Anthony Hilton: Our mad approach to pension-fund deficits

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It does not really matter if people want to believe silly things, as long as they don’t act on them.

It does not really matter, therefore, if the way pension-fund solvency is calculated is an affront to common sense, as long as people treat those valuations as opinion not fact.

We forget at our peril that the calculations of pension solvency are an artificial construct; it is not a factual calculation when a tweak to an assumption or two can make any deficit disappear.

But that is precisely what is now widely forgotten. Every month, half the pension-consulting industry queues up to toss out ever more inflated estimates of the combined deficit of defined benefit pension schemes as if these numbers were unassailable truths.

Meanwhile, all the other consultants, plus the investment banks and legions of advisers produce ever more fanciful and expensive ideas to help pension trustees deal with the consequences. 

The result after a few years of this is that pension-fund investment has been completely distorted and defies logic, with some funds routinely making investments they know for certain will lose them money over the next 10, 20 and even 50 years.

They are doing this, not because it needs to be that way, but because the industry has become mesmerised by these calculations and convinced it has to act on them.

We are talking about a misallocation of capital on a truly heroic scale, running to tens if not hundreds of billions of pounds — sums so large they pose a threat to the wider economy.

The origin of the problem is that accountants and actuaries decided that, when making estimates about the future, pension funds should only count what they could be absolutely sure of achieving.

In the investment world, convention has it that only the totally secure return on government bonds can be considered as certain —though this is itself a heroic assumption in an age of sovereign defaults. 

The yield on bonds is therefore used to calculate how much the assets of pension funds will grow over the next few decades. This determines how big the asset pot needs to be today if it is to grow to big enough to pay the pensions in years to come. If there are not enough assets in the pot today, that shortfall is the deficit figure.

It follows from this that every time interest rates fall, the assets will be assumed to grow at a slower rate. Therefore you need more of them now to avoid a shortfall in future. Each rate cut compounds the problem. Those doing valuations are forced to assume that the assets in pension funds will yield next to nothing for decades to come. 

But in the real world, pension funds do not earn next to nothing — at least as long as they ignore the advice of consultants peddling liability-driven investment schemes. Left to their own devices most, even in these markets, make a return significantly higher than the bond yield. 

There was proof of this earlier this week. Karen Thrumble has been measuring pension-fund performance for many years, first with WM — later State Street — in Edinburgh and now with Pirc.

Published this week under the Pirc banner, her Local Authority Pension Performance Analytics demonstrates that the average local authority pension fund grew 5.6% in the quarter to the end of June.

But the more fundamental point is that “over the medium and longer term, fund performance remains extremely strong with the average fund returning almost 9% over the last three years, 8% per annum over the last five years and 7% over 10 years” — the period that includes the 2008 financial crash.

If the reality is that the average pension fund in her universe has made 7% in a 10-year period — which no one could describe as easy — why do we take seriously a solvency calculation that assumes they will only make 2% or less? Why the hand-wringing over theoretical deficits when, in the real world, funds are making returns that are more than they will need to meet all their obligations in full? 

The negative consequences are very real. In the past week, plastics company Carclo cut its dividend because it says it needs more money to top up its employees’ pension fund.

It was a high-profile case but across the nation for years now, money that companies should have used to invest for the future, to grow their business and to improve productivity has instead been poured into pension funds to cover deficits that only really exist in the mind. 

When in a hole, you should stop digging but we are going ever deeper.

Consultancy Hymans Robertson yesterday issued a press release that said pension costs could be cut by £350 billion, or an average of £32,500 per pensioner, by using a lower inflation measure as the yardstick for future pension increases. This, it added, “could take a third off the £1 trillion pension deficit”. So now it is pensioners’ payments that are in jeopardy because of deficit phobia. 

How in a sane world did we get here? Well, it was said about one of the more intractable disputes of the 19th century that only three people understood the Schleswig-Holstein question — one was dead, one was mad and one had forgotten the answer. 

You might apply the same to pension-fund valuation. Yet such is the power of inertia, so entrenched is the status quo and so lucrative is it for the armies of consultants and advisers that even sane people think that hey have  no choice but to follow the rules of a mad system. 

The actuaries and accountants who started all this have a lot to answer for. It is time for them to go back to the drawing board.

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September 14, 2016 |
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