All entries for Monday 23 February 2015

February 23, 2015

Pension regulations' unintended economic consequences

Every private defined benefit pension scheme (including final salary schemes) is expected to be funded at all times. That means having enough assets to cover the liabilities there and then if need be. The idea is that if something awful happens to the sponsoring employer the scheme can be wound up in an orderly fashion. It is solvent and all the pensions can be paid from the money raised by selling the assets - notionally at least.

If there is a deficit its trustees have to put in place a recovery plan requiring extra contributions by members and employers.

This regulatory regime is partly enshrined in the law, partly the convention that now places a large emphasis on avoiding all sources of risk wherever one can be identified. This protects the Pension Protection Fund from claims but it has unfortunate wider economic consequences. It affects both long term economic growth and short term cycles.

The system of regulation focuses entirely on short term risk and volatility. Pension schemes traditionally used to invest for the long term to get the best returns. Now they are advised to avoid the short term volatility inevitable in such investments. This leads to a short-termist mentality that is harmful to economic growth.

Yet 'short-termism' has long been recognised as one of the main problems with the UK economy. Governments have tried to address it by various initiatives, most recently by the Kay Review of UK Equity Markets and Long Term Decision Making. Pension funds have a key role to play in supplying long term capital but they are being given incentives not to fulfil it for example to 'de-risk' their investment portfolios by switching from equities to government bonds.

The second unintended macro-economic effect of the funding regime is that funds are in deficit and have to make extra payments during a recession. Currently (February 2015) the combined deficit of all DB schemes stands at over £300 billion. This is treated as a gap that has to be filled as soon as practicable by a recovery plan to increase savings into the scheme. These payments come out of company cash and wages and so are a subtraction from effective demand. This is a substantial sum: the latest figure for deficit reduction payments is £25.6 billion to reduce deficits for the 2014/15 year.

Thus the regulatory regime is a pro-cyclical factor that makes recessions worse.

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