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ON the face of it Rahm Emanuel, mayor of Chicago; the managers of India’s Tata Steel; and the UK retailing entrepreneur Sir Philip Green have precious little in common. Yet all, in one way or another, are hostage to pensions blight.
In Chicago, the former White House chief of staff is struggling with a $20bn pension deficit. If half-decent pensions are to be paid, shared sacrifice is required between public employees, pensioners and taxpayers. The politics and legal process of this are ferociously difficult. But if Mr Emanuel fails to find a way, bankruptcy may loom.
With Tata Steel’s operations in the UK the problem is that a pension fund deficit looks like a poison pill to potential acquirers of businesses Tata is anxious to sell. The scheme reportedly has £15bn of assets and a deficit of £485m. No credible buyer would take that on, so the government is now trying to get backing for a plan that would ringfence the scheme.
In the case of Sir Philip Green the issue is reputational as well as financial. Having failed to turn around the tired department store chain BHS, he sold the company last year for a nominal £1 to buyers who were not obviously well equipped to handle a retail and financial basket case. BHS has now collapsed, with a pension scheme deficit that amounts to £571m, the current market cost of paying an insurance company to cover all the scheme’s liabilities.
The defined benefit model of pension provision is supremely unsuited to today’s world of low or negative interest rates.... Defined benefit pensions thus become very expensive to fund
These are symptoms of a much wider malaise — namely, that the defined benefit model of pension provision is supremely unsuited to today’s world of low or negative interest rates. To establish the solvency of a pension fund, actuaries use a discount rate broadly related to current market rates to estimate the present value of pension liabilities. The lower the rate, the bigger the liabilities.
Today’s rates are a historical aberration. Not even in the depression of the 1930s did policy interest rates and the yield on government bonds turn negative. If market valuations revert to the mean, as they have always done, today’s liabilities will prove to be absurdly inflated.
Yet actuaries are understandably reluctant to stray far from market values even though those markets have been comprehensively rigged by central bank bond buying programmes. In this hall of mirrors the one certainty is that today’s pension fund deficit numbers will turn out to be wrong.
Another consequence of central bank intervention is that the price of equities and other risk assets have soared, which means that future returns on these inflated valuations will be lower. Defined benefit pensions thus become very expensive to fund.
Who gets hurt in this peculiar environment? With public sector schemes the pain can be felt in varying degrees by scheme members, taxpayers and recipients of public services. In the private sector it is the sponsoring companies that take the biggest hit as they have to top up pension funds to help reduce deficits. Because defined benefit pensions are related to salary levels, not investment returns, members are protected so long as their scheme remains solvent.
Among the worst potential victims are those members of defined contribution schemes — usually the majority — who invest in a lifestyle option whereby they automatically swap risky assets for bonds, regardless of whether they are cheap or expensive, as they approach retirement. When interest rates start to normalise they will incur big capital losses because rising rates cause bond prices to fall.
The wider impact of pensions blight on animal spirits in the boardroom and household spending habits is impossible to quantify. What we can safely posit is that an exit from the low or negative rates that cause the blight, however desirable for the pensions system, is unlikely to be a smooth and painless affair.
Published in Dawn, Business & Finance weekly, May 23rd, 2016
