Home > Financial arcana > More clarifications of the obvious

More clarifications of the obvious

If you think that Gordon Brown carried out a tax raid on pensions in 1997, which was the main cause of the end of final-salary pension schemes in the UK private sector, then you are wrong.

In 1997, the government did indeed abolish the tax relief on dividends paid by firms into pension funds. But on the same day it cut corporation tax by 2%, such that the final outcome of the legislation was revenue-neutral. Profits were taxed less in the first place, in exchange for which people lost the ability to get some of the tax money back if their shares were held as part of a pension fund rather than just as shares. The net effect on the income that flowed from the companies to the people was zero.

There were three real factors which led to the move away from final salary pension schemes in the UK – all of them are based on the fact that before 1997, the cost to a company of offering final salary schemes was understated:

1) Changes in life expectancy: average male life expectancy in the 1950s, when most final-salary schemes were created was 65; it’s now 80. This makes schemes that provide a defined benefit from age 65 onwards an order of magnitude more expensive than they were. Perhaps actuaries should have allowed for increasing life expectancy over time when calculating the costs of these schemes 20, 30 and 40 years ago – but they didn’t, and now it’s payback time.

2) Unwinding of contribution holidays: if you’re a plc, there’s an incentive during the good times, when your pension fund temporarily rises in value because stock markets are booming in general, to cut contributions as the pension fund is nominally overfunded. This is silly. Yes, if you’re a short-to-medium term investor, it’s rational to keep trading within the bubble – but if you’re investing for 30 years ahead, then you are grossly fiscally irresponsible if you base your required contributions on market fluctuations rather than, say, applying historical P/E ratios to your stock portfolio.

3) Introduction of FRS17: the accounting standard FRS17 forces companies to recognise pension fund deficits on their corporate balance sheets. Which is fair enough, as in the long run they’re ultimately accountable for them. However – especially as FRS17 forces mark-to-market on pension fund assets – companies are reluctant to show their financial statements swinging wildly each year based on an institution over which they have absolutely no control.

Overall, it does not make sense for an engineering company or an oil company or a retail company to take financial responsibility for an enormous pot of money (in the case of many companies, a pot of money larger than the market value of the company itself) on which its shareholders have no claim; nor is it especially sensible for an individual to base their retirement plans on the continued existence of an engineering company, oil company or retail company.

People who had private sector final salary schemes before 1997 have done very, very well because of the changes in life expectancy now compared with expectations when the schemes were set up. But this makes them the lucky beneficiaries of actuarial miscalculations. It does not mean the schemes as they existed in 1997 were sustainable, and it certainly doesn’t mean that Labour are evil pension thieves because the unsustainability of the final salary model became apparent on their watch…

Categories: Financial arcana
  1. dsquared
    April 30, 2008 at 3:38 am | #1

    Lots of FT conventional wisdom that ain't so here:

    Perhaps actuaries should have allowed for increasing life expectancy over time when calculating the costs of these schemes 20, 30 and 40 years ago – but they didn’t, and now it’s payback time

    Not true, largely. Looking back at actuarial expectations of life expectancy at retirement in 2000 from the 1940s, what you are impressed with is how well they predicted the improvement in life expectancies, not how badly. The decrease in mortality rates is one of the best understood and most predicted demographic trends there has been, and its impact on the pensions industry is wildly overstated. The financial impact has come not because of under-reserving, but because new joiners to DB schemes are *actually* *more* *expensive* to provide pensions for.

    To make this clear, there is nothing that could have been done in the past by actuaries or anyone else to make it cheaper to provide pensions to the current generation of retirees. If they had run with reserves that took into account the projected life expectancy increases, this would have been totally inequitable – it would have been equivalent to forcing the 1940 generation of scheme contributors to subsidise the pensions of the 1990 generation.

    if you’re a plc, there’s an incentive during the good times, when your pension fund temporarily rises in value because stock markets are booming in general, to cut contributions as the pension fund is nominally overfunded. This is silly.

    Not really. Since shareholders bear the risk of having to pay accelerated contributions if the scheme becomes underfunded, they ought to take every opportunity to reduce their burden if they're overfunded. Your suggested strategy would most likely result in the buildup of huge structural surpluses, which the current state of pension law would make it very difficult for plc shareholders to get their hands on (IMO there's been a huge overreaction to this post Maxwell; pensioners have a right to be sure that their scheme is honestly and prudently managed, not to a one-way bet on the stock market). Some schemes are going into deficit now, but the contribution holiday money did not just disappear when the plcs distributed it back in the good days; it has presumably been reinvested into assets which earned a return in the meantime.

    Overall, it does not make sense for an engineering company or an oil company or a retail company to take financial responsibility for an enormous pot of money (in the case of many companies, a pot of money larger than the market value of the company itself) on which its shareholders have no claim; nor is it especially sensible for an individual to base their retirement plans on the continued existence of an engineering company, oil company or retail company.

    Yes it is and yes it does; pooling risks at the employer level has a whole lot to recommend it (not least the fact that the biggest risk to a final salary scheme is the level of final salaries, which the employer is the best person in the world to manage). This model is and remains sustainable; it's just that an awful lot of companies realised during the 1990s that moving from a DB to a DC scheme was potentially a very good way to smuggle through a pay cut. This had nothing to do with the Labour Party (and even less to do with the abolition of the ACT credit) but the whole "final salary schemes, relic of the Harold Wilson era" theory is equally untrue.

  2. April 30, 2008 at 10:30 pm | #2

    Some schemes are going into deficit now, but the contribution holiday money did not just disappear when the plcs distributed it back in the good days; it has presumably been reinvested into assets which earned a return in the meantime.

    Genuinely touching.

    This model is and remains sustainable; it’s just that an awful lot of companies realised during the 1990s that moving from a DB to a DC scheme was potentially a very good way to smuggle through a pay cut

    It's like there were two Dsquareds…

  3. dsquared
    May 1, 2008 at 12:39 am | #3

    it has presumably been reinvested into assets which earned a return in the meantime

    implies, if you think about it "and therefore profits are higher than they would otherwise have been now that the contribution holiday has ended, meaning that the parent companies are in better shape to make up deficits".

    The real Big Evil of the last ten years have been the solvency regulations, which more or less force pension funds to buy high and sell low, all in the name of trying to make the pension fund's solvency independent of the plan sponsor. The big move into bonds in 2003 is something that can fairly and squarely be blamed on Brown.

  4. Matthew
    May 1, 2008 at 7:57 am | #4

    "Not true, largely. Looking back at actuarial expectations of life expectancy at retirement in 2000 from the 1940s, what you are impressed with is how well they predicted the improvement in life expectancies, not how badly."

    I thought the issue was there had been a bit of a step change in the last decade or so – as shown in the charts on p.182 here…5 years out?
    http://news.bbc.co.uk/1/shared/bsp/hi/pdfs/30_11_

  5. May 1, 2008 at 10:41 pm | #5

    “and therefore profits are higher than they would otherwise have been now that the contribution holiday has ended, meaning that the parent companies are in better shape to make up deficits”.

    Heroic assumption. If the company took a holiday of value X, and distributed the cash to its shareholders, the pension fund got X/its percentage shareholding rather than X, which is less by construction. Furthermore, there is no reason to think the long term stream of income from the security is any greater as a result of a one off lump sum, so the fund's shareholding shouldn't rise by enough to compensate this in a rational universe.

    Nyah, nyah, rational universe

    Point taken. But if you can assume the widows' money was invested in something rationally useful rather than executive bonuses, I can assume the share price reflects the net present value dah dee dah dee dah. Further, we actually know that companies did indeed do a lot of stupid things in the great bull run.

  6. May 2, 2008 at 8:50 pm | #6

    I thought some contribution holidays were compulsory; wasn't/isn't there some law about overfunding pensions?

  7. dsquared
    May 3, 2008 at 12:04 am | #7

    Heroic assumption.

    I don't think it's particularly heroic. After all, profits in the aggregate *are* a lot higher than they were in the 1990s and I don't think it's unreasonable to believe that having a bunch of capital invested in corporate assets rather than financial instruments in a pension fund has something to do with that; also, there weren't all that many cases of companies simply paying out their pension holiday as a special dividend – distribution policy's a really blurry subject but I don't think that overfunded pension plans match up all that well to cash returns.

    wasn’t/isn’t there some law about overfunding pensions?

    Yes, because in some cases it's a tax dodge.

  8. May 9, 2008 at 8:26 am | #8

    "people lost the ability to get some of the tax money back if their shares were held as part of a pension fund rather than just as shares"

    I thought the pension fund could claim back all the advance corporation tax. In which case a "few" people with shares in pension funds lost a largeish chunk of cash while a lot more people (all the other shareholders) made a smaller amount of cash, companies having 2% less CT to pay.

    That may be revenue-neutral, but it's still a big hit on the pension funds.

  9. May 15, 2008 at 12:39 am | #9

    Excellent stuff, now try explaining that to The People.

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