The products that are guaranteed — to lose you money
COOPER ON CASH KATHRYN COOPER
24 May 2009
(c) 2009 Times Newspapers Limited. All rights reserved
This is the perfect time for banks to flog us guaranteed products — just after the trough of a bear market (we hope), when fear and greed are present in equal measure. Investors don't want to miss out on the potential for a sharp rebound, but heavy losses are still fresh in the memory.
Step up the guaranteed equity bond, or Geb. It offers you the chance to benefit from any rally in the stock market, while at the same time guaranteeing your capital in full.
And it's big business. Barclays alone has a programme to sell £12 billion of such products to even the smallest investors, with the government's National Savings & Investments busy touting the schemes, too.
However, anyone whose friendly bank manager offers them a Geb should look up a recent study by David McCarthy of the Imperial College Business School for the Department for Work and Pensions.
His paper looked at demand for guaranteed investment products and the results were damning. "The robust conclusions of our analysis appear to be that demand for guaranteed investment products is virtually zero for all individuals examined — males and females of all levels of education and wealth — if the guarantees are priced at fair market values ..." In other words, if we all acted rationally, virtually no-one would buy a guaranteed bond. Perhaps someone at the DWP should tell someone at National Savings.
The report looked at the kind of guaranteed bonds typically offered by both high street banks and NS& I. They generally last for five years, after which you get your capital back plus a return based on the FTSE 100 index over that period.
It's rarely obvious to savers that these products carry a very high cost in the form of the dividends forgone, which can amount to 15% to 20% of the initial capital over five years. "I was surprised by the lack of transparency," McCarthy said.
Admittedly, McCarthy carried out the research for the DWP to work out whether guaranteed products should form the default option for personal accounts — the pension schemes into which savers will be automatically enrolled from 2012.
He was therefore assessing them over a period of 30 years, and admits demand may be higher if you need your money back in five years' time.
However, many high-street banks flog these products on a rolling basis, launching a new one just as their last five-year one matures. On that basis, McCarthy couldn't see much demand for the products either inside or outside a pension. Many investors who took out such products after the last bear market are now finding to their cost that these plans are not a panacea.
Take the Woolwich Premium Protected Growth plan, available at the end of 2003. It offered 100% of any rise in the FTSE 100 over five-and-a-half years, plus your capital back in full. It is due to mature in July, and adviser Bestinvest calculates it is unlikely to provide any return. Woolwich, owned by Barclays, will no doubt argue that this is better than the volatility you would have suffered in the stock market over the same period — but with payouts included, the Footsie is up 21%.
And you would have been even better off in cash. At about the same time as its Premium Protected growth plan, Woolwich was paying 4.98% on a fixed five-year bond — or a total return of 24.9% compared with very little from the structured product.
The results of McCarthy's research were so clear cut that he implies guaranteed products shouldn't be allowed anywhere near personal accounts. You'll be far better off with a balanced portfolio of bonds and equities — and deprive your bank manager of a fat 4% commission in the process.
Kathryn Cooper is editor of the Money section
FT REPORT - FUND MANAGEMENT
Guaranteed products 'too pricey'
By Sophia Grene
11 May 2009
(c) 2009 The Financial Times Limited. All rights reserved
Guaranteed products are "too expensive to be attractive to most people", according to research for the UK's Department of Work andPensions.
But most independent financial advisers recommend structured products to clients, another survey finds. More than 90 per cent use them to provide capital guarantees, while 25 per cent like the access they provide to alternative investments such as commodities.
The DWP research, carried out by David McCarthy of Tanaka Business School, focused on guarantees as part of a pension scheme, and looked at the cost of a typical five-year guaranteed capital bond offered by high street banks. It put the hidden cost, in the form of dividends paid to the seller rather than the buyer of the bond, at 15-20 per cent of initial capital invested.
Responding to a post on the subject on FTfm's blog, Stuart Fowler, founder of No Monkey Business, a wealth manager, commented: "To replace long-term holdings with a permanent strategy of rolling over structured products is irrational, as the option cost will broadly match the expected equity risk premium less the costs of the structure."
Mail and Guardian: Money: A flexible national pension plan?
2 July 2008
Recommendations by a leading authority on pension economics go against the more commonly held view that retirement funds should not be accessible before retirement.
David MacCarthy, a senior lecturer in finance at the Tanaka Business School at Imperial College in London, says that experiences in developing economies show compulsory savings are seldom successful.
Encouraging people to save can be done by reducing the cost of saving and providing access to those savings for major financial needs.
MacCarthy says rather than introducing the national social security system (NSSS) as envisaged, the government should focus on the needs of the individual.
"What South Africa needs is a trustworthy, low-cost and easy- to-access savings vehicle," says MacCarthy.
He cites Bolivia as an example of the failure of a compulsory system where less than 10% of economically active people contribute. People find ways to avoid contributing by working informally or for smaller employers.
A recent survey by FinMark Trust showed that lower-income earners prioritise housing and education above long-term retirement savings.
The reality is that for many people in the lower-income groups, the current social old age pension (Soap) will provide a greater income than they earn now.
They are aware also that there is a high chance they might not reach retirement age. It is therefore financially rational for them to prioritise current financial needs.
MacCarthy says because many people in this segment have erratic income, their savings have to be liquid to provide financial assistance during times they are not earning.
If people are forced to place funds in inaccessible, long-term investments, they will find a way to opt out of the system.
The majority of respondents to the Sanlam employee benefits retirement fund survey believed that a national pension fund will have a negative effect on retirement savings. There was also a strong view that funds would experience higher levels of resignations so that people can access their funds prior to the implementation of the proposed NSSS. There were concerns about labour unrest among lower-income earners who would not be able to access these funds.
A retirement survey conducted by Old Mutual showed that 53% of people surveyed had mixed feelings about the NSSS.
MacCarthy says for people to participate willingly, the fund should be viewed as a savings vehicle that can be accessed for major financial needs, such as housing, education and healthcare.
The Singapore pension system is an example of how successful this type of model can be. It has an extremely high level of contribution as a percentage of salary, about 40%. However, members are allowed to access these funds for key financial requirements.
In most cases members access the funds to buy homes, the same priority highlighted in the FinMark Trust survey.
MacCarthy says that although the actual replacement ratio (retirement savings as a percentage of salary) is lower in Singapore, it does not mean the system has failed but rather that it has met the needs of the people. He argues that people are far more rational about their financial needs and will make the correct financial choices.
Costs are one of the biggest hurdles to savings. MacCarthy says an investment with an annual management fee of 1,5% will reduce the total balance of the total value of the investment by 30% after 40 years. This is an area where a central savings pool can be used to reduce costs dramatically.
MacCarthy says the UK is developing a pension system where costs will be reduced to 0,3% a year, meaning the total value of an investment after 40 years will be reduced by only about 8%.
In the UK the fund will be a default option, which citizens can opt out of and elect their own fund.
Experience shows that people tend to stick to the default option simply because they cannot be bothered to make the change. MacCarthy says the same inertia applies to savings.
Although people faced with major financial crisis would go to the trouble of accessing these funds and filling out the necessary forms, it is unlikely that people would go to all that trouble if they just want to buy a car or spend on a higher lifestyle.
David O'Brien, who heads the Old Mutual retirement fund reform team, disagrees. He says the debt crunch has seen many people resigning from their jobs to access their pension funds.
He argues that if people are prepared to risk their jobs to access cash for debts, they would have no problem in dipping into flexible savings arrangements. He says in the South African context where there is virtually no social welfare, access to funds for a life crisis might be necessary. He believes it would be preferable to see a payment of income from the pension fund rather than a lump sum during periods of financial need.
Financial Mail: Not enough to live off.
4 July 2008
The Financial Times Limited. Asia Africa Intelligence Wire. All material subject to copyright. Financial Mail (c) 2008 All rights reserved
RETIREMENT FUNDING Not enough to live off Less than 40% of final income, even after 35 years of saving that's what the average member of a pension or provident fund can expect to receive after retirement. This finding from the 28th Sanlam retirement survey confirms what the industry has been saying for many years: most people are not saving nearly enough. And in most occupational funds membership is compulsory as a result of employment contributions are down but costs are up. Sanlam Structured Solutions CEO Dawie de Villiers says the decline in contributions can be attributed mainly to the drive towards cost-to-company pay structures. Employers offer employees the option of constructing their own employment packages and, inevitably, they choose an option that will give them higher take-home pay. Sanlam Employee Benefits strategy head Elias Masilela (co-author with De Villiers of the report) says the number of retirement funds in SA is estimated to be between 9000 and 13000.
Only 200 funds were consulted for the Sanlam survey. But the 10 biggest funds in SA have as members about 50% of the economically active population, or 3,5m people. The survey looked at a cross-section of funds.
Rowan Burger, head of consulting strategy at competitor Alexander Forbes, says the Sanlam survey is a useful snapshot of the industry but adds: I do think it is difficult to assess any trends from their survey, simply because there is a small, random sample of participants, and any changes over years are more likely to be a consequence of the different sample sets than of actual trends. Alexander Forbes produces a member-focused survey, which Burger says is interesting because it separates the rating factors that affect behaviour such as gender, salary level and age. The argument for focusing research on members is that if they are bearing the responsibility, they need to be informed about the effects of their own behaviour.
The Sanlam survey illustrates how investment risk and costs are passed on to members of defined contribution (DC) schemes, and that the implementation method is horribly inefficient. In defined benefit (DB) environments, members receive a pension according to a formula that is usually a percentage of their final salary, multiplied by the years contributing to the fund. So the employer bears the investment risk.
If most members are still not retiring with appropriate provision, what is the private sector doing with the information? If nothing, who is this stuff aimed at really? Might government do a better job? Masilela says this is a vexing issue, and though it is more a policy question, it does not exclude the private sector from finding solutions.
The Sanlam survey found that members are beginning to express concern about their income at retirement but at the same time, about 60% of members do not understand communication from their funds. Though it has been proved that 75% of members are in effect sitting in default portfolios and have not exercised member investment choice, De Villiers confirms that less than 10% of institutional funds at Sanlam are in passive portfolios.
Pension experts David McCarthy of Tanaka Business School at Imperial College and local consultant Rob Rusconi agree that institutional money would be better off in cheaper, passive (index-linked) investments, which provide returns comparable with those from actively managed investments.
De Villiers says the audience for the survey is a lot wider than principal officers. The point is to say where we are in the industry. How do actions and communications affect members? He concedes that while members receive a lot of communication, they receive much less education on financial matters that is informative and interesting. De Villiers agrees that the private sector is not serving members' needs better. We need to educate more than push products. And bring costs down, of course. Rusconi and McCarthy found that compounding of costs can result in a 20%-30% reduction in retirement benefits.
But De Villiers also adds that the retirement industry is only now maturing in terms of the move from DB to DC, and now we can look at pooling funds into cheaper vehicles.
And at the same time, members should also take responsibility. For example, many are not taking advantage of tax concessions. Most do not know about government's plans for retirement reform and the national savings fund. Of those who do, about 40% said they would rather resign to access their pension benefit than be forced to save it in the national scheme.
But De Villiers says he has a lot of faith in national treasury. The Government Employees Pension Fund is now the biggest and, arguably, the most sophisticated in the country. Desne Masie Dawie de Villiers Make it interesting Elias Masilela A vexing issue
Business Day (South Africa): National pension plan delayed.
19 June 2008
The Financial Times Limited. Asia Africa Intelligence Wire. All material subject to copyright. Business Day (South Africa) © 2008 All rights reserved.
National pension plan delayed Senior Business Writer THE proposed National Social Security System (NSSS) is unlikely to be implemented by 2010 as first expected, and the government favoured a phased implementation of the model, Elias Masilela, a chief strategist at Sanlam's employee benefits division, said yesterday.
An analysis of Sanlam's employee benefits business at a symposium in Midrand yesterday revealed employee contribution levels to retirement funds were equivalent to about a 30% replacement value. A replacement value is a measure of one's income in retirement relative to that enjoyed while working. This figure was low compared with an average 56% among Organisation for Economic Co-operation and Development countries and 75% among north African countries, and taking into account the high levels of unemployment and poverty in SA.
The hope is that the government's proposed social security reform will mitigate this negative trend by compelling every income earner to save for retirement, said Masilela. He said the government was targeting a 40% replacement rate with the NSSS, but 60% would be in line with international trends. David MacCarthy, from the Tanaka School of Business in London, said the proposal for a defined benefit component to the NSSS would have the effect of transferring wealth from the poor to the wealthy. Liquidity in savings was also extremely valuable for poorer people, due in part to factors such as higher mortality. To encourage them to save, the savings vehicle should ensure access to their money if they needed it, McCarthy said.
The key to successful defined contribution systems was low charges. A 1,5% management fee each year would chew up 30% of a fund balance by retirement. The Bottom Line: Page 14
LETTERS TO THE EDITOR
Bad news for actuaries but maybe not for everyone else.
By DAVID MCCARTHY
27 February 2006
(c) 2006 The Financial Times Limited. All rights reserved
From Dr David McCarthy.
Sir, If the introduction of the national pensions savings scheme (NPSS) accelerates the demise of private sector defined benefitpensions, it will be very bad news for the members of the Association of Consulting Actuaries (ACA), which probably explains why they are opposed to it ("Pensions scheme would be mistake, warn actuaries", February 21). Whether this is bad news for the rest of us is a different story.
Many of the proposals of the ACA to reform defined benefit pensionsseem to amount to little more than allowing employers to change retrospectively promises they have made whenever company actuaries get their projections wrong. They give employers the opportunity to introduce yet more opaqueness into pensions that employees already struggle to value.
The ideal occupational pension is one that allocates risk between employers and employees in an economically efficient way. My research for the Department for Work and Pensions on this issue shows that occupational final salary pensions do not achieve this objective: they are a risky (and therefore expensive) way to compensate employees. Unfortunately, many employees and even some employers are yet to realise this.
Defined contribution pensions are more economically efficient than defined benefit schemes for most workers. At least workers who are exposed directly to investment risk in their defined contributionpensions can see clearly what the risk is, and can take steps to reduce it (by, say, investing in low risk assets).
The ACA proposals will give employees the worst of all possible worlds - protection from none of the risks already present in defined benefit pensions, and indirect and opaque exposure to investment and longevity risk.
Viewed against such a pension, defined contribution pensions in general, and the NPSS in particular, actually look decidedly attractive.
David McCarthy, Lecturer, Tanaka Business School, Imperial College, London SW7 2AZ
Financial Adviser: Knowledge not balance will uncover true road to success.
27 October 2005
(c) 2005 Financial Adviser
On 30 August this year, the department for work and pensionspublished a set of three independent reports it had commissioned into hybrid, or risk-sharing, pension scheme designs.
One of these, by Kevin Wes -broom and Tim Reay of Hewitt Bacon and Woodrow, has already been covered in Financial Adviser through an article written by Kevin Wes-broom, so I will refer to it only briefly.
Instead I will concentrate on the reports by Deborah Cooper of Mercer and David McCarthy of Tanaka Business School at Imperial College London, and I will add some observations of my own.
The reason why the government is so interested in hybrid pensionsis quite straightforward. Defined benefit schemes put huge risks on to employers. Defined contribution schemes put huge risks on to employees. Surely there must be some compromise based on risk-sharing which produces an optimum outcome? The search for the Holy Grail of pension scheme design has begun.
The Wesbroom and Reay paper is called Hybrid Pension Plans: UK and International Experience. In its review of other countries, the paper states "in virtually all cases, the hybrid plans that do exist are as a result of constraining legislation".
This suggests to me that employers in other countries, for whatever reasons, are not naturally attracted to hybrids.
They do hybrids only when they must. A clue as to why that might be comes on the following page, when the authors state: "the concept that 'values can go down as well as up' is not widely understood or accepted by the general public in many countries, particularly in Continental Europe." So employers who establish hybrids are offering up a hostage to fortune -" if things work out badly the employees may argue that they had not had the risks properly explained to them in a way they could understand, and this could then form the basis of a claim for compensation. Does this by any chance sound familiar to readers of Financial Adviser?
The paper by Ms Cooper is called Comparing Pension Outcomes from Hybrid Schemes. It summarises the results of an analysis of what pension is likely to be paid to people at retirement, depending on their working history and the occupational pension schemes available to them. There is, not surprisingly, a lot of number crunching in this paper, with the outcomes depicted in several charts. To me the key comments are "pure defined contribution schemes can produce better results than most other designs, with a high degree of probability -" even when the underlying investment strategy is low risk- Thus defined contribution schemes are not inherently poor providers, as they are sometimes portrayed. The difficulty with many of the defined contribution schemes that have been established over the recent past is that they have been used to replace final salary schemes that targeted a high level of benefit".
In other words, defined contribution is a good vehicle in principle, but if you put a lot less in than you put in the defined benefit scheme, you should not be surprised if you get a lot less out.
This observation resonates with the recently-published Association of Consulting Actuaries 2005 Pension Trends Survey report, which has observed average contributions to defined benefit schemes going up from 15.8 per cent in 2002 to 22 per cent today, while contributions to defined contribution schemes still, on average, equate to 10 per cent of earnings.
Out of the total sample of the ACA survey, 82 per cent of the defined contribution-only firms had less than 250 employees -" 96 per cent had fewer than 1000 employees -" and 74 per cent of the defined benefit plus defined contribution firms had fewer than 1000 employees, so these results are relevant to the size of corporate clients of most pensions-specialist advisers.
In the conclusion of Ms Cooper's report, she argues that the degree to which the employer and employees share the risk that a 'target' benefit might not be delivered is fundamental to the variety of outcomes.
A final salary scheme produces a consistent outcome -" as long as the employer does not go bust -" but that misses some of the very good outcomes which defined contribution could produce -" of course it also misses the very bad defined contribution outcomes. From the viewpoint of shareholders in the employer's business, the simple solution is pure defined contribution, since that requires no capital support, but that imposes greatest risk on the employees.
Mr McCarthy's paper is called The Optimal Allocation of Pension Risks in Employment Contracts, and is perhaps the most academic of the three papers. It examines different types of occupational pension for their performance in five different risk areas -" investment, individual mortality, cohort mortality, salary and job tenure. If workers are behaving rationally in an economic sense, which type of scheme should they prefer?
The key conclusion seems to be: "In our model, the optimal pension scheme design was defined to be the one that resulted in the lowest overall cost of compensation for the employer. The pension design which appeared to be the most economically efficient for our base case worker -" a 35-year-old male with median earnings for a male with a degree -" was the pure defined contribution pension."
Mr McCarthy readily admits that there are a number of limitations to his research. For example, it does not allow for some types of scheme -" such as defined benefit or hybrid -" being more expensive to run than defined contribution where the scheme is not very large, but the reverse could be true in very large schemes. Most pensions-specialist financial advisers tend to work at the small to medium end of the corporate spectrum I think, where the running costs of defined contribution will be lower than for more complex benefit structures.
My suspicion is that employers moving from defined benefit tend to regard a hybrid benefit structure as a way of avoiding highlighting the reduction in risk and commitment they are shouldering compared to defined benefit.
Financial advisers could talk to members about the hybrid benefit structures until they were blue in the face, but I suspect in practice the chances of even most sophisticated employees understanding the risk profile and potential range of outcomes are pretty small.
With a lot of communication effort, and with highly sophisticated members, it may be possible to effectively convey the hybrid issues. But there have been at least two very high profile cases -" one a bank and the other a leading firm of accountants -" where lack of employee understanding has been the downfall of hybrid arrangements.
If bankers and accountants cannot get their heads round the risks of hybrids, how on earth can we expect the public to do so?
It is possible to fall into the trap of assuming that the only way to mitigate investment risk is by risk- sharing in the benefit structure, but it is perfectly feasible to mitigate the investment risk in a pure defined contribution scheme.
With life-styling, the fund accumulates in a range of equities until, say, 10 years before the expected retirement date of the member, and is then gradually moved in to a bond-based fund, to more closely match the investments underlying annuities.
The concept of lifestyling is not without its drawbacks, for example when a member retires unexpectedly early, but it can reduce expected volatility of outcome and therefore reduce investment risk, and it is applicable to pure defined contribution benefit structures.
Another concept which is perfectly at home with pure defined contribution is a smoothed unitised investment vehicle.
At its simplest, this could be described as "however far the investment performance is away from 7 per cent a year, what you will get is half way between actual and 7 per cent". In other words, a damper applies to the deviation of investment performance from 7 per cent. I am using 7 per cent as an example -" this figure could be set from time-to-time in the same way that spread betting operates. This concept already exists in the marketplace, and may be thought of as a modern and transparent form of with profits.
Having read the three papers commissioned by the DWP, I am strengthened in my support for pure defined contribution over hybrids.
It may seem harsh to say to employees: "Here is my employer contribution, but after that you are on your own", but at least it is hard to misunderstand. What these reports demonstrate is that, in many cases, it might also actually turn out to be the best value for all concerned.
Stewart Ritchie is director of pensions development for Scottish Equitable
Pensions Week: News: Business schools join chorus of disapproval.
10 October 2005
(c) 2005 Pensions Week
Academics have attacked the government's Pension Protection Fund (PPF) levy proposals, saying it will hit the weakest schemes the most.
Anthony Neuberger at Warwick Business School and David McCarthyat Tanaka Business School, Imperial College criticised the PPF levy structure, saying the burden will fall on weak schemes.
Calculations based on figures in the PPF's consultation document implied that a quarter of the levy will be taken from just 4% of schemes, while the strongest 50% of schemes will only pay 15% of the levy.
Neuberger and McCarthy argued that the weakest schemes will struggle to pay and said the assets would otherwise be used to reduce scheme deficits.
The academics went on to argue that the proposed levy is volatile and unpredictable, particularly for schemes with weak sponsors.
Historical evidence suggested that a quarter of weak sponsors are downgraded, and under PPF proposals downgrading is likely to result in a significant increase in the levy.
They said that it was also unclear how strong the PPF would stand when faced with large claims and questioned whether it would face similar problems as the Pension Benefit Guaranty Corporation in the US.
Although the PPF has said that any levy increase would be on a pro-rata basis, Neuberger and McCarthy said with the levy falling so heavily on the weakest schemes, it is questionable whether the PPF would be able to raise the levy substantially without causing a high level of damage to these schemes.
Academics cast doubt on pensions 'lifeboat'
20 April 2005
(c) 2005 Times Newspapers Limited. All rights reserved
Government's Pension Protection Fund is not "politically feasible or
economically sensible", a leading academic said yesterday. David McCarthy, a lecturer at the Tanaka
Business School at Imperial College, London, said the PPF was likely to face
"many years of low claims interspersed irregularly with periods of very
that, because UK pension funds have invested about 60pc of their assets in the
stock market, a vicious cycle had been created. "If [pension fund]
defaults are high, then equities will be very low and so pension funds will be
underfunded. So the PPF will be lumpy," he said.
paper written with Anthony Neuberger, he wrote: "We suggest the magnitude
of the claims in unstable periods will be so large that it will not be
politically feasible or economically sensible to build up reserves to meet
similar situation occurred with the US Pension Benefit Guaranty Corporation,
which had average claims of only $300m a year between 1980 and 1999, but which
now has a $23.3billion deficit.
paper, which will be published in June, continues: "When such a crisis
does occur, it may well be impossible to meet claims by a steep increase in the
levy on employers. It is hard to see any alternative to the Government's
attack comes after Standard & Poor's predicted the PPF would have
liabilities of almost £900m a year, forcing it to raise its annual £300m levy
on companies with final-salary pension schemes..
Pensions fund remains unfair;Business editor's commentary
29 September 2005
(c) 2005 Times Newspapers Limited. All rights reserved
PROTESTERS staged a mock mooning on Brighton beach this week to demonstrate their resentment over the loss of their company pensions because of the collapse of the companies themselves. The protesters are waiting for compensation through the Financial Assistance Scheme, although it is apparent that it is already woefully underfunded.
The Pension Protection Fund (PPF), trumpeted at the Labour conference as the Government's way of ensuring that corporate collapses will not leave pensioners unprovided for, also looks to be heading for financial meltdown.
It seems Turner & Newall's scheme is close to being tipped into the PPF, bringing with it costs that could top Pounds 125 million. Yet it is only the biggest in a queue of funds lining up to be bailed out by corporate colleagues. The estimated cost to business has already doubled from Pounds 300 million to Pounds 600 million. But there are some who doubt whether, in its current design, the PPF is workable.
A new paper argues that the levy system, which collects proportionately more from weaker funds and less from stronger ones, is flawed. It claims that, if the weaker funds do pay the levy, it will be at the expense of topping up their ailing pension funds -so it risks quickening their arrival in the PPF.
The paper -by Anthony Neuberger, of the Warwick Business School, and David McCarthy, of the Tanaka Business School at Imperial College -is a response to the Pension Protection Levy consultation. It risks drawing the wrath of those companies that have better-funded schemes and are already angry about being forced to pay a levy towards supporting the funds of companies that have been less prudent. The suggestion that the levy should be tilted so that a higher proportion of the burden falls on them would persuade some companies that they should try to exempt themselves altogether by winding up final salary schemes.
But bailing out pension schemes that may have been underfunded for many years is an expensive business. According to Mr Neuberger, either the taxpayer will have to do it or business will.
It is logical that stronger businesses will be in a better position to do this than businesses that are struggling, and have been given the thumbs down by the ratings agencies that will be pivotal in determining the risk-based element of the levy. It would not, however, be seen as anything like fair.
(c) Times Newspapers Ltd, 2005
FT REPORT - FUND MANAGEMENT:MARKETPLACE
MARKETPLACE: Equity falls may ruin PPF.
By BRENDAN MATON
16 May 2005
(c) 2005 The Financial Times Limited. All rights reserved
The new Pensions Protection Fund faces a lethal combination of rising claims and weak sponsors if there is a sustained decline in equity markets, according to two leading academics.
Professor Anthony Neuberger of Warwick Business School and David McCarthy of the Tanaka Business School, Imperial College reckon that in a worst-case scenario claims on the PPF would rise to 30 times the average.
To cover such liabilities, the PPF would need reserves in place worth 24 years of average contributions.
"It's a horrible claims profile," Mr Neuberger told the National Association of Pension Funds conference in Manchester last week.
Mr Neuberger and Mr McCarthy contend that the PPF could enjoy long periods of calm when it deals with only small claims. But when equity markets suffer long periods of depreciation, sponsoring companies would be weaker.
Pensions Management: Feature: Pension Fund Insurance Will the PPF go the way of the US fund?
Dr David McCarthy and Anthony Neuberger
5 April 2004
(c) 2004 Pensions Management
The Pensions Bill currently going through parliament establishes a Pension Protection Fund (PPF). The PPF will protect members of defined benefit schemes where the sponsor becomes insolvent and there are insufficient assets in the scheme to cover the liabilities. The PPF is modeled on the Pension Benefit Guaranty Corporation (PBGC), the body set up in 1974 to guarantee defined benefit pension plans in the US.
The PBGC is a worrying exemplar. After many years of low claims, and building up a surplus, the PBGC has suffered three years of extremely high claims. It is now $11bn in deficit. With an annual premium income of under $1bn a year, there is concern about its solvency, and whether some form of government bail-out will be necessary. In the words of its chairman, Elaine Chao, who is also the secretary for labour, "it is clear that the financial integrity of the federal pension insurance system is at risk."
In creating a similar body here, are we in danger of experiencing similar problems? Is there a substantial risk that the PPF will face very large claims that cannot be readily met from a levy on the industry, and will ultimately fall back on the public purse? Or are the problems of the PGBC specific to the US, and unlikely to be repeated here?
Our research shows that what happened in the US could well happen here. Claims on the PPF arise when firms go bust. Firms do not go bust at a steady rate; in times of financial distress the rate of insolvency rises sharply.
According to Moody's, bond defaults globally were three times as common in the last five years as they were in the preceding, more benign, five year period.
But it is not simply the clustering of insolvencies that causes bad claim periods. Insolvencies are much more likely in a period of stock market weakness because companies facing funding problems will be in a poor position to raise cash by selling assets.
But after a period of steep decline in stock market prices, most pension funds will be in severe deficit. Analysis by Watson Wyatt, looking at company balance sheets in 2002/3, shows that after the bear market of 2000 to 2003 the median FTSE 350 company had a deficit in its pension fund equal to one quarter of its liabilities.
A simple model of pension insurance that we have developed shows that the problems experienced by the PBGC are not simply the result of bad luck. In a severe financial downturn claims on the PPF will be much more frequent, and also much larger, than normal.
The extreme lumpiness of claims is an inherent property of any pension insurance body. The PPF will be characterized by many years of small claims interspersed with rare and unpredictable periods of exceedingly large claims. These periods will occur when the stability of the whole of the financial sector is under maximum strain.
We have used our model to simulate the claims experience. Our results are shown in table one. They suggest that the worst year in a 30-year period is likely to have six times the average annual claim rate.
It is not inconceivable that the worst year could have 20 times the average annual claim rate. If the PPF is to ensure it has enough funds to meet these bad years, it will need to build up reserves of the order of 20 years of average claims. This does not look politically acceptable.
But if the PPF does not pre-fund, it will have to borrow and raise premium rates after a period of high claims. This is also problematic. The increase in premium rates would have to be large. The rise would occur at a time when many firms are close to insolvency, their own pension schemes are in heavy deficit, and they are under strong pressure to rebuild solvency.
The pressure for a public bail-out of the PPF may becomes irresistible; the alternative of letting the PPF itself default is unthinkable.
What can be done to avoid going down this road? Limiting the degree of under-funding is critical. Risk-rating PPF premiums would help a bit, with schemes that are under-funded paying higher premiums. But if the risk-rating is to be effective in encouraging weak sponsors to fully fund their schemes, the premium has to be very high.
The PBGC has risk-rating, but it has not been very effective; the additional premium they charge is 0.9%/year of the deficit. A financially distressed firm will find it cheaper to borrow from its pension fund at a 0.9% premium than borrow from the market, and thus will have no incentive to repair any holes in its pension scheme.
The PPF must be introduced in tandem with strong minimum funding requirements. While the Pensions Bill provides for scheme-specific minimum funding requirements, none of the details have been spelt out. The requirements will need to ensure that pension schemes have sufficient assets to buy out the PPF-guaranteed liabilities at all times. This is reminiscent of the old minimum funding requirement (MFR).
It is ironic that the government has only just agreed to scrap the widely unpopular MFR, only to be forced to introduce it in somewhat modified form to prevent the PPF being a large systemic risk to the sector as a whole.
One of the most disliked features of the MFR is the way that any scheme close to its MFR level would have to either invest almost entirely in bonds, or face a highly erratic contribution level. The new scheme-specific funding requirement, if it is to protect the PPF from huge claims, will have exactly the same effect.
One way of mitigating the impact of the funding requirement on investment strategy would be to reduce the level of benefits guaranteed by the PPF. For then a pension scheme would typically have assets substantially in excess of the level required to buy out the guaranteed liabilities, and would then be relatively unconstrained in their choice of investments.
A generous PPF with weak funding requirements poses a risk to the health of all sponsors of DB pension schemes, and may ultimately lead to a substantial call on public funds. To contain this danger, the level of pensions guaranteed by the PPF need to be restricted. Strict funding requirements will be necessary to ensure that in general schemes can at least buy out the guaranteed liabilities. These may force weaker schemes to cut back their equity exposure.
Dr David McCarthy is a lecturer at Tanaka Business School, Imperial College and Anthony Neuberger is associate professor of finance at London Business School
Pensions Management: Perspective: Wanted: a vision for pensions.
Matthew Craig, editor|(AA)in|(AA)chief
5 April 2004
(c) 2004 Pensions Management
There is a desperate need for the government to show long-term vision in creating a stable framework for pensions and imagination in dealing with the current problems affecting pensions. Unfortunately, neither quality is currently on display.
Most commentators outside Whitehall agree that the presentpensions system discourages many people from saving and is unsustainable in the long-term. At the same time, the government's inability to think or act constructively is draining the reservoir of public confidence in pension saving. The twin disasters of Equitable Life and the loss of pensions at underfunded final salary schemes with bankrupt employers illustrate this latter point.
The government's response to the Penrose report was on narrow party lines, with blame heaped on 'the other lot', rather than imagination being applied to find ways of restoring public faith inpensions. Pensions are a long-term commitment and people need to be able to trust that the money they save today will be there in 20 or 30 years, if not longer. As we could be moving into a more volatile world, the past stability of the life office sector may be fading, so confidence building will become important.
Similarly, the first debate on the pensions bills saw the government repeat its line that the taxpayer should not pay compensation for private sector scheme collapses. Morally, the case for compensation is strong, as many speakers in the Commons made clear. The government may also face a legal challenge over its implementation of European rules to safeguard pensions. But so far it has refused to take the opportunity to help the many employees who have lost theirpensions. Again, confidence is eroded.
Combined with the declining propensity to save, a severe loss of confidence in pensions could create a long-term disaster in the UK'spensions policy. The new pensions bill and simplification may create the foundations for pensions saving, but confidence in the system is the glue that holds the structure together.
In contrast to the lack of imagination in most government thinking (aside from the radicalism of the Inland Revenue's simplification proposals), the pressures of the past few years have forced many at the pensions coalface to come up with new ideas. This is shown in this month's roundtables on the future of fund management and outsourcing.
PM this month also carries special features on scheme communications and retirement income solutions, bringing you useful information and comment. In all cases, we are very grateful to our sponsors.
Also in this month's issue, academics David McCarthy and Anthony Neuberger consider the strength of the PPF proposals, while PM's Katie Hope looks into the opaque world of investment fees and the working parties of the Raising Standards campaign report on progress to date.
Finally, this month's issue carries a reminder that we will soon be looking for entries for this year's Pensions Management awards for pension scheme excellence. As the article on page 14 says, this is a great way for schemes to get recognition for all their hard work. Schemes that enter are entitled to two places at the awards presentation in October, an event not to be missed.
We will also be running our technology awards for products and services that make life easier for IFAs, so if you want to get involved in these awards, see page 14 and register your interest.
Pensions Week: News: PPF - PPF needs govt support, experts state.
26 January 2004
(c) 2004 Pensions Week
Two leading academics have said the proposed Pension Protection Fund (PPF) will not work without an implicit government guarantee and adequate funding of pension schemes covered by the insurance scheme.
Their findings are unlikely to please the Department for Work andPensions (DWP), which has ruled out government backing for the PPF, which is planned for a 2005 launch.
Anthony Neuberger of London Business School and David McCarthyof Tanaka Business School, Imperial College, presented research last week into the pricing and design of pension guarantees.
They concluded that the PPF needed huge reserves if it was not to go into deficit. They also found that it would be very difficult, if not impossible, to set true risk-related premiums for the PPF.
As a result of this, government funding is likely to be necessary and cross- subsidies would exist between schemes if smoothed premiums are charged. To control the risk of moral hazard, where underfunded schemes take advantage of the PPF, Neuberger and McCarthy said schemes would need to have adequate funding and regulation to require this would be a necessity.
According to present estimates, UK defined benefit (DB) schemes which will fall under the PPF have combined liabilities of GBP600m, with the largest 20% of DB schemes owning 80% of liabilities.
Neuberger said: "An extreme risk-rated premium is not practicable and can't be calculated. The amount charged would go up and down all the time, so there would be very little benefit to the insurance."
He also said linking PPF premiums to credit ratings contained political and practical problems and would not be a fair charging basis.
Speaking at a seminar where the research was presented, DWP chiefpensions economist Robert Lazlett said that while the broad shape of the PPF had been decided, many critical details had not and that the DWP was still in listening mode.
Watson Wyatt worldwide partner Syl Scheiber said the main lessons of the US pension scheme insurance plan, the Pension Benefit Guaranty Corporation (PBGC), were that either premiums had to be risk-related or that schemes had to be adequately funded.
The PBGC currently charges a premium of $19 per head, plus 0.9% of unfunded liabilities. It covers 44 million workers at 33,000 pension schemes and currently pays $2.5bn in annual benefits to 450,000 retirees at 3,200 plans.
Despite fears over the current deficits in the PBGC, Scheiber said it had overcome worse funding problems in the seventies and eighties than those it currently faced.