Pensions. On the cheap

Date: 17/04/04

The government is not owning up to the full cost of protecting the promises made by company pension schemes

THEY are meant to be the Rolls-Royces of the pension world. But company pensions, expensive to provide and seemingly so safe and solid, can turn out to be financial death-traps. Since the collapse last month of Mayflower, a British bus-building company, many of its 3,400 workers are facing big holes in pensions supposedly tied firmly to their final salaries. They may not do as badly as the former workers at the Cardiff plant of ASW, a steel company, who will collect less than a fifth of the pensions they were promised, according to Ros Altmann, a pension consultant. But they join some 60,000 employees hit this way in the past few years.

There is the potential for much more grief. Currently, Britain's company pension schemes offer benefits worth £850 billion ($1.53 trillion), but the assets backing them are worth only £560 billion, according to Mercer, an actuarial firm. That hole stems from the three-year bear market in equities plus the rising costs of annuities.

The government's partial solution to the problem is the Pension Protection Fund (PPF), roughly similar to America's Pension Benefit Guaranty Corporation. The British scheme provides compensation worth 90% of benefits to people of working age, with a maximum payout of £25,000 a year for someone retiring at 65; less at earlier ages. Inflation-linked rises thereafter will be significantly less generous than for company pensions.

A levy on private occupational schemes will raise £300m a year towards the new fund. Half of this will come from a flat-rate premium, initially set at £10 per member. The other half will come from risk-based premiums, in which firms with under-funded pension schemes pay more than those with better-funded ones.

That sounds a good deal in the circumstances. Too good, say independent pension analysts. Deborah Cooper, an actuary at Mercer, says that to provide cast-iron benefits, the PPF needs pounds 600m a year. But in its first year of operation it will receive just the flat-rate premium, worth £150m. Other actuaries agree: “The PPF is getting off to a crippled start,” says Raj Mody of Hewitt Bacon & Woodrow, who fears that there may be a bulge of claims in the first year, when there is least money to pay out.

Another big worry is how the PPF will invest its money. The plan is that it should be run like a pension fund, investing in equities as well as bonds. Leaders of the actuarial profession have written to the government, expressing their concern about this approach. “If the government doesn't want any risks with the PPF then it should run it like an insurance company and invest in bonds,” says Michael Pomery, president-elect of the Institute of Actuaries. However, that greater security would push up the cost of the levy.

The main concern, though, is ensuring that private pension schemes based on final salaries are properly funded, argues Michael Orszag, research director at Watson Wyatt, an actuarial firm. This will be doubly important once the PPF comes into existence. Insurance creates “moral hazard”: employers may put too little into the pension fund and make risky investments in the knowledge that someone else will foot the bill.

In short, the PPF appears to be offering more than it can provide. Since many of the workers covered will be too young to receive pensions, it should be able to pay immediate claims from its cashflow - the annual levy and income from pension-fund assets of insolvent companies. However, Ms Cooper of Mercer estimates that after ten years the PPF is likely to have built up a deficit - the excess of claims over its assets - of £3 billion in today's money.

The government is ruling out any use of taxpayers' money to bail out the PPF if it runs into trouble. It retains reserve powers to reduce the level of compensation if there are large claims against it. But John Ralfe, an independent pension consultant, thinks this stance will be politically untenable. “When the cupboard is bare,” he says, “who do you look to? You try telling aggrieved pensioners the PPF is not an arm of government.” Mr Mody agrees: “If get-out measures are built into it, this defeats the political purpose of setting up the PPF in the first place.”

The gap between the PPF's aims and means leaves the government open to the charge that it is trying to offer company-pension insurance on the cheap. In the short term, this approach will probably be feasible: pension obligations stretch a long way into the future. However, it stores up trouble for future taxpayers. As so often when politics meet pensions, the temptation to go for the quick fix seems to have proved irresistible.

Article suggests that the UK government is not owning up to the full cost of protecting the promises made by company pension schemes.

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