The occupational defined benefit (DB) pension scheme is a masterpiece of institutional contractual design. It is vastly superior to anything that can be provided for themselves by individuals. In fact, in current times, individual (defined contribution) pension provision operates at an efficiency of just twenty percent or so of the optimal DB arrangement. The sources of this advantage are manifold:
• Risk Pooling
• Risk Sharing
• Time Continuity
• Economies of Scale
• Economies of Scope
While each of these merit expansive discussion, that would detract from the broader view; the key point is that this inefficiency is extremely costly, in terms of the tax concessions and more, to society broadly and the tax-payer in particular.
The problem with occupational DB is simply that the sponsor employer may go out of business before all pensions have been discharged. The sole risk is sponsor insolvency. The image of naked disenfranchised pensioners on Brighton beach is unforgettable. Though, in part, itself a problem of inappropriate prior regulation, this prompted the rafts of regulation subsequently enacted. Unintended consequences and insane expenses were heaped upon pension schemes. The scale of this deserves some thought – while actual pension costs (that receivable by pensioners) rose by sixty percent, the cost to employers of providing them rose by more than 300 percent.
Contrary to popular opinion increasing longevity does not make occupational pensions unsustainable. Only too much of the debate around pensions has been driven by the petty politics of envy, party ideology and political convenience. Growth in our economic output has far outstripped the growth in pension cost – they have, in fact, become economically more affordable.
The now near-total closure of DB pension schemes is attributable to one simple fact. The current accounting rules and pension regulation have made them far more expensive for a company to provide than any benefit that company derives from this form of employee compensation.
A large part of the problem is the mistaken belief that funding a scheme can resolve the issue of sponsor insolvency. It cannot; at least not in any cost-efficient way. The problem is simply that when insolvency occurs, a scheme which is fully funded under current accounting and actuarial standards is insufficiently well-funded to be able to cope with the vicissitudes of uncertain financial markets, and the other risk factors, such as membership-specific longevity, that a scheme faces. The magnitude of this problem is very large – currently around 50% of a scheme’s value.
One of the best illustrations of the haplessness of the regulation of pension schemes is the requirement for a scheme to be fully-funded, or to be aiming for that objective, at all times. This is defensive over-kill, leading to strategies such as liability driven investment, which are very costly. If football regulations required teams to field ten defenders, then fewer goals would be scored – if all long-term investors operate to short-term horizons, fewer investments will be made and the returns to market-based investment will be lower. This regulation harms the real economy.
“Fair value” accounting is firmly rooted in the freshwater economics of efficient financial markets; a faith which was totally discredited evidentially by the financial crisis. However, this is yet to filter through to either accounting standards-setters or pension regulators.
The very idea of measuring pensions, which are streams of retirement income, in terms of their capitalised asset and liability values is profoundly flawed. The regulator appears to be unaware that applying a balance sheet insolvency test to pension schemes evaluated in this “market-consistent” manner is also inappropriate. Bond markets require an event of default to have occurred, and remain uncured, for acceleration and the processes of recovery to commence. This is equitable insolvency, not balance-sheet insolvency. Using an equitable discount rate when a balance sheet rate is applicable not only distorts the valuation, making the scheme seem weaker than it is in reality, but it also induces the potential for costly and unnecessary remedial actions, and even makes insolvency itself more likely.
If we wish to value a pension scheme correctly, we need to move away from this balance sheet view based upon discounted present values for liabilities and market prices for assets. That mixed attribute standard is itself bizarre, implying that we may reconstruct bond portfolios with equities and equity portfolios with bonds, when we know that is not feasible in any practical setting.
The correct approach would involve comparing the projected pension liability cash-flows with the projected cash-flows of assets held. Pension liability cash-flows are routinely estimated in actuarial valuations. The cash flows of securities held are less frequently examined, though they are the fundamental basis of the security’s value. For bonds, these future cash-flows are contractually known. For equities, the situation is less certain, but dividend volatility is an order of magnitude lower than price volatility, and highly predictable. Comparison of the two sequences of cash-flows requires no more than the calculation of the internal rate of return which equates them.
This may appear radical, but its simplicity can be made evident. Consider the elementary case, in which the contributions for a year are fixed (as a proportion of wages or as cash amounts) and the pension benefits awarded actuarially estimated. In the absence of any segregated investments, the internal rate of return which equates these cash-flows, current contribution and future pension payments, is the company’s cost of that contributed capital. Whether any market investments or segregated investment portfolio will achieve that is a matter of judgement. Whether that cost of capital is acceptable in the absence of any investments is also a matter for the management and shareholders of the company.
This approach has the added benefit that it is intrinsically long-term, avoiding entirely the gyrations of market prices and rates, and the short-termism which that induces. It also closely aligns pensions to their economic roots. A pension is economically a claim on future production; it is appropriate that producers should write these claims directly. It is naturally superior to acquiring these claims as negotiable securities in markets which have deformed them beyond recognition. If anyone doubts that markets deform such claims, they need do no more than examine the relation, or its absence, between economic output and growth and financial market returns.
The insolvency problem is best dealt with by insurance, not funding. In some ways the creation of the Pension Protection Fund was recognition of this, though that is a mutual compensation scheme and not a pension indemnity assurer. From this difference through to the detail of its operations, the PPF is a masterpiece of inept design, imposing constraints, limitations and sunk costs which are entirely unnecessary, though very substantial. Private sector pension indemnity assurance has operated successfully in other countries, notably Sweden, for many decades. It is interesting to note that they have not suffered any comparable collapse of their private pension systems, though they have experienced similar issues such as increasing longevity.
Recently, the trend has been to introduce newer hybrid forms of pension; in the UK, “defined aspiration” or in the Netherlands “real pension contracts”. These are simply DB with major structural elements amputated. Only too often they appear designed to mislead the employee as to their inadequacy and incompleteness.
The optimal DB pension contract is, in fact, the occupational insured book-reserve DB scheme. It was invented long ago in Germany, and by many accounts gave us their post-war Wirtschaftswunder. But we should not expect the financial services industry to advocate or lead such an approach. Companies offering such schemes would be far more independent of bankers, advisors, agents and financial markets than they are in the current imbroglio.