Last updated: October 16, 2012 9:01 am

Pension schemes face 30-year funding gap

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Employees face a much greater risk their pensions will not pay out than regulators have made assumptions for, amid growing efforts by the industry to tackle the problem of underfunded schemes.

Companies such as BT Group and British Airways, which have some of the largest UK pension funds, face the biggest risks because they have mature schemes that must pay out millions of pounds to retired members every year.

Analysis by Towers Watson, a consultancy, shows that managers of defined benefit schemes, which offer a fixed annual pension, are far more exposed to the threat of volatile equity markets than had been calculated.

This is because they need nearly 30 more years before they will be able to fully “de-risk” their schemes – switch out of riskier investments, such as equities, and move into safer assets like index-, or inflation-linked, bonds, which allow fund managers to offer close to guaranteed payments.

Towers Watson says UK schemes have liabilities of £2tn compared with index-linked gilts supply of £0.5tn and that it will take until 2039 before the supply of index-linked gilts matches liabilities.

This is much longer than the estimate of about 10 years by the UK Pensions Regulator. Schemes must match their liabilities – current and future payments – with assets, revenue from equity or bonds, to make sure they can meet all their pension obligations.

Although schemes use other fixed income assets, such as conventional gilts and corporate bonds to match liabilities, index-linked government bonds are thought the best instruments to buy as they guard against inflation and are also considered almost risk free.

Fund managers have reduced the amount of equities they hold to 40 per cent from 60 per cent since 2006, but some want to cut their exposure further, as the recent roller-coaster ride in equity markets has put pressure on deficits and increased fears over the ability of schemes to pay out.

BT, which has suffered from the sharp falls in equity markets, was this year forced to make a £2bn payment to halve a pension “black hole”, but fund managers say the company’s scheme is likely to remain underfunded, or without enough money to guarantee pensions will be paid in full, for years.

Alasdair MacDonald, head of investment strategy at Towers Watson, said: “Some pension schemes may not need to remove all their risk because they have plenty of time before their members retire, but those mature schemes that have to make payments to pensioners every month are more likely to want to take as much risk off the table as possible.

“They need guaranteed fixed income payments, protected from inflation, so they can pay their retired members.”

Worries over the lack of suitable assets to match liabilities has prompted the National Association of Pension Funds, which represents 1,200 pension schemes with combined assets of nearly £800bn, to look at alternative ways to match liabilities with safe assets, such as the creation of a debt market linked to infrastructure projects.

Joanne Segars, chief executive of the NAPF, said: “There is simply not a big enough supply of index-linked bonds. We need other gilt-like instruments to help schemes match liabilities. We are currently looking at other assets, such as infrastructure instruments, that might offer ways to de-risk portfolios.”

The Towers Watson calculations are based on UK Debt Management Office projections and assumptions that index-linked issuance will remain constant.

Separately, on Tuesday, the National Association of Pension Funds warned that workers’ pension pots were at risk of losing up to a quarter of funds under the government’s pension plans, as workers switched jobs and schemes. The charity called for a low-cost “aggregator scheme” where savings could be pooled in a single place.

Steve Webb, minister for pensions, said: “Far too many people have absurdly small amounts of money scattered between far too many pension schemes. I am determined to make sure that people start to build up decent pension pots and keep track of them.

“For too long, an overly complex system has made it hard for people to transfer their money between pension schemes. We need a big shake-up to make it safe, cost-effective and easy to move your pension pot around.”

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