The problems of the last decade for public and private sector funds are well documented. These include:
- investment returns have been very poor by historical standards and less than the actuarial assumption (see Table 3 below);
- interest rates have been at historical lows, increasing the assessed value of benefits earned and the estimated cost of the scheme;
- increasing longevity is adding to the cost/value of the pension promise;
- accounting standards relating to the reporting of pension liabilities have not been helpful. They have created the scope for enormous volatility in the funding position from year to year and this together with increased scrutiny has encouraged organisations to reduce the risk associated with the cost of their pension promises; and
- more recently, the recession has had an impact on affordability.
Asset |
10 year return |
UK equities |
1.6% |
Overseas equities |
1.6% |
UK bonds |
5.4% |
Cash |
5.2% |
Property |
6.2% |
Total assets |
3.1% |
RPI |
2.7% |
The last decade has seen exceptionally low returns from equities, and this has dragged down total asset returns for pension funds. These have been only marginally higher than inflation, below increases in earnings and over 3% below actuarial assumptions. It is not surprising that funding levels have plummeted and there has been a need for significant increases in employer contributions. Increases in life expectancy have of course further added to costs.
This last decade has been a very difficult environment for pension funds providing defined benefit schemes. The cost to employers has increased significantly and for those with defined contribution provision, they would have done well to generate a return that matched inflation. This, together with very low annuity rates meant that their pension was much less than they had anticipated. It is not possible to design an effective pension scheme in such an environment, but it does highlight the issue of how risks should be shared between employee and employer (and the tax payer).
Looking forward, we need to ask what returns can we expect in future?
In Table 4 below, the long term historical returns from equities, gilts and cash are compared with prospective returns based on GMPF Fund Managers’ forecasts.
|
Equities
% per annum |
Gilts
% per annum |
Cash
% per annum |
Long term historical
return (source Hymans) |
6.0 |
0.9 |
1.2 |
Prospective Returns
(Manager Forecasts) |
5.5 |
0.5 – 3.5 |
0 – 2.5 |
The conclusion is that real returns of 3.5%-4.0% per annum (that is, above CPI) are realistically achievable going forward. It is also worth noting for GMPF that 1% on investment return is the equivalent of 5% of payroll and if the number of employee members starts to fall as expected, the 5% of payroll will of course increase.
The importance of prospective returns is that it has a significant impact on the calculation of the cost of the pension promise (in a defined benefit scheme) or value of pension saving (in a defined contribution scheme)
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