Some unpalatable pension arithmetic

There are so many fronts in the Armageddon in which the Irish economy is now engaged that some have received less attention than they deserve. The pensions’ crisis is an example. As most of the contributors to this Blog can look forwarding to drawing public service pensions – or like are already doing so – they might not be personally too concerned about the situation facing members of defined benefits schemes that have to rely on employer and employee contributions to meet their liabilities.

The collapse of equity prices has devastated the asset side of pension schemes’ balance sheets. In line with the conventional belief in a long-run “equity premium”, most schemes had between two thirds and three quarters of their assets in equities a few years ago. To make matters worse, the “home bias” of most Irish schemes led to an overconcentration in Irish equities, whose recent performance has been among the worst in the world. As a result, over the last eighteen months the assets of typical Irish pension funds have declined up to forty per cent. All the gains of the bull market of the 1990s have been erased, and in many cases asset values are back to where they were ten years ago but liabilities have continued to grow. Ominously, the annual average return to diversified portfolios over the past ten years has been less than the annual rate of inflation.

To this equity shock should be added a “longevity shock” –the good news on the demographic front has added more years to life expectancy over the past ten years than over the previous twenty and Ireland in particular has been enjoying a catch up with the most advanced countries on this front. Actuaries have to take account of the impact of this on pension schemes’ liabilities. About two years have been added to life expectancy at age 65 since the start of the century – equal to an increase of about twenty per cent in the life span of a pensioner.

And if this were not enough, there is the prospect of lower term “risk free” interest and annuity rates, which will inflate the present value of pension fund liabilities.

So there has been a perfect storm in this area too.

The legislation governing defined benefits schemes stipulates that pensioners have a priority claim on the scheme’s assets. Contributing members take second place in the queue. As a result, the developments outlined above have devastating implications for contributing members.

To give a very simplified example, consider a scheme that roughly balanced its assets and liabilities at €1 billion in early 2007. The scheme was mature in the sense that roughly half of its liabilities were in respect of pensioners.

Assets

Liabilities

Total €1 billion

To pensioners

€0.5 billion

To contributing members

€0.5 billion

Focussing exclusively on the decline in asset values – leaving aside the impact of increased longevity and falling interest rates – the situation at end-2008 would be:

Assets

Liabilities

Total €0.6 billion

To pensioners

€0.5 billion

To contributing members

€0.5 billion

The priority claim of pensioners on the assets will absorb €0.5 billion, leaving a residual of only €0.1 billion to cover the entitlements of contributing members. This represents only 20 per cent of their accrued benefits.

Long-serving members of a scheme like this should be very worried indeed. Their plight is a time bomb ticking away that has been somewhat ignored in light of all the other economic concerns we are facing. While there are as yet no precise estimates of the size of the aggregate deficit in these schemes, the total certainly exceeds the amounts being used to recapitalise the banking system.

What can be done? If pension schemes fail to meet a statutory minimum funding standard (MFS) each year, they must prepare a funding proposal to employers and members that will address the deficit over a medium term horizon. In the course of 2009 the Pensions Board will be receiving a steady flow of reports from schemes that do not meet the MFS and hence are technically insolvent. Short of a sustained and massive stock market recovery in the New Year, the scale of the contributions increases that would be required to redress the deficits is enormous and unlikely to be acceptable to hard-pressed employers and employees. This raises the spectre of large scale closures of defined benefits schemes, which would have serious social repercussions.

The issue of the potential inequity in the treatment of contributing members relative to pensioners will come to the fore as schemes are being wound up. It is hardly acceptable that someone with twenty or thirty years’ membership of a scheme should be entitled to a mere fraction of what they believed they had accumulated as pension entitlements.

Happy Christmas and a better 2009!

3 thoughts on “Some unpalatable pension arithmetic”

  1. This post raises a host of important questions. While it is clear that raising the retirement age will be part of the long-term response to improved longevity and the improved health status of older people, this does not resolve the funding problems for those retiring over the next 5-10 years. An interesting dimension is what is the appropriate expectation concerning living standards for retirees. Of course, this is a central issue in terms of public sector pensions – should pensions be stabilised in terms of the real (ie inflation-adjusted) income level, or should the current indexation to occupational earnings be retained? Of course, the prospect of deflation plus public sector wage cuts may alter the answer!

  2. Brendan’s post and Philip’s comment raise two further issues.

    (i) Why are (fragile) business corporations regarded by policymakers and trade union officials as credible residual guarantors of long-term pension liabilities? I recall posing this question at some conference or other many years ago and being told that ‘large’ employers, such as the banks, were credible, but ‘small’ employers less so! There is an enormous fallacy of composition in the macro design of occupational pension schemes, in that the circumstances of equity market collapse are precisely those in which the residual guarantee is required, and impossible of delivery.

    (ii) Why don’t pension fund trustees put more of the funds in index-linked gilts? Why don’t Governments issue more?

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