View from City Road: Unintended burdens for pensions

Pension funds have lost about pounds 12bn, courtesy of the Chancellor of the Exchequer. Though no more than a back of envelope estimate, it highlights the extent of the penalty they suffered in the Budget. Even Robert Maxwell did not cost that much.

This is so large that there may have to be changes affecting pensioners, companies and investors. All could suffer, especially if, as many in the industry fear, further tax changes follow.

The cost reflects the way pension funds are valued on the basis of the dividends they receive rather than on the market value of their assets. If dividends fall, so do the value of the funds, even if share prices hold up. The budget tax changes to dividends will prove extremely expensive for pension funds.

Whereas they now reclaim the 25 per cent tax credit on dividends, in future they will be able to reclaim only 20 per cent. Their cash flow will fall by about pounds 600m a year in aggregate.

There are two ways of putting a capital value on this annual cost. The first and most vague is simply to multiply it by 20 - which is no more than a round number that reflects the long timescales of pension investment.

Sceptics of such actuarial approximations might consider a slightly more methodical approach.

Start with pounds 320bn assets - the total in pension funds. Then take the UK equities portion - 60 per cent of the total. Then cut that by 6 per cent, which is the fall in the yield as a result of Tuesday's tax changes. Lo and behold, it comes to pounds 12bn too.

The effect will vary according to the type of pension arrangements. Defined contribution schemes may shortly have to consider cutting the pensions they pay to pensioners, something that will not buy the Government many votes.

On the other hand, defined benefits schemes, the majority, may have to secure higher contributions. More than half of all companies have been enjoying a holiday from making contributions to their pension funds, benefiting from a boost to profits and cash flow.

Over time these holidays are bringing down surpluses - though Bacon & Woodrow, the consulting actuaries, say they still stand at 20 to 30 per cent on average. Many companies that previously enjoyed holidays are now having to restart contributions - BT, for example, will restart its contributions next month. This trend is likely to quicken.

The effect on earnings - and therefore on investors too - will be masked by the triennial valuation cycle. And by the wondrous ways of accounting rules embodied in SSAP24. It should also be offset by the benefits to cash flow from the dividend tax changes, worth pounds 900m in the first year.

Whether Mr Lamont meant to bring about all these changes is doubtful. He was more concerned about his funding requirement than pensioners' incomes.