October 11, 2013

Find me Drake’s Drum!

Following on from the last-but-one Update with another Sir Henry Newbolt poem, you will recall the legend that Sir Francis Drake is not dead, but resting, and will return to save his country when someone is desperate enough to beat his drum.

Pension schemes certainly need a saviour at present. Consultants Hymans Robertson recently produced a report stating that pension scheme deficits for the average FTSE 350 company have increased by an astonishing 70% between 2010 and 2013, despite the FTSE 100 index rising to levels not seen since 1999. Average pension scheme assets have risen since 2010 by 30%, but are offset by a 25% increase in already-high liabilities.

The saviour this time could be the spirit of George Ross-Goobey. Those with long memories may remember him as the manager of the Imperial Tobacco Pension Scheme in the 1950s. He realised that although the economy was growing, yields on gilts (then 3%) were lower than the yield on equities (then 4%). Over the course of two or three years, Ross-Goobey managed to persuade the Imperial Scheme’s trustees to move the entire fund into equities – and predominantly into smaller companies, rather than the monolithic FTSE 100 companies. This approach was spectacularly successful. By contrast, those schemes that remained invested in supposedly safe gilts lost money right through to the end of the 1960s.

So what is the current position? Gilts yield around 3%, and equities 4%, and the economy is now growing, albeit at something of a snail’s pace. However, the stock market as a whole has been going like a train. The FTSE 100 index is up 16.8% over the last year, and the Sunday Times reported recently one prediction that the FTSE 100 index could treble within the next ten years. On the other hand, if your scheme buys a 10-year gilt and its yield rises from 3% to 4%, the capital value of the gilt drops by 25%. Does that sound like a safe investment?

Meanwhile Mark Carney, the new Governor of the Bank of England, has indicated that interest rates will remain at their current record low levels until the unemployment rate falls to 7%. Best estimates make that at least two years away. Mark Carney himself believes it may be three years.

At the same time the actuaries and pension consultants Barnett Waddingham have announced that schemes have spent over £3 billion this year buying bulk annuities to cap off their pension liabilities. But they also announce that the UK bulk annuity market is rapidly shrinking, with the large insurers like Legal & General absorbing smaller competitors. It is generally the case that the less competition there is, the higher the prices rise – or am I being too cynical?

The result is that schemes (except perhaps the very largest) will soon be unable to afford to buy bulk annuities. If schemes try to “do it themselves” and buy gilts to match the pension liabilities, they will lose money and so the schemes’ liabilities will increase. The only way out is up – that is, to grit your teeth and buy equities.

In its simplest form, a pension scheme is a device to provide a stream of relatively small monthly pension payments. It does not matter how these payments are provided, so long as they arrive. If annuities are becoming too expensive, the scheme can pay the pensions directly from the scheme fund. So long as the scheme fund does not run out before the last member dies, everyone should be happy. The problem is that the members are living longer and longer.

So the argument runs something like this :

(a) Scheme liabilities continue to increase, despite schemes adopting “liability-driven” investment plans.

(b) “Liability-driven” investment plans use gilts and other low-yielding investments.

(c) Yields on low-yielding investments will remain low for the foreseeable future.

(d) Annuities have priced themselves out of the market for all but the very largest schemes.

(e) Investing for growth (that is, in equities) has become the only sensible option to deal with existing deficits and increasing member longevity.

While it would be interesting, to say the least, to have Sir Francis Drake back, it would be more realistic to have another George Ross-Goobey as our investment manager . . . .

If you have any comments on this blog please contact Roger May on 020 7583 2222 or [email protected]

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