July-August 2011

LIABILITIES: Cushy retirement – a thing of the past

Braking-freeLord Hutton’s proposed changes to the state pension system could have considerable implications for the public and private sectors’ schemes, writes Dominic Wallington of RBC Asset Management.
The new government, which many thought would muddle through as an unwieldy coalition, has surprised with its cohesiveness, sense of purpose and levels of confidence. While elements of the fiscal deficit remain cyclical, the real future net liability for the British economy remains the welfare state. It is likely that altering the fabric of his structure will continue to be the priority for a muscular government with deficit reduction as its primary focus and an intention to roll back the state. The implications of this for public and private sector pensions are likely to be considerable. Lord Hutton’s recently-published paper, Independent Public Service Pensions Commission Interim Report), has proposed significant changes to the state pension system. The debate around the nature of reform has been galvanised by what many consider to
be a high degree of generational inequality. Youth politics is currently focusing on the reduction of educational subsidisation but may well switch to a focus on the fact that the wealth of the nation is peculiarly tilted towards that portion of the population that was entitled to free higher education, benefited from a secular bull run in housing and is now drawing down final salary pension schemes. Yet despite reforms, these pension rights are still generally considered as sacrosanct, as free education was in the past. It is unclear how effective the democratic process can be at implementing change when the Government has to provide the electorally unpopular message that tomorrow may well deliver a lower standard of living. But there will be many whose sense of entitlement can no longer be met if the current economic environment is not subject to improvement. It has to be remembered that the payment of tax represents a social contract between people who neither know each other nor may have much in common in terms of age and outlook. The gnawing need for security that characterised and bound together the generations that had gone through the Second World War is no longer understood by those who have been swaddled by a welfare state that was set up to address the problems of what most consider to be a bygone era. If we add to this issue the fact that the burden will be borne by a smaller percentage of the population as the baby boomers retire,  then it is easy to see a situation whereby the further dismantling of the welfare state has more general support than would be first supposed. The question is really, how and at what speed will this course of events unfold? A broad recognition that the general intention to provide decent pensions became specified too extensively into the guarantees of the final salary schemes led to a phasing out of this approach to new workers in the private sector. However, despite some changes, this structure still broadly exists, on an unfunded basis, in the public sector. Lord Hutton’s proposals to replace final salary schemes with career average pensions seeks to correct a status quo described as “untenable” in his report. Those with a political axe to grind about the welfare state at both ends of the spectrum always mention the pension rights of French railway workers when talking about the inefficiency of the public sector or the rights of workers. The truth is more prosaic. When pension plans for railway workers were set up, early in the 20th century, they had heavy manual jobs and generally started work in their teens. By the time they retired, aged 55, they tended to be exhausted and, as a whole, only lived ten years or so beyond the age of retirement. This is no longer the case. Those who have a sense of entitlement to this scheme now are as misdirected as those who saw it as symptomatic of a flawed system. All it tells us is that when the circumstances change, so must the assumptions that build the infrastructure. In the same manner, the French government’s organisation of a structural default on its future liabilities by changing its retirement age from 60 to 62 years old in the summer of 2010 was motivated by the fact that because people are living longer, there is a greater pension cost. This demonstrates that final salary schemes are not the only issue, but longevity is also an important consideration. The UK government followed its French counterpart by reducing the level of inflation protection available to pensions in the public sector by changing the measure from the retail price index (RPI) to the consumer price index (CPI). It is entirely possible that this is the start of a creeping reduction in the rights of retirees. Hutton’s report has suggested that public sector workers pay more of their salary into their schemes, retire later and move to a government-guaranteed pension based on the average earnings over a lifetime. This last measure would obviously favour lower paid employees. It would be unacceptable to suggest that this will not impact on the retirement prospects for those affected but, presumably, the Government feels that if it has lower future net liabilities it will have greater flexibility to give assistance where needed and will be operating from a more sustainable base. These measures will also improve the otherwise intractable levels of inter-generational inequality. We have seen an immediate impact in the private sector as well, given that British Telecom (BT) was able to apply the Government’s indexation policy changes to elements of its pension plan because of its history as a public utility, thereby, at the stroke of the pen, saving nearly £3bn (€3.4bn). Alternative approaches
For many years BT had seen its share price react more extensively to the ebb and flow of its pension liability than to its operating environment – understandable, given that this deficit stood at nearly £8bn in mid 2010 and the company was putting £500m cash into the scheme each year. As analysts have factored in this deficit change and the resulting increase in the net present value of the business, BT’s share price has reacted very positively. It is entirely possible that other companies in the private sector will be able to follow suit, but it will be dependent on the individual scheme rules, and often these are not made public. It appears feasible that privatised companies that have schemes little or unchanged from their public sector days are most likely to benefit, but investment analysis of this theme will have to be very bottom-up in nature. What is more likely to happen is that existing final salary schemes in the sector become extinct over the next decade or so. Higher regulatory requirements on such schemes have also imposed pressure by requiring they are managed along insurance company lines so that if the company disappears, the pension fund has sufficient assets. Diageo, the alcoholic beverages firm, has responded innovatively to this by handing its pension scheme £430m worth of maturing whisky in 2010 with an agreement that the company would pay the pension fund a fee every year for the right to use the assets. This “sale and drink-back” scheme will likely be copied by other companies keen to accelerate conservative funding while not wishing to use cash because the regulations make it difficult to remove it should the scheme move into surplus. This form of pension solution
will provide better clarity for shareholders as well in terms of how and where the cash in many companies is utilised. In the final analysis, we have a new and aggressive government determined to address the deficit. We have an ageing population and, therefore, a greater tax burden on the working population, most of whom will not see the level of retirement benefits available to those who are currently retired or who will shortly retire. This is unlikely to lead to a land grab of wealth from the older generations, but we will probably see a continued creeping reduction in the rights of retirees in the public sector which will reduce the future liability and, therefore, the burden to younger generations. The private sector has already converted much of the pension risk to the individual through the defined contribution framework and the remaining final salary schemes will disappear over time. Innovative approaches to outstanding liabilities will clarify to management and shareholders how corporate cash flows will be applied and the regulatory environment will lead to the earlier adoption of conservative funding of defined benefit schemes. These sorts of moves, if handled correctly, could lead to a simpler, fairer pension structure in the public and private sectors and could also mean that the current short-term obsessions over discount rates and investment returns are replaced by longer-term structural adjustments. Dominic Wallington is chief investment officer at RBC Asset Management UK. ©2011 funds europe

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