The pension deficit is much talked about in UK news; it was blamed for the collapse of BHS, but what is it? A pension deficit is the extent to which the value of a pension lags behind the amount needed to fulfil promises of retirement income to members; it has been growing in many developed economies.
The growing deficit is one of the most complicated financial issues in modern times. But who or what is to blame? There have been numerous attempts from the government and financial institutions to bolster pension funds for retirees, but is the pension system just too broken?
Living longer costs more
Improvements in life expectancy and declines in birth rates means that there is a smaller working population and a growing pension population. Historically, the working population have helped to pay for retirees but as people live longer the number of retirees increases and we have an aging population.
Life expectancy is currently 82, in 1970 it was 72. This addition of 10 years can be seen across Europe and the US and puts huge pressure on the pension requirements. Whilst people are living longer they haven’t necessarily adjusted their retirement expectations, this has led to a situation where more money is needed.
Employers realised this and that’s why they have started changing the types of pension plans they offer employees. Traditionally, employees were offered ‘defined benefit’ pension plans, this is a guaranteed income, usually as percentage of final salary, at retirement. As individuals have started to live longer the liabilities on these have increased. This is a cost to the business so many have move to ‘defined contribution’ schemes. Employers and employees pay into an investment fund and enjoy the proceeds when they retire, there is no guarantee on this amount.
A challenging investment environment
The pension deficit has recently been worsened by the bond market’s response to Brexit. UK gilt yields have dropped to their lowest ever. Ten-year gilts yield less than 0.60%, whilst the yields of several large economies, including Germany and Japan, were already negative, even the US Treasury yields dropped below 1.4% for 10-year notes, bringing them to a new historic low. Some of Europe’s largest pension schemes responded to this decline in bond yield by issuing emergency guidance to retirees to warn that members could see cuts to their pension benefits.
Pension funds typically hold a range of government bonds and inflation linked bonds to match its future liability to pay out to its scheme holders. The guarantee of retirement income is comparable to interest payments on a bond. Right now the expected future returns from buying bonds are increasingly lower. In order for a pension fund to be able to guarantee an income for the future, they must buy more bonds. The lower the yield, the more the pension fund must buy. To keep up with this increasing pension liability, companies need to set aside extra money into their pension funds. This could lead to there being less money for investment and growth, as well as less money for shareholders. This damages the growth prospects of the company.
Can we save the pension deficit?
Short-term, realistic solutions to closing the pension deficit include:
- Higher contributions from employers
- Higher contributions from employees
- Reduced benefits at retirement
Many pension providers are attempting to make up the shortfall in returns by investing in riskier alternative assets. This translates to a higher allocation in equities, high yield corporate bonds or even property, private equity and hedge funds. With greater risk comes greater expected returns, the diversification also ensures there are multiple sources of returns and risk diversification.
Rising bond prices and poorly designed pension fund asset allocation is creating a retirement landscape with increased inequality and social unrest. Asset allocation decisions are becoming more and more important to ensure a fairer pension universe that provides a practical alternative to defined benefit pensions. Individuals need to take ownership of their long-term savings by making regular contributions to investments. The further away the need for money is, the higher the level of risk should be. A long term focus on income generation is the only way to close the pension gap.
