Pensions disaster

I wrote this back in 2006, in the balmy days before the world decended into its current mess. It still stands up - and the situation is even worse...

"FRS17. It doesn’t look much but these innocuous initials and numbers are going to have more influence on more peoples’ lives than any chancellor or central banker. They will probably ensure that hundreds of thousands retire impoverished and dozens of companies go bankrupt. It is a perfect example of the law of unintended consequences; it has distorted bond and stock markets; it will affect your life and wealth, almost certainly for the worse; and it is showing at a cinema near you. Not bad for an accountancy rule.

FRS17 is the accounting rule that insists that companies have to match the assets in their pension funds with the liabilities of the pensions they are contracted to pay their employees – and any surplus or deficit has to appear on the balance sheet of that company. Nothing wrong in that you might think and, in the salad days of the 1990s’ stock market boom, you would have been right. If you were a director of a company or a pension fund trustee, you would have been so relaxed at the surplus in the pension fund that you would have decided that your company no longer needed to contribute to its fund and that the money was better given back to shareholders – or, perhaps, used to buy one of those “new paradigm” internet companies...

Bad news comes in threes, and often more. First, the stock market tanked and two things happened. The first was that equity-dominated pension funds nearly halved in value and, as a result, actuaries (that shadowy breed for whom the old joke goes that accountancy was too exciting) started sharpening their pencils and revising down their expected future investment returns well into single figures. At the same time, they discovered that modern medicine is very good and that we are all living longer.

It was at this point that the real sting in FRS17 became apparent, because what it assumes is that the all those pensioners are going to draw their pensions tomorrow and that the pot has to match their requirements. A moment’s thought suggests that this doesn’t reflect reality as a pension fund has members who are in their thirties as well as their sixties and that, while some will have their hands out over the next five years, those in their thirties can’t touch it for twenty years at least. However, the rules are the rules and suddenly, in the trough of the 2003 bear market, directors and pension-fund trustees found themselves looking into a black hole and were forced to liquidate their equity holdings at precisely the point at which they should have been diving in and filling their boots. So the first result of FRS17 was to make a bad market worse. Frightened by the pit into which they had looked, those same ladies and gentlemen then read in their newspapers of the travails of the directors of Equitable Life. What Equitable Life had done was to guarantee returns to their policyholders that were dependent on bond yields that proved to be way too optimistic, leaving Equitable Life on the edge of insolvency and the new board of directors looking for someone to blame. Who better than the old board? Despite the fact that the combined assets of the old board would barely make a dent in the shortfall, there ensued a legal case that swallowed tens of millions from both parties but which succeeded in enriching only lawyers. However, what it also succeeded in doing was scaring the living daylights out of anyone with responsibilities for pensions because the self-evident penalty for a commercial mistake (and will anyone who hasn’t made one please raise their hand) was to face a legal avalanche and potential bankruptcy. And all this for a modest salary.

Not surprisingly, directors and trustees became very, very risk averse. But what do we mean by risk? For the man or woman in the street, risk means investing in Enron and losing the lot when it goes bust. The way they get round this is by diversification – buying a basket of shares to “lay off” the risk. For the financial industry, however, risk means something rather different. Risk tends to be used interchangeably with volatility (how far the investment performance may be different from what you expected). But, given sensible diversification, the only time when risk and volatility are actually the same thing is in the short term – when you are forced to sell to meet liabilities. Over the long term, as many academic studies have shown, if you are prepared to take on volatility (and illiquidity), you are likely to be rewarded with out-performance. This is pretty basic capitalism as who is going to take any risk with equity investment if you get the same long-term performance with a Gilt?

You would have thought that pension funds should be the ultimate in long term investments, with a mix of short-term assets such as bonds and cash to cover short-term liabilities and property and equity investments to give extra returns for the pensioners of twenty years from now. However, a combination of FRS17 and Equitable Life has meant that risk management – not return management – has become the focus, with everything channelled into making sure that there is no possibility of any nasty surprises, even if that is condemning pension funds to disastrous underperformance. This underperformance is almost guaranteed if the pricing of long index-linked gilts is any indication. These are now being bought at a yield of 0.5% – the only buyers presumably being pension funds as it is difficult to imagine any other informed investor being in the queue to buy them at this rate. It gets worse. Because pension funds’ liability calculations rest upon the yield of these long-dated bonds, if yields fall then liabilities rise and apparent deficits increase – so they have to buy more index-linked stock to try and stay ahead of their liability – which drives yields yet lower in a spiralling vicious circle. Interestingly, going back to the nineteenth century, the long-term real rate has been around 3% so if pricing reverts to the historical norm, then the buyers of these assets will be sitting on major capital loss.

In the meantime, it is not just the pensioners of the future who are going to be affected but it is already hitting the new pensioners of today. The current rules mean that, on retirement, pensioners have to buy an annuity at the prevailing rate – and what is that prevailing rate based on? You’ve guessed it – long gilt yields – which are being distorted by, right again, FRS17. So here you have a Mad Hatter’s tea party where unfortunate current retirees are being hit in the wallet by the same forces that are going to ruin their childrens’ retirement plans.

Capitalism, however, is extraordinarily adaptive and clever minds in the City are working out how to make money out of this clear anomaly – after all, bubbles in the bond market are an extremely rare phenomenon. Smart fund managers and finance directors are doubtless calculating how they can issue index-linked debt to pension funds and then do what the pension funds should be doing and take the equity risk premium that attaches to a long investment horizon. Capitalism is also cruel and, once again, it will be ordinary people without the choice of being able to cross the street to a better deal, who will be hammered. The sophisticated will be making money out of the other side of the book.

How will this “perfect storm” in pensions, as one analyst has put it, play out? It is difficult to imagine that the government can sit by and let the current situation carry on as it is a situation caused by regulation, and regulation, after all, can be changed. When that happens the smart money will be short of the long bond market – unfortunately, that smart money is unlikely to include pension funds."