since the current alternatives used (risk free rate, Gilts, expected asset return) “lead to over or under estimates, bias and volatility.” He argues that it is “meaningless to operate a ‘prudent’ funding standard” if pension liabilities are inaccurately quantified from the misrepresentation of the present value that has arisen as a result of such ‘prudence’, prompting Keating to favour an IGR approach which considers the input (contributions) in delivering the output (pensions). The IGR will accurately reflect the true state of pension funds, and make it a stable reporting tool due to its limited susceptibility to certain factors that affect the conventional discount rate.
Whilst I do believe that accounting standards and the mathematics behind calculating the present value of these liabilities have created an artificial worry to some extent; this does not mean that we should tolerate firms with such huge deficits. The moral hazard associated with allowing such behaviour does not set a good example and could encourage a laxer approach by companies in the future when trying to address such huge deficits (implicit bailout/funding guarantee from the PPF). Funding from the PPF is inefficient as Keating argues; who stresses insurance is a more appropriate solution to potential sponsor insolvency. The need for appropriate parties to react and change the functionality of the current schemes is imperative, but may only happen after sponsor insolvency, followed by high social costs, which are inevitably going to be burdened by the tax-payer.
Despite the measurement issues and explanations expounded upon above, there is clearly a ‘real’ series of concerns about the level of pension funding. A study done by OECD shows retirees today will have 40% less than what retirees 15 years ago with the same income and scheme will have[4]. This has prompted OECD to encourage governments worldwide (the UK is not the only country to be experiencing a pension crisis) to increase public spending and implement accommodating reforms to nurture sustainable economic growth, especially considering the fact that pension expenses are expected to rise in the future due to the predicted change in the age demographic. Economic growth depends on the level of productivity, and advances in technology may help foster productivity in MEDCs with such skewed age demographics. However the competition from outsourcing coupled with potential competition from machines could put more strain on governments to adequately provide pensioners and workers with a guaranteed income in the future, emphasising the need to find a sustainable solution.
Pensions are a delicate matter, obviously, because the threat of losing some or all of your post retirement income is going to cause tension, and this tension causes uncertainty, uncertainty in how people, firms and possibly the government are going to react. The focus must now be to implement policies and approaches that are going to correct this pension fund liability, and calm the public and reassure them their pensions are safe, especially considering that the magnitude of the deficit can be in part explained by complying with overly prudential accounting.