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The Actuary The magazine of the Institute & Faculty of Actuaries
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Occupational pension schemes – conflicting priorit

Ros Altmann’s article (The Actuary, August) discusses what might be done about the lack of security for accrued pension rights under defined benefit pension schemes. But this is just one aspect of a fundamental problem, and it makes no sense to treat the symptom rather than the disease. The disease is employers making pension promises they cannot be sure of affording.

To put this into a wider context:

  • The state wants to ensure that as many as possible build adequate provision for retirement, and encourages pension provision (the effectiveness of the encouragement is another question).
  • Individuals want to be confident that the provision will be there when they need it. They want a generous and predictable level of benefits and expect the security to be comparable with that of benefits provided by a regulated insurer.
  • Private-sector employers want affordable and predictable costs.

Unfortunately, this wish list contains obvious internal conflicts relating to cost and risk. In DB schemes, somebody has to underwrite future benefit promises which depend upon inflation, salary progression, and length of life. No commercial insurer could accept the salary risk, but the other risks can be accepted at a price which reflects the capital which needs to be provided to ensure the liabilities are met.

In an effort to minimise cost and risk simultaneously, pension schemes have long invested heavily in equities. For decades, the gamble came off. Employers reaped the benefit, enjoying contribution holidays with the odd concession to the members (which incidentally established the precedent that the employer underwrote the equity investment risk). Unfortunately, in more recent times the gamble has been unsuccessful. Employers have bitten off more than they could chew, and many could not afford to make good the losses.

Pension schemes also cheerfully assumed that their existing tax treatment would continue, but this turned out to be a risk which few, if any, had recognised. There is no guarantee that taxes will not be raised again, and the risk is commercially uninsurable – but all DB schemes are exposed to it!

When schemes are unable to meet members’ expectations, the eccentricity of the laws which gave priority to existing pensioners becomes apparent, revealing yet another risk for members of pension schemes.

Ros Altmann calls for better disclosure of the security of members’ rights under DB pension schemes, so that they can make informed decisions about their participation in the scheme and consider transferring out. She also calls for government underpinning of the Pension Protection Fund (PPF).

Even if we consider only the security problem, neither of these is satisfactory. Transfers out are a pure gamble which may well leave the member worse off than if they remain in the scheme (we are still clearing up the mess from the last time members transferred out in an attempt to improve their lot!). And even if the PPF were guaranteed by the government, protection would only be partial (other problems relating to the practicality of the PPF are beyond the scope of this letter).

So while either or both steps would help a bit, they would not address the underlying problem that employers have made costly pension promises which they could afford only if everything turned out alright.

A more radical solution is required. For benefits accruing after a certain date, private-sector employers making pension promises should be required to provide a level of security comparable with that of an investment in a regulated financial institution such as a bank or insurance company. The regulatory structure would include prudent provisions for future liabilities, solvency capital, and mismatching reserves. Such a regime would sound the death knell for most final salary schemes. So be it; employers shouldn’t make promises with their fingers crossed behind their backs.

Some defined benefit schemes might continue, providing (revalued?) career-average benefits, and other benefit structures might be developed, such as pensions denominated in the shares of the employer – admittedly not as satisfactory as pensions linked to final pay, but affordable and the risk much clearer.But the majority would convert to DC. Would that be such a bad thing?

So much for the private sector. The public sector makes comparable promises, but the cost is hidden – nevertheless, the taxpayer has to underwrite it in the long run. I believe that the unfunded liability for public sector employees cannot continue to spiral out of control any more than it should in the private sector – what is sauce for the goose is sauce for the gander. The public sector should move en masse to (funded) defined contributions, starting (of course!) with MPs…!