Tuesday, 25 August 2015

Pensions–the stock market crash is bad news for an unlucky few.

pensions crisis

"Pensions hit as stock markets crash"  is the usual tabloid headline and in the past it was never true. That was for three reasons. Firstly many of us had final salary "Defined Benefit" (DB) pension schemes which guaranteed our pension even if the asset levels of the funds fell because Equities had fallen in value - however dramatically. Second these DB schemes were invested in a variety of asset classes of which Equities were only one. Bonds, Gilts, Property etc. were not (directly anyway) affected when stock values fell. Third the law requires that when Assets in a scheme fell, and if they stayed below Liability projections for some time, then the "sponsor" of the Fund, usually the employer, must fund the shortfall with a cash injection. Despite the changes in the world of pensions all of the above remains true for all of us lucky enough to be in DB schemes - crucially that includes almost everyone working in the public sector where DB remains the norm. These are the "Haves".

So what about the "Have-nots"? Over the past twenty years or so most DB schemes have been closed to new entrants and even before that significant numbers of workers either had no pension or had only a "workplace savings" scheme of far lower real benefit than DB. These savings schemes were often dressed up by employers and the Financial Services sector as being “Pension” schemes (and called “Defined Contribution” (DC)  Pensions) but in fact they were not. True on retirement the employee was required to purchase an annuity with the accumulated savings – and an annuity is a pension (of sorts!) by another name. But what DB gives in terms of predictable and often inflation-protected income in retirement is largely absent in a DC scheme. And the changes to the law in the 2014 Budget – the so-called “Pension Freedoms” - mean that a saver, if he or she chooses to, can take the money and run. There is no obligation to convert the built up “cash pot” into future income by buying an annuity.

Although we use the term “cash pot” the savings in DC schemes only actually become cash when the assets in which the pot has been built up are sold. And this is where falling stock markets are potentially very hazardous. DC scheme assets favour equities because over time such an investment provides higher returns than more secure but lower return asset classes like bonds and gilts. The key point here is “over time” – indeed the timeframe is absolutely crucial to DB schemes where short term falls in stock values are largely irrelevant because the timeframe over which the assets have to deliver returns is so long – thirty years or more. And over the decades, despite swings and roundabouts along the way, the stock market will provide a better outcome than the alternatives.However there is one exceptional risk for DC schemes which does not exist for DB. The value of a saver’s pot  depends on the value of its underlying investment on the day that the employee becomes a pensioner. And that day is usually predetermined. So if the Stock Market has fallen 10%  a few days earlier the employee’s pot will also have fallen - and the amount of his pension (if he buys an annuity) similarly.

The switch from DB to DC has taken the risk associated with pensions away from the employer and placed it on the employee. It has removed the guarantees inherent in a DB scheme  - there is no expectation that a DC scheme  will deliver a pension that relates in any way to the employee’s recent earnings. Nor that it will be inflation-proofed. Nor even that the actual value of a pension pot will not be subject to the vicissitudes of stock markets.

There have been some positive developments in pensions in recent times – not least “auto-enrolment” which brings many employees into workplace savings (for retirement) who were not there before. But the switch from DB to DC has been a social shift of a scale which has still not been fully understood. In the public sector, post Hutton, benefits have been somewhat reduced but an employee – including new employees – still has a DB scheme of which to be a member and benefits from it which far exceed the new DC norm in the private sector.  Not least of these is the fact that the “shock horror”  headlines really do not apply to DB schemes members at all. They may not apply to all DC schemes members either – but for those approaching retirement and the moment when they cash in their “Pot” it really can be very bad news indeed. 

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