Gilt yields are down and asset rises are not enough to stop liabilities rising overall. And yet the demand for derisking has seen a recent spike. The following tables and text explain all.

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These monthly indices will enable readers to follow the price of buying out pension liabilities. The first chart tracks affordability for different membership types, the second is a projection of pension costs based on four RPI/CPI scenarios.

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This index will appear each month in Pensions Week to enable readers to closely follow the price of buying out pension liabilities. The prices are based on two scenarios: a scheme with 50% equities, and one with 65% equities.

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Mark Gull, co-head of ALM at Pension Corporation writes the "Talking Head" column in Financial News. He says: There is now a whole industry dedicated to corporate engagement and socially responsible investment strategies for pension funds. There has also been a trend for UK pension funds to move away from equities and invest in bonds, especially corporate bonds; this is mainly because as a pension fund matures, bonds are a better match for its liabilities.

A whole industry has grown up over the past few years around corporate engagement and socially responsible investment (SRI) strategies for pension funds. This is to help pension fund trustees avoid issues that could cause upset to their members, reputational risk to themselves and possibly their sponsor. For example, a healthcare company pension scheme is unlikely to want to invest in a tobacco company. At the same time they seek to avoid shocks to the value of their investments while achieving the targeted returns.

The aim of this exercise has been to ensure the assets are managed appropriately and to date the focus has been on equity holdings where it is easier for schemes to raise specific concerns, vote on directors’ pay, and express their views on the company’s sustainability strategy.

However, a debate needs to be had about appropriate levels of engagement for investors in corporate bonds and what would constitute an acceptable engagement strategy for debt holders. The shifts in pension funds’ investment strategies mean the time for this debate is now.

The trend of UK pension funds moving away from equities and investing in bonds, and particularly corporate bonds, has been apparent for the past few years.

The Pension Regulator’s purple book 2009 shows that on average, equity allocation for all UK pension schemes has fallen from 61 per cent in 2006 to 46 per cent while fixed income allocation has risen from 28 per cent to 37 per cent. The reason for this is that as a pension fund matures, bonds are a better match for its liabilities, and pressure to match those liabilities has increased from regulators, sponsors and trustees themselves.

Pension schemes that have adopted socially responsible screening may well have avoided BP’s equity. And if their screens had highlighted BP’s poor management of environmental risks in the Gulf of Mexico, they would have avoided seeing chunks wiped off an investment.

But it is possible the same pension schemes might be holding BP debt. And at some hair-raising moments recently some of BP’s bonds have been trading with the same yields as junk bonds. If the schemes had chosen not to invest in BP equity on environmental risk grounds, their members would not be happy to see the same schemes buy BP debt, funding the company that way. It is also possible that should BP issue more debt, this will be in the major corporate bond indices. Many pension funds with funds benchmarked off corporate bond indices will end up buying that debt.

So if a pension fund has signed up to an SRI investment policy for its equities surely their corporate bond manager should not be funding a company simply because it falls within their universe. Yet this happens.

What are the options for a pension scheme with an SRI policy owning corporate bonds? How much engagement should it have with companies when corporate bond holders do not get a vote at the AGM.

Where do bond holders have leverage over companies on environmental, social and governance issues?

The easy answer is just to accept that “bond holders don’t vote”, do nothing and simply stop engaging.

But if trustees believe they should engage with companies, the time that corporate bond investors can do this is when the company issues a bond.

At that point a contract is entered into between the borrower and the lender. The lender (in this case the pension fund) has the ability to ask for various terms before signing over the money. These are normally covenants linked to financial ratios but investors could ask for other social rated covenants.

However, there would need to be a change of attitudes and to investing in corporate bonds for the trustees to demand their fund managers engage in this way.

One final point is that there is no real literature available on the returns of screened corporate bond portfolios.

As DB schemes mature, moving away from equities and into corporate bonds, and greater numbers of pension fund trustees want to engage with companies, there needs to be a wider debate about engagement for corporate bond holders.

Just saying “corporate bond holders don’t vote” is ducking the issue.

Mark Gull is co-head of ALM at Pension Corporation

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A huge increase in life expectancy is one of the great achievements of the human race over the past two centuries. Increased longevity has transformed both individuals’ lives and their societies, with the most marked changes taking place in the developed world. Actual increases in life expectancy have been far more substantial than previously projected, with the result that governments, businesses, financial markets, and individuals must radically readjust their plans.

Moreover, the current trend shows no sign of leveling off. For example, between 1981 and 2000 the life expectancy for 65-year-old males in the United Kingdom increased by approximately three months for every year, and future life expectancy is widely expected to continue to increase. Therefore, it is increasingly important that governments, businesses, and individuals consider the economic, societal, and financial implications of an aging society in diverse but important policy areas such as pensions, health care, and long-term care provision. For example, pension liabilities increase by 3% or more for every added year of life expectancy.

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The role of government in society, the size of the public sector workforce and the long-term affordability of their pension promise (much of it in the form of unfunded defined benefits) are increasingly coming under scrutiny, with the new Government indicating severe cuts ahead. Some commentators are warning of ideologically-driven reductions, which could give the UK a double-dip recession, others are pointing out that the substantial fiscal deficit leaves few other options and argue that a smaller state would in any case lead to a stronger and healthier economy.

It seems that we have been here before. In the early 1990s – after more than a decade of Conservative government and at the peak of the previous recession - public sector employment stood at around 6m (22¼ per cent of total employment). Faced with a fiscal deficit of nearly 8 per cent of GDP, the then government embarked on an ambitious consolidation programme. By 1997, when the Labour Party was elected into office, public sector employment had dropped by more than 770,000 to less than 5.2m. The pain to British society was, however, relatively modest as nearly 1.7m new jobs were created in the private sector over the same time, comfortably offsetting any cutbacks in the public sector.

The resultant squeeze on public services left many voters discontented though, opening the way for the Labour Party to win the 1997 general election on the promise of better public services, especially in the areas of education and health care. Between 1998 and 2005 public sector employment crept up again to 5.9m (19¾ per cent of total employment); then fell slightly before jumping to 6.1m as the Royal Bank of Scotland and Lloyds Banking groups were reclassified as public sector entities following the government’s bailout of the financial institutions.

Could today be a déjà vu moment then, with the new Conservative-led government just having to repeat what its predecessor did nearly two decades ago? Unfortunately the challenge will, if anything, be more severe. Not only are there question marks over whether the private sector will pick up in the same way as it did in the 1990s to absorb the likely redundancies in the public sector (worries of a jobless recovery loom large), much of recent public sector employment growth was also in areas which richer and ageing societies care about a lot: education and health care. Around three quarters of the increase in public sector employment during Labour’s years in office was in these two areas. Reflecting the power of the grey vote, the new government has already stated that it intends to increase real spending on the NHS in every year of this parliament. We will have to wait for the Spending Review in the autumn to see how deep the education budget will be cut. As long as these functions are predominately performed and financed by the state, there will be a tendency for public sector employment in these areas to creep up. This suggests that with the elderly representing an ever larger part of society, this and future governments will have to run ever faster just to stand still and really have to rethink the role of the state in the future. It will also not make dealing with the future build up of public sector pension promises any easier.

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Events have clearly escalated over the last fortnight, since we briefly pondered the hidden risks of deep sea drilling for pension funds [attach link to previous article], aka the ongoing BP oil spill saga. If anything, the risks highlighted then have only been exacerbated by the latest turn of events.

The US government has taken an increasingly strident tone and comparisons like the one with the events of 9/11 drawn by Barack Obama are a worrying use of political rhetoric. Combined with the recent calls from Zac Goldsmith that pension funds should be cognizant of the environmental risks within their portfolios, there is clearly increased pressure on trustees to rethink the place of BP and other such companies in their portfolio.

Additionally, the agreement by BP to defer dividends for the next three quarters and set up a $20bn escrow account will reduce its attractiveness as an equity holding for many pension funds, for whom the dividend was a vital source of cashflow to pay current pension payments. Given that other oil companies such as Shell are exposed to the same risks, will some of these choose to hold back some part of their cashflow going forward as a future reserve? Either way, trustees are going to be fearful of first, another Deepwater Horizon-like disaster for these companies and the resulting equity losses; and second, the deferment or cutting of future dividends.

Taken all together, this does not bode well for pension funds. Many have already taken a bath on the equity valuation, as we already highlighted, which may well be crystallised now as some look to exit positions as a response to perceived regulatory, political and reputational risks.

However, it’s hard to see where they can go to get the replacement vital cashflow that the dividends from BP provided. Nearly half of UK dividends in 2009 came from 5 companies – BP, Shell, HSBC, Vodafone and GlaxoSmithKline. One has now deferred its dividend and another is looking less attractive as it plays in the same space. The inevitable result then is an increasing concentration of pension fund risk in an ever smaller handful of high dividend stocks. That does not fill one with confidence.

There is also the spectre of sponsor risk mentioned previously. This is now larger than ever – BP’s trustees will be troubled by this additional call on and threat to the company’s cashflow (a large part of the business is after all derived from the US) and its implications for future contributions into the pension scheme. Every other trustee out there will also now be wondering if the same could happen to the corporate sponsor of their pension scheme, which could trigger an increased push towards de-risking.

Lastly, there is another growing macro risk. BP is a huge contributor to government coffers, having paid £15bn in tax over 2008 and 2009. Given where the deficit is and the growing pressure to do something about it, the government can ill afford to see a hit on this front.

Like the pension funds, the government is also dependent now for its own needs on the cashflow of a significantly reduced pool of companies in the aftermath of the crisis.

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• EU bailout plan is a sticking plaster only – the problem is far from solved
• Many risks still remain for pension funds
• Slow EU growth may also threaten any export-led recovery in the UK

Today’s European government debt crisis echoes the private credit crunch of 2008, but with Greece resembling Bear Stearns rather than Lehman Brothers. While financial markets have welcomed the bailout, this is a sticking plaster that effectively only kicks the problem down the road, buying European countries some time to deal with their fiscal profligacy. Regardless of whether Greece is salvageable, we are now in uncharted territory and the fear must be now over bigger potential problems further down the line, such as Spain, which are equally dependent on the kindness of strangers. The intricate web of who holds whose debt – as beautifully illustrated by the New York Times – means that counterparty risk is front and centre-stage once again. It also makes evident why the EU is prepared to defend the euro with a $1 trillion support package.

Pension funds should be wary of the pitfalls ahead. In the run-up to the collapse of Lehman Brothers, far too much pension fund risk was left on the table in the hope of a market recovery. That failed to materialise and many risks – liquidity and counterparty risks in particular – went unnoticed. Pension funds can ill afford a repeat of 2008 in 2010, especially now that the era of bailouts is slowly replaced by a new era of austerity measures.

Not only do pension funds need to anticipate mounting market risks, they must also expect sponsor risk to grow. Given the muted domestic demand within the UK, European growth was always going to be a large part of any export-led UK recovery given the region’s importance as a destination for British exports. That is now in doubt. Europe’s debt crisis – though wallpapered for now - ought to be ringing pension fund alarm bells.

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• New coalition government’s main domestic policy challenge is to reduce the substantial deficit. It intends to achieve this mainly by reducing government spending.
• Government also intends to index state pension to earnings growth from 2011 onwards. This is one year earlier than planned by the previous government, which in 2006 made a 2012 implementation dependent on state of public finances.
• Coupled with the fact that government promises to raise NHS spending in real terms every year over this parliament (while acknowledging the implications this might have on other spending areas), this clearly demonstrates the importance of the grey vote in British politics.

Not surprisingly the key domestic policy challenge identified by the new Conservative-Liberal coalition government is to reduce the fiscal deficit over the course of this parliament. At around 12 per cent of GDP, Britain’s deficit is currently one of the largest in the developed world. The new government intends to achieve this mainly by reducing spending rather than raising taxes.

Faced with this challenge, it is perhaps a little surprising though that the new government has also announced that it would index future increases in the state pension to earnings growth rather than inflation from April 2011 onwards. When the previous Labour government launched its pension reforms in 2006 – following the 2005 recommendations of the Pensions Commission and in an economic climate dominated by eternal optimism - one of the key policy announcements was to change the indexation rule from 2012 at the earliest but in any case by the end of the next parliament. In the words of the previous government, the timing of that move would be “…subject to affordability and the fiscal position…”

Fast forward four years and it appears that we can afford to move to an earnings link even earlier than originally planned. Just to make sure that pensioners will definitely not fare badly over the coming years, the government even promises a “triple guarantee” that “…pensions are raised by the higher of earnings, prices or 2½ per cent…”

So while those in employment can expect sluggish nominal earnings growth for years to come as the economy only gradually recovers and might even face falling disposable incomes as tax and NIC increases (the latter not affecting pensioners) appear inevitable given the fiscal deficit, pensioner incomes seem relatively safe. Indeed, most pensioners will also benefit hugely from the new government’s announced policy to increase the personal income tax allowance to £10,000 over time. Such a move would take most pensioners out of paying income tax altogether.

Add in the fact that the government wants to increase NHS spending in real terms in every year of the parliament – which disproportionately benefits the elderly – while fully acknowledging that this will mean even deeper cuts in other spending areas and it is clear that the grey vote clearly matters.

But it is not all good news for pensioners, in particular future pensioners: the government also announced to review the date at which the state pension age should be increased from 65 years to 66 years. As it stands this will take place between 2024 and 2026 – the new government seems keen to bring this forward. On the face of it, this appears to be a relatively easy way to save money but how much could realistically be saved given that only a minority of people actually works until the official age? Currently less than three quarters of males and females aged between 50 years and 64 years and 60 years respectively are still in employment and that rate is much lower for those at the upper end of that age group than those at the lower end. What will those without any other forms of income live off if they fail to extend their working lives?

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Pension reforms have been high on the political agenda in many developed countries over recent years and pension issues have been discussed intensely in the public as a result. In recent years, much effort has been devoted to make state, public and private pension systems fiscally more sustainable in the light of demographic change. In many developed countries, this has been achieved - at least ex ante - by encouraging greater private sector and personal involvement. Equally, many governments in emerging economies and developing countries have been pursuing their own pension reform agendas.

Nevertheless, despite this spotlight on pensions, many important facets remain badly understood and need to be discussed in greater detail. Most observers would agree that societies have not yet reached the end of the reform process and that dealing with pensions may always remain “work in progress” as new information becomes available – such as on trends in life expectancy - and as societies evolve. Furthermore, additional effort will most likely be required to ensure that the desired outcomes will eventually materialise.

Pensions Tomorrow intends to contribute to this much-needed debate on how to take pension systems forward – both in the UK and internationally – over the coming years by offering high-quality and timely analysis as well as independent peer-reviewed research.

The purpose of this note is to ask some of the key questions that could inform future research into pensions. The general issue under consideration is not new. How to structure the future provision of pensions, taking into account wider economic, demographic and societal considerations at home and abroad?

Most people are not aware that formal pensions for the many are a relatively recent phenomenon.¹ In the past, people worked and once they got older and could no longer work, their children looked after them. And once their children got old, their own children looked after them – in short, the family unit mattered.

In the western world this informal arrangement fell apart more than 100 years ago. Partly in response, western societies created the welfare state (e.g. Bismarck’s introduction of the state pension in Germany in the 1880s), which provided a safety net through different means and also led to the creation of an industrial workforce with employment contracts rather than diffuse commitments within communities. But one should not forget that when the welfare state was created in many countries, life expectancy was hardly higher than the legal pension age – government outlays were limited. Bismarck’s Germany had a life expectancy of just over 50 years, so pensions from the age of 70 years onwards were a minimal fringe cost for the government.

In recent decades, falling fertility rates and ever increasing life expectancy has put increased pressure on the welfare state in the developed world and many pension schemes – including both state and public sector – have been perceived to be unaffordable now, forcing governments to reconsider their policies. In some countries, strong inward migration is considered to be an appropriate policy response but closer scrutiny shows that this can hardly be a long-term strategy –at most, it gives policy makers some breathing space and a limited opportunity to postpone any hard decisions.

Governments around the world have been dealing with this issue for years, international organisations, think tanks and trade unions have given advice, and universities have provided valuable analysis. Societies have been dealing with this in their own particular ways, reflecting differences in cultural and historical backgrounds, and economic and demographic circumstances. Despite the closer integration of the world economy, in most countries, this issue has been treated as a domestic issue.

The private sector has played its own important part in many countries by offering occupational pensions or by offering financial products, helping both the sponsors of pensions as well as individuals prepare financially for retirement. The fact that governments across the world have reduced ex ante their future fiscal burden by encouraging greater private sector and personal involvement does not mean though that this will also be ex post the eventual outcome. For the desired outcome to materialise, the private sector and personal involvement must develop as intended. Experience from around the world shows that this has not always been the case, requiring frequent and potentially costly policy changes and putting additional burdens on individuals and businesses alike. The complex interactions between fiscal policy and pension savings also play a role for both – an area touched on briefly later in this essay when we examine the role of tax relief.

In a number of developed countries, for example, defined benefit pension plans have been closed to new members as scheme sponsors face increasing liabilities in the light of ever higher life expectancy and find the resulting regulatory funding requirements increasingly unaffordable. Does this trend require adjustments elsewhere in a country’s pension arrangements? Will today’s structures deliver the desired outcomes or do participants such as governments and financial markets need to innovate?

There are a number of ways the issue of future pension provision could be approached. For example, one might want to think about the issue in terms of desirable objectives for a pension system such as:

• Efficiency (static and dynamic)
• Equity (fairness)
• Affordability and sustainability (both financial and social)

These objectives could then be used as a core set of overlapping “lenses” when looking at the issue of future pension provision, though other “lenses” are feasible too. Importantly, as we shall demonstrate, these “lenses” can be used to study pensions simultaneously at a range of scales from large “big picture” macroeconomic themes such as political uncertainty to subtler, smaller scale but equally important issues such as the management of assets and liabilities for an individual pension fund. There is also the issue of credibility – in particular, political consistency – which cuts across all the lenses under consideration here and is touched on later in the essay. However, before doing so, this note provides some background on pension arrangements in developed and developing countries.

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¹ The award of pensions itself dates back much further. Monarchies awarded pensions for services as far back as the Middle Ages though there were few beneficiaries. This was also a common practice in Roman times, with the last Western Roman Emperor Romulus Augustus being the last to be pensioned off when he was deposed by the Germanic chieftain Odoacer in 476 AD.

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The rapid increase in life expectancy is without doubt one of the great achievements of the human race over the previous two centuries. It has not only transformed individual lives, it has also profoundly transformed societies. These increases have been experienced in most societies, with the most marked changes taking place in the developed world, while more modest gains have been made in the majority of developing countries.

Life expectancy is one of the three so-called vital parameters to generate population projections. The other two are fertility rates and net migration. All three also matter for the provision of pensions. Longevity matters directly because it determines, in combination with the time of entry into retirement, how long someone can expect to receive a pension. The time of entry into retirement generally coincides with an exit from the labour market.

Fertility rates and net migration matter indirectly because they affect the size of the working-age population. For example, with the number of people aged 65 years and over increasing rapidly in most developed countries, the long-term sustainability of socalled state pay-as-you-go (unfunded) pension systems depends crucially on a government’s ability to raise taxes, which in turn depends on the size of the economy and hence also the size of the workforce. The future size of the economy also matters for the ability of defined-contribution pension schemes to deliver prosperity for pensioners in the future. This is because the future profitability of businesses will depend on market opportunities. At its most basic, market opportunities depend on the number of people who can purchase products and services.

Setting up an efficient, fair and sustainable pension system is a major challenge and might never fully be achieved. The challenge is made larger still by the fact that longevity trends – and hence one of the key parameters determining the size of the challenge – are not well understood. Actual increases in life expectancy have generally been much more substantial than previously assumed in official population projections, with the result that government, business, the financial markets and individuals had to readjust their behaviours and plans.

It should, therefore, be a priority to improve the understanding of future longevity trends. For individuals, increased longevity is desirable and not surprisingly, there-fore, most developed societies spend a significant percentage of GDP annually on healthcare and medical research to ensure that we all have longer and healthier lives. As the population ages, this share is projected to increase over the coming decades and governments will have to ensure that the public finances will remain sustainable and government policy inter-generationally fair. Equally, increases in longevity can lead to large unanticipated retirement costs for business and governments.

Consequently, this paper focuses on longevity. The following section discusses historical trends in life expectancy, the main drivers of these trends, which have changed over the last century, and what impact these changes had on society more generally. The section also presents the evolution of the official UK population projections over recent decades. Section III discusses the effect of and potential responses by individuals, businesses and governments to increased longevity. As in our earlier paper on the economic landscape of pensions provision, we argue that these responses could be assessed in terms of their impact on the efficiency, equity and affordability of a society’s pension system.¹ The identification of desirable responses might also indicate whether existing institutional structures or markets perform optimally. Section IV argues that the uncertainty of future longevity trends adds another layer of complexity over an already complicated issue and that it is therefore useful to improve our understanding of these trends. The paper shows the different options individuals, businesses and governments have to address the challenges created by this inevitable uncertainty.

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¹ Pensions Tomorrow A White Paper, Frank Eich and Amarendra Swarup, 2008 at www.lse.ac.uk/collections/management/PDFs/Pensions_Tomorrow_White_Paper.pdf.

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