Economy

How secure is your benefits plan?

They are often described as ‘gold plated’ or ‘guaranteed’. They are certainly ‘generous’. Today they are as rare as chicken teeth. But the recent crisis that hit the pension sector after Kwasi Kwarteng’s disastrous mini-budget in late September has raised concerns about how safe occupational defined benefit pension plans really are.

The collapse, which led the Bank of England to prop up the markets, revealed an astonishing and previously unknown level of leverage – borrowing – hidden in the occupational pension system.

Financial watchdogs admit they were unprepared for the sudden sell-off of government bonds (Government IOUs), which led corporate pension funds to sell assets at burning prices, as investors were shocked by the unfunded tax cuts Kwarteng proposed.

Consequences: Former Chancellor Kwasi Kwarteng delivers his ill-fated budget

Regulators now admit they were unaware of the magnitude of the leverage built up as a result of commitment-driven investment (LDI) strategies employed by pension funds, designed to keep their funding levels healthy so they could deliver the promised future able to meet payments.

Just a few months ago, almost no one had heard of LDIs, not even the pension fund managers charged with advocacy for members.

It was “an acronym few of us knew, but now many of us have read about it,” said Lord Hollick, co-chair of the House of Lords’ Committee on Economic Affairs. His committee has now launched an investigation into what went wrong, one of many ongoing.

Due to the chaos, the assets of many pension funds have fallen in value. So should the ten million participants in these defined benefit schemes be concerned? And if so, what can they do about it?

A QUICK RE-CAP OF HOW WE GOT HERE

Until ten years ago, defined benefit occupational pensions were commonplace.

Payouts are based on the number of years an employee has worked and, usually, their last paycheck at retirement. Once retirement income is taken, it is typically linked to inflation until you die.

It is crucial that the investment risk of such schemes is borne by the employer. That means employers have a financial and legal obligation to pay a defined benefit pension, as and when it is due.

As more of us live longer, this has become increasingly expensive for most companies to comply with.

As a result, many have closed these plans – both for new employees and for further retirement contributions from those with existing benefits in the plans.

New entrants are now offered cheaper and less generous ‘cash purchase’ or ‘defined contribution’ plans instead. Here, the employee assumes all investment risks, with the employer contributing to the plan on behalf of the employee.

But existing commitments by companies to pay pensions in defined benefit plans still need to be fulfilled in a timely and complete manner.

So fee-based investment advisers devised LDI strategies for defined benefit pension funds to limit the cost of an estimated £1.4 trillion in future pension benefits. By using leverage to increase the returns on gilts and other assets like stocks, the companies behind the retirement plans were able to limit the amount of money they had to put into the plans to close any funding gaps.

This cost-cutting approach proved extremely popular, especially when interest rates were stable and ultra-low. About 60 percent of the company’s 5,200 defined benefit plans now use LDIs.

But LDIs came loose after the mini-budget led to an unprecedented sell-off in government bonds, as investor confidence in Liz Truss’s government ebbed and the cost of government borrowing skyrocketed.

The sell-off forced many pension funds to sell gilts to raise cash quickly to meet the cash demands of the banks they borrowed from.

As the price of gilts fell, a doom loop was only averted when the Bank of England staged a £19bn bailout package.

Analysts at JP Morgan initially reckoned the fateful sale would cost pension funds up to £150bn, though they’ve since revised that figure by half as markets recovered.

In recent weeks, a number of large companies have detailed the blow they have received. The BT pension fund, the UK’s largest defined benefit scheme, says it has lost £11bn amid the market turmoil.

The value of the telecom giant’s pension fund has fallen by more than £21bn since June last year, nearly 40 per cent, as a result of its LDI strategies.

BT seems comfortable with this, saying its strategy has ‘performed as intended’ and its funding position has not deteriorated. To be clear, there is no danger of a plan going bust.

In fact, in the Alice-in-Wonderland world of pension accounting, the funding position of many plans has improved as their liabilities have declined faster than their assets.

The latest figures from the Pension Protection Fund (PPF), which guarantees the pensions of failed companies, show that pension funds have a surplus of £375 billion.

In that sense, LDIs did what they were supposed to do, even though the PPF admits it doesn’t have enough data to accurately assess the impact of leveraged LDIs.

“People really shouldn’t be concerned if there are short-term fluctuations in the value of assets held by their defined benefit plan,” said Tom Selby, head of retirement policy at investment platform AJ Bell. ‘Actually, this is part of investing for the long term. The aim is to achieve growth over decades and to offer retired participants a pension income.’

He adds: ‘What really matters is the financial strength of the company behind the pension scheme.

‘If an employer remains solvent, he is legally obliged to pay out the promised pensions.

‘If your employer goes bankrupt, you may see a decrease in the value of your pension, although the PPF will still act as a valuable lifeboat for benefit participants.’

ONE FINAL THOUGHT

Perhaps the real damage caused by the LDI saga is reputational rather than financial.

After a series of pension scandals from Robert Maxwell and the Mirror pension fund to Equitable Life and, more recently, BHS and British Steel, consumer confidence in pensions, already fragile, has taken another hit.

But that should not lead to hasty decision-making, warns Selby.

“While there may be valid reasons for leaving an occupational pension scheme, they will generally be related to personal circumstances rather than the finances of the scheme,” he says.

He adds that someone who is in poor health, or wants to prioritize the efficient passing of money to loved ones in the event of death, could benefit from a pension transfer.

But in most cases, the best advice is to keep your available benefit where it is.

As for those in defined benefit pension plans in the public sector, LDIs are not a problem. The government will always be there to ensure that your promised pension is paid.

Some links in this article may be affiliate links. If you click on it, we may earn a small commission. That helps us fund This Is Money and use it for free. We do not write articles to promote products. We do not allow any commercial relationship to compromise our editorial independence.

Show More

Jacky

The author of what'snew2day.com is dedicated to keeping you up-to-date on the latest news and information.

Related Articles

Back to top button