With bond yields tumbling across the world, worries about the ability of UK pension funds to provide income for retirees are growing. Here we explore the complex world of pensions to find out how we’ve ended up with such a significant amount of unfunded liabilities and why it matters.
Pensions can be complicated to the point of being almost impenetrable. We’ll do our best to explain the main types of pension schemes in the UK and how the market has evolved. Historically, many large employers have run defined benefit (DB) pension schemes, which offer pension benefits to employees throughout their retirement, based on the length of their service and typically, their final salary. Many people currently in retirement are on such schemes that are administered by pension fund trustees. These trustees make decisions on behalf of the scheme’s retirees, with the aim of ensuring that it has enough assets to meet its liabilities, or in other words, the income needs of its pensioners now and in the future.
This is where it gets complicated. The ‘assets now’ part of the equation is easy to calculate on the basis of prevailing market valuations. The ‘liabilities now’ bit is also reasonably straightforward, being a product of all of the scheme’s pensioners’ current income benefits.
Forecasting the future value of these assets and liabilities is somewhat more difficult and is the product of actuarial science. These forecasts rely on a number of assumptions, including the life expectancy of retirees and the future returns from the various asset classes in which a scheme invests. The value of these assumptions can influence the outcome of the forecasts greatly.
Furthermore, pension funds use a blend of government bond and investment grade corporate bond yields to discount the value of their long term liabilities. In short, when bond yields go down, the predicted value of pension schemes’ liabilities goes up.
For a variety of reasons, therefore, defined benefit schemes have come unstuck over the past 20 years. Not only are people living longer than had initially been expected, but asset returns have not, in broad terms, lived up to expectations, with gilts outperforming UK equities for much of this period. The biggest problem, however, has been the progressive decline in bond yields, most recently exacerbated by the Bank of England’s decision to cut interest rates in the aftermath of the UK’s decision to leave the European Union. Clearly the UK’s pension deficit challenge has nothing to do with Brexit – it’s been building in the background for years. Recent estimates, however, now suggest that the UK’s corporate pension scheme liability shortfall may exceed £1trn, more than half of Britain’s GDP.