Opinion

Rising interest rates finally explode the myth of your pension fund deficit

7 min read

15 March 2018

It’s been a long time coming but finally reality is catching up with the “experts” who have been insisting that pension fund managers find the money to stuff their portfolios with more and more bonds to address so-called actuarial deficits.

It is a scandal perpetrated by the Pension Industry Regulator, egged on by pension fund consultants, the Bank of England (BoE) and the FCA. Many heads should roll for the damage it has done to the British economy and our pockets. No doubt the financial establishment will close ranks but they are losing credibility in the eyes of anyone who cares to look.

I like to think it was Anthony Hilton, writing in the Evening Standard in 2016, that first drew attention to “Our mad approach to pension deficits”. He put the madness succinctly and with lucidity: “We are talking about a misallocation of capital on a truly heroic scale, running to tens if not hundreds of billions of pounds – sums that 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, any pension fund should only count what it 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. 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 grow at a slower rate. You need more of them now to avoid a shortfall in future. Each cut compounds the problem.“

Hilton’s conclusion was suitably unforgiving: “How in a sane world did we get here? 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 that even sane people think that they 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.”

Unsurprisingly his article set off a storm of protest in the actuarial and regulatory world. The general tenet of their huffing and puffing was how can a mere journalist be expected to understand the calculations needed to quantify what these deficits are? The man is a charlatan and should be ignored. Indeed he has been as the pensions world has staggered under ever increasing deficit figures.

But then something happened. Interest rates are going up! And what has that done to defined benefit pension deficits? In just one month they have halved. The Pension Protection Fund’s 7800 Index reported that across Britain’s almost 6,000 defined benefit funds the combined deficit in January fell from £104bn to £51bn. At a stroke of a pen the pensions bogey is disappearing.

This mickey mouse accounting would be funny if it wasn’t so serious. Earlier this month the BoE admitted, in a report it commissioned, that its QE induced driving down of interest rates had a knock-on effect on defined benefit pension fund schemes where liabilities rise when interest rates fall, thus increasing costs for employers backing the schemes. The BoE said that at one point the combined deficit reached 15 per cent of GDP.

It found that companies with large deficits paid lower dividends and companies required by the regulator to make deficit recovery contributions spent less on dividends and investment than other businesses.

Indeed the latest example of this induced strife is the lengthening strike by university lecturers over their pension scheme’s deficit, which resulted in a letter published in the FT from the former chief accountant of the mighty Railways Pension fund (RPMI Railpen), Dr Tim Wilkinson, and the immediate past president of the Institute of Chartered Secretaries and Administrators, Frank Curtiss.

To quote from their letter: “We think insufficient attention is being directed towards regulatory framework. Actuarial and accounting standards, bolstered by several pensions acts, have become divorced from the economic reality of running a defined benefit scheme. The calculation of liabilities using bond rates exogenous to the pensions ecosystem, coupled with the statutory requirement to eliminate deficits quickly, can make schemes appear unaffordable when, even on prudent assumptions, they have healthy cash flows in perpetuity.

“The resulting deficits and costs are little more than accounting and actuarial illusions, but are made real by regulations. Employers balk at the expense, with the result that schemes are indirectly forced to close by the very regulations that are designed to protect them.”

The absurdity of how our pension schemes are valued and the damage that has been done has been going on far too long. The myopia of those in charge of this vital industry is a scandal so heads should roll as reality dawns. Meanwhile the next time you are told you have a pension deficit that needs addressing ignore the false prophet.