Central discontinuance fund
The obvious question that keeps coming up is “Why can’t pension funds be insured against this kind of risk?”, or something like that. It’s a good question and acres of newsprint have been devoted to it recently since the Government proposed in the pensions Green Paper that a Central Discontinuance Fund should be considered.
For those of you who are thinking “So what’s a Central Discontinuance Fund when it’s at home then?” or similar, read on.
The idea behind such a fund is that it would effectively pool all the Defined-Benefit funds of companies that fall over and run as a sort of a massive closed scheme. That is, it would invest the funds and pay out the retirement benefits as they become due so the individual scheme members wouldn’t lose out just because their company had hit the wall.
It seems a compelling idea until you start thinking about the way in which such a closed fund would actually operate in real life. For a start, the amount of money transferred across to it with the pension schemes of bust companies might not be enough to cover the pension liabilities transferred across for the employees concerned. Even if it was, it might not stay that way as things change over time. As assumptions on mortality and longevity keep getting revised there would be a very real chance that the money would run out, particularly if the stock market goes to hell in a handcart just at an inconvenient time, when maybe substantial benefits become due for payment. Obviously, any such scheme would need a guarantor if it was to be relied on to meet the promises to the employees at various agreed dates in the future.
And that is what makes this particular pensions problem a bit of a toughie. It’s a problem that everybody seems to think can easily be solved as long as someone else takes responsibility for it.
Some say one way of doing this would be for the Government to act as the guarantor. They’ve got a load of money and would therefore be the best bet. The counter argument to this goes something along the lines of; “But why should taxpayers want to subsidise members of defined-benefit pension schemes?”. The other problem is the Government clearly doesn’t think it should be guarantor either, that’s why the Green Paper suggests other people should be, and what do we all think about that?
Well, other Defined-Benefit company pension schemes could be required to do it. But, the compelling argument against that goes something like; “Why should well-funded companies subsidise weaker ones?”. And anyway, insurance, that’s the way to do it. Get someone to insure it. Problem solved.
But insurance may not be the answer either. For a start, the risks are not easy to quantify. In the current economic climate it’s difficult enough working with risks that are well-understood. And anyway, this kind of commercial insurance isn’t like insuring houses or anything like that. With house insurance, even though millions of properties are insured, only a few are going to be unlucky enough to do something like burn down, for instance. It’d be pretty unlikely all the houses in the UK would ignite on the same day, unless some act of war or act of God were responsible. Like a meteorite the size of Wales landing somewhere around Milton Keynes, say. And there’s small print for that kind of stuff anyway. Not that there’d be many of us left to read it. But I’m straying from the point.
The thing is, insuring something like a Central Discontinuance Fund would be insuring what is called a systemic risk. That is one where the whole thing could go south all at the same time. At the time of a general economic downturn, for instance. It’d be a bit like the meteorite thing with house insurance, but without the act of God get-out clause.
The other problem with any type of insurance solution is, of course, the ‘moral hazard’ one. Some employers may deliberately underfund their pension scheme or take risks with it knowing they are protected by insurance if it all goes horribly wrong. So it’s not an easy one, this. It’s a real hot potato.
Many are saying, though; “Well look, hang on, this sort of thing works elsewhere in the world, America for instance. Why can’t it work here?”. Well, there is a scheme in America, it’s called the Pension Benefit Guarantee Corporation, or the PBGC for short. The PBGC gets a lot of pensions people in the UK quite excited, but I’m not sure it’s actually what everybody seems to think it is. As I understand it, it only guarantees basic benefits to people, not their full expected final salary promise and guarantees even less if people do things like retire early, or want to provide spouses’ pensions for example. This kind of thing is not what I think our Government has in mind in the suggestions it makes in the Green Paper.
In any event, all’s not well with the PBGC anyway as far as I can see. It is possible it could end up billions of dollars in deficit in the next ten years or so according to reports of its own estimates. Also, Steven Kandarian, the Executive Director of the PBGC is quoted as saying recently:
“... the pensions insurance program creates a moral hazard, tempting management and labor at financially troubled companies to defer their pension obligations. This unfairly transfers the cost of under-funded pension plans to responsible companies and their workers. These financially strong companies at some point will have had enough, and will exit the defined benefit system, leaving only those which pose the greatest risk of claims.”*
I think the strong point brought out there goes to the heart of this big issue. It is underfunding of pension schemes that is the real problem, not the difficulties of finding some external way of insuring or guaranteeing the pension promises employers make to their employees.
It would probably make more sense if we look at more realistic ways in which Defined-Benefit schemes can ensure that the benefits of those yet to retire are fully allowed for within the company pension fund set up for that very purpose. Change can’t be expected to happen overnight, but it should be possible for realistic funding proposals, that could be effective, say over a ten-year period, to be put in place so that people can stop worrying about their pensions and get on with their lives.
· Statement made to the US Senate Committee of Finance on March 11, 2003.
4 April 2003
This document is based on Scottish Life’s understanding of current tax law and the Inland Revenue’s proposals and the Pensions Green Paper issued on 17 December 2002. These proposals are subject to consultation and may change in the future.