Hamish McRae: 'It is nuts. The people behind our pension schemes understand zilch about markets'

The PPF - one of the most stupid outcomes you could imagine
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The Independent Online

I was at a pensions conference in Chicago last autumn and asked this question of the audience: who would they trust to run their own pensions - their employer or the government? One person put her hand up and said I had left something out: she would not trust either of them; she would trust herself.

And of course she was right. One of the few redeeming features of the increasingly ill-tempered debate about pensions is that more and more people will realise they have to take control of their own pension provision. It will simply be too risky to rely on an employer to run a sensible scheme, or on some future government to treat its savers fairly.

If you did not believe that, the past week should have been convincing. A continuing stream of companies are changing the conditions of their final salary pension schemes - either shutting them to new entrants, or changing to average salaries, or switching to a money purchase basis. Understandably people feel sore, though for reasons noted later, I suspect that those moving to a money purchase scheme will have reasons to be grateful.

All this has been going on for several years, but now there are a couple of other factors. One is that companies are approaching the end-March deadline when their occupational schemes are assessed on their risk level, which affects the amount they will have to contribute to the new Pension Protection Fund.

The other is that the financial year ends soon, on 5 April - at which point the terms change under which payments can be made into a pension. This will greatly increase the case for people having some form of pension that they themselves can control.

The first of these factors is a prime example of the law of unintended consequences. Ever since the Maxwell pension scandal, which - ahem - some senior Labour figures know more about than they should, there has been pressure for some kind of collective protection fund. But as it would be unfair for well-resourced schemes to pay the same as those in potential trouble, funds are being rated for their risks. Those that are notionally more risky have to pay more.

That is the theory. What has actually happened is one of the most damaging and stupid outcomes you could imagine.

The trouble is, the only way of being absolutely sure a fund will enough money to cover its liabilities when people retire in 20 or 30 years' time is for it to hold investments that match the maturity of those liabilities. That, in practice, pushes pension funds into investing in long-dated gilts. So a government stock that pays back x pounds in 2035 is deemed safe, even though it pays a terrible rate of interest, offers no scope for capital growth and gives no protection against inflation.

It gets worse. Pension funds are not legally required to pile into gilts but the "cover your backside" culture of advisers and trustees puts great pressure on them to do so. The result is that interest rates on gilts have fallen and their price has correspondingly gone up. In the most extreme case, a very long-dated index-linked gilt, the yield dipped below half a per cent.

As anyone on the brink of retirement will now know to their cost, the yield on gilts is one of the main factors determining annuity rates, the other being life expectancy. Thus pension fund liabilities are valued using bond yields. So the fact that the funds are buying gilts leads to reduced annuity rates.

Not only are they being pushed into bad investments, the effect is to increase their liabilities, making those that appear under-funded even more so.

It is nuts. The people who thought this up may be very clever at setting actuarial requirements but they understand zilch about markets.

So what is to be done? I suppose the Government could take off a bit of pressure by issuing more long-dated stock. It is borrowing big and will have to go on doing so. But that would be only a marginal help.

More fundamental would be to change the way pension fund liabilities are assessed. As Denis Gould of AXA Investment Managers pointed out on Friday, almost everyone agrees that equities will ultimately outperform the current low level of bold yields and there could be changes to stop this trend towards gilts. "Because many liabilities are long term in nature, schemes should be allowed to operate a long-term investment horizon."

That must be right. What we need to avoid is the sort of regulation that forced Standard Life to sell £7.5bn of its equity portfolio two years ago, near the bottom of the market, to fulfil the new arbitrary solvency requirements of the Financial Services Authority. Other life assurers had to do much the same, albeit on a smaller scale.

On a sensible long-term view, pension funds ought not to depart too far from the global mix of world assets in the pie chart: 47.7 per cent equities, 30.0 per cent bonds and 21.2 per cent in property and other assets. Maybe investment should be a bit more skewed towards equities.

On a very long view, in the next chart, equities have outperformed other assets and will probably continue to do so. It is commonsense that any fund ought also to have some investments in the fast-expanding economies of Asia. The one thing it absolutely should not do is confine itself to UK gilts.

This leads to a further thought. There is a general assumption that final salary schemes are best for the employee. But provided the employer puts a reasonable amount into the pot, and provided the investments are weighted towards equities and growth markets, it is perfectly possible that a money purchase scheme could produce a better result. That applies particularly to people who change jobs a lot.

And the ultimate money purchase scheme is your own one: a self-invested pension plan (Sipp). In theory, the new rules on payments into a plan, which replace annual percentage limits with a lifetime total, should not really change the equation greatly. But in practice, they seem to have done so. Some people thought Gordon Brown's recent decision that property could not be put into a Sipp would deter people from taking them out, but the pension groups that run the plans report strong demand.

The whole question of how the new lifetime limit works, the fact that some people will be clobbered who won't have expected it, and the implications for the markets as more and more people take control of their own pensions - all this is going to be a huge and complex story.

We are lucky as a country to have a large funded pension sector (see third graph), one of the biggest in the world. But our regulators and advisers should be aware of the enormous damage they are doing in forcing pension funds into poor investment choices. If they don't feel a certain collective sense of shame, well they should do.

Bye bye cathode ray, hello broadband

Suddenly we seem to be in the middle of a new burst of hi-tech take-up, when the number of people using the new technologies surges upwards.

It was, so to speak, an internet Christmas - as present buying from our computer screens took off. Online shopping is now around 9 per cent of the total, according to the Interactive Media in Retail Group. If that sounds a lot, remember that something like half of all holidays and flights are now bought on the net and these big-ticket items pull up the total.

We have also made two other big switches. One is to broadband, which overtook dial-up last May. The UK now has the highest number of broadband connections in Europe, nearly 10 million. One of the reasons people seem more comfortable shopping online is that their connections work so much faster.

The other switch is towards flat screens, both for computer monitors and, more dramatically, TVs. The 60-year reign of the cathode ray tube ended last year. Dixons has stopped selling these TVs and I expect it will be impossible to buy one in a couple of years' time.

Meanwhile, a string of new applications are coming through, with Tesco's move into internet telephony one of the most interesting. We are pretty close to a situation where fixed-line phone calls will be so cheap as to be virtually free. Expect mobile calls to follow as "clever" phones that can switch from picking up a hotspot computer signal to a home wireless one are rolled out.

But the most interesting practical thing to look out for in the coming months will surely be this. Will this array of new kit entice us to spend more?

Not sure about that, but if the answer is yes, then expect the present mini-uplift in consumer sales to continue - and the prospect of lower interest rates to recede with it.