This was written as a response to this post on mallowstreet.com, which itself was a summary of a presentation given at the annual TUC pensions conference which made several points including advocating pension schemes reject Liability Drive Investing as a “distraction”, and focus instead on future income streams. The blog also questioned the relevance of buy outs in a world where the PPF exists.
What is the purpose of a pension scheme?
Answer: To pay the right amount of money at the right time.
How should the assets be invested?
Answer: In assets which pay the right amount of money at the right time*
There was a time when corporate defined benefit pension schemes took in far more in contributions per year than they paid out, they could make investments knowing that a potential loss would not have to be realised for many years to come, that current pensions could be more than covered by new income for the foreseeable future, and that if the worst happened, the sponsoring employer could easily pick up the bill.
When long term becomes short-sighted
Things have changed. Not only are many schemes in a situation (or will soon be in a situation) where they must pay out more each year than they receive (necessitating a very different approach to managing the assets, as insurance actuaries have known for decades**), but also the large size of schemes relative to corporate sponsors means that the assumption of the employer being there to pick up the bill is no longer valid.
If this wasn’t bad enough, add to that the fact that previous predictions over-estimated future asset returns, and under estimated future human longevity, meaning that in hindsight the schemes were never taking in quite enough income, even in the “good” times.
There’s no getting away from the fact that many pension schemes out there do not currently contain enough assets to pay all the benefits due, even at relatively optimistic levels of future asset returns. This manifests itself as a chronic rather than acute condition: the patient dies slowly, and the reality can always be ignored for a few years, but ultimately the prognosis is not good.
The solution to this problem is not to “kick the can down the road” further by making more optimistic assumptions for what the assets can deliver.
The solution is to invest in assets which will pay the pensions as they fall due, that is to say assets which generate a contractual cash flow such as fixed interest and inflation linked bonds. Where the scheme does not have sufficient assets to fully invest in this way to deliver the full benefits, the gap must be made up by a combination of taking carefully managed investment risk and agreeing a manageable contribution schedule with the sponsoring employer.
The PPF has undoubtedly been a hugely positive development in the history of UK defined benefit schemes, and the security for members of these schemes. However trustees cannot ignore the fact that the PPF benefit will in most cases be less than the scheme’s benefit, and with the trustee’s role being to act in the interests of delivering the promised benefit to members it should in general be quite optimal for trustees to be in favour of buying out the benefits with an insurer (if this is an option) as in most cases this will represent a higher degree of benefit security than continuing to run the fund. Of course there are always other factors in this decision, and each case is different.
It is unfortunate (and in many ways unfair) that future generations will not have the benefits of a defined benefit pension, but the current system is unsustainable in current form for the reasons mentioned above, and needs to be run off in the vast majority of cases. It is then incumbent on the industry to put forward sustainable solutions for providing meaningful pensions to future generations that learn from the shortcomings of the previous system. This won’t be easy but at the same time the industry has a huge amount of tools at its disposal in the form of investment knowledge and strategies that can be utilized to help deliver both the income and capital growth that will ultimately be needed to sustain future generations in retirement.
* C J Exley; S J B Mehta; A D Smith “The financial theory of defined benefit pension schemes” (1997)
** F M Redington “Review of the Principles of Life Office Valuation” (1952)