Paying for an index-linked pension is extraordinarily expensive when interest rates are low
By Buttonwood
HOW much does it cost to fund a traditional final salary pension? A lot. OECD tables show that 65 year-old men can expect to live for 19 to 21 years after retirement, while women may manage 22 to 28 years. The traditional UK schemes paid a sixtieth of salary for every year of employment, up to a maximum of 40 years, or two-thirds of final salary. US schemes were the same, with the important exception that full inflation-linking was rarely guaranteed.
There are really three ways of costing this. The first, practiced by US public sector pension funds, is to discount the liabilities by the assumed rate of return on the fund. This is subject to all manner of criticisms; first, it encourages overoptimism, second, expected returns are unlikely to match assumptions, third, no other liability (tax, debts to suppliers) is accounted for in this way and fourth, the liability will still be there even if the assumed return is not achieved.
Financial economists and regulators have, on the basis of this last point, argued that a pension is a bond-like liability. So the second cost approach is to discount the liability by corporate bond yields (those rated AA). And the third approach is even harsher; what it would cost the employer to match the cashflows exactly without risk? The answer is to buy inflation-linked government bonds.
When interest rates fall, that means the cost of making pension contributions goes up. The chart from the Redington consultancy shows that with real rates of 2%, the cost of funding an inflation-linked pension is 27% of payroll; when real rates are zero, it rises to 50%, and it gets startlingly expensive after that. Real rates on inflation-linked bonds are around zero, or even below it on long-dated UK issues. Even if you add in a percentage point or so, to reflect the credit spread on AA bond yields, you would struggle to get to 1% real.
There are two important implications. US public sector pension funds are paying in a bit above 18% of payroll and that includes money designed to narrow the deficit which, even on a generous accounting basis, is around a quarter of liabilities. Of course, many schemes don't have to offer inflation-linking. But inflation-linking is important to a retiree who might live another 25 years; at 3% inflation, prices double over that period. Such retirees will be more dependent on social security, which is more generous than its UK equivalent, as they age.
Many employees are in defined contribution schemes, where total contributions (employer and employee) are more like 10% of salary. As the chart shows, such contributions will deliver a benefit that falls well short of a DB equivalent. A recent report suggested that members of US DC schemes should save at least 15% of their salary; UK employees should save even more, because of less generous state provision.
The recent British pension refoms which gave employees the "freedom" not to buy annuities don't alter the maths. In fact, they may make matters worse. By tempting retirees to take cash (and hand over what might be over £1 billion in cash to the government this year), they will leave the elderly with even smaller pots to get through their last 20-25 years. Governments should focus on getting workers to realise that they need to save more, a lot more.
