Looks interesting: the future of pension scheme assets

For Finch, a longer term “look-ahead” at the prospects for the position of UK final salary pension plans does not look all that depressing. In fact, he remains cautiously optimistic ­ and not just because in the worst case scenario, pensions cease to matter.

“Look at it like this. There is a tremendous international effort going on which should stop matters from getting much worse. If these efforts fail dismally, then pension scheme deficits will be absolutely the least of our problems,” he says.

In that kind of meltdown people have to live purely for the hour ­ there is just no place in chaos for thoughts of a well-funded retirement.

If gilt yields start rising, that would help restrict the rise in the value of scheme liabilities by limiting the absolute fall in corporate bond yields once the premium over gilts starts to unwind.

“We have seen short-term interest rates move from 4% to 1.5%,” says Finch, “but the long government bond yield today is above where it was at the end of 2007.” At that time, the 15-year government bond was yielding 4.35%. As of the end of January, it was 4.48%, up from a low of 3.8% at the end of December, so gilts are on the rise.

“The only way they will fall is if we have another ‘flight to quality’. If that happened, the impact on the global equity markets would be dire indeed. But, once again, if things get that bad we won’t be talking about pensions, but about how to survive today,” says Finch.

Inflation fears
However, rising yields could signal greater inflation in future which would increase scheme liabilities, at least partly offsetting the benefit from rising yields. On the inflation point, Finch adds that auditors need to be a little less rigid and formulaic when analysing the way companies are accounting for their pension liabilities.

“When you are projecting inflation over a 20 to 30-year period ­ over the scheme’s remaining life, in other words ­ a movement of one percentage point upwards or downwards in your inflation assumptions can move your liabilities by 20%.”

Christopher Clayton, head of pensions advisory at Close Brothers, is much less sanguine than Finch in saying the worst of the problems are now over for FDs. He says it is undeniable that many UK final salary schemes are now back where they were four or five years ago and all the hard work of boards of directors and trustees to plug the deficit gap has been wiped away. It is not just the market crash ­ longevity increases, too, have wrought havoc. There are just too many key figures in the scheme calculations that are heading off in directions that are bad news for scheme liabilities ­ the current movement in AA-rated corporate bonds being the exception that proves the rule.

“Take Babcock International,” says Clayton. “Looking at its 2008 annual report and accounts, what it says is that if the total life expectancy figures it uses in its scheme are wrong by as little as half a year, that will add £42.5m to its debt.” Clayton points out that it is important to remember that pensions and pensions planning have a contingent universe as their backdrop and anything can and might happen.

“The bigger issue ­ much bigger than fund deficits ­ is what happens to the insurance companies that have written the annuities that underpin the benefits of retired members and that will provide the annuities for those retiring in future, if longevity goes up sharply. If we all live to 110 they will simply not be able to afford to pay out on their annuity promises,” he says.

So forget plunging equity values, the one thing that really gets FDs worked up is longevity. “The classic push-back from a finance director is: ‘My employees will never live that long’. Actuaries, however, respond by saying, ‘You can’t be sure’. The point is that the numbers in the actuarial tables are based on the actual experiences of men and women whose youth lies 50 years in the past. Dramatic changes in lifestyle can throw out those numbers hugely.

“Buyout firms such as Paternoster tend to be very guarded about how they arrive at their assumptions for longevity, but, generally, the tables are based on actual increases in longevity and they underpin the assumptions people make. The assumptions are not based upon looking ahead to the technology in the labs,” Clayton says.

The nub of the matter, for finance directors, is that there is just too much that is unpredictable about all this and, as such, this is not a risk they want on their balance sheets. The National Association of Pension Funds says 25% of companies in the UK will close their schemes during the course of this recession. Clayton argues that this probably understates matters quite considerably. There’s certainly nothing boring about the pensions environment today, but FDs could do without the Chinese curse of living in such interesting times ­ and for so long.