From the TUC

How the Government can help DB pensions

02 Dec 2009, by in Economics, Pensions & Investment

The National Association of Pension Funds is right to call on the government to issue more index-linked and long-dated bonds (FT report). Interestingly 80% of their members say that this is the single most helpful thing that government could do to help preserve defined benefit pensions (ie pensions with a promise that pay out depending on your length of service and the terms of the pension rather than on the performance of investments).

Employers say they dislike DB pensions because they have to shoulder all the risk. They do not know how their investments will perform, they say, and they do not know how long members of their scheme will live. In addition scheme deficits can yo-yo around in an alarming way as the value of their investments go up and down.

But if they can invest in bonds that are linked to inflation over the long term that reduces their exposure to risk. They no longer need to be worried about future inflation. This also reduces their deficit when the scheme is valued.

I’m struck that pension scheme managers say this is the most helpful thing government can do. There is much more noise made about further deregulation of DB pensions than about bonds, but here is a way of government helping DB without further threats to future pension benefits.

There are other good arguments for providing these kind of gilts too.

Over at CentreForum Giles has argued that they can be an important way of funding the deficit. In this paper he says:

The answer lies in a greater use of index-linked bonds. They cost more to service if inflation rises, or less if it falls. There is a considerable demand for such bonds from pension funds, one which is probably unfulfilled at the current rate of issuance.

It was a little noted bright spot in the last Budget that the forecast for debt interest in 2009-10 was £3 billion lower than the year before, despite overall debt levels climbing by £150 billion; this is largely due to lower charges on indexlinked debt.

The next government should announce an intention of increasing the amount of debt issued in this way – perhaps to 40 per cent or more. Doing this will reassure the market that it does not intend to inflate its problems away. It may lower the risk premiums on all forms of government debt, and throughout the economy. It will also help to stabilise the fiscal position in the event of another deflationary episode, as deflation lowers their cost. Finally, the strong demand for these instruments makes them a cheap source of funds for the government – they have recently been issued with real yields below 2 per cent.

While this blog yields to no-one in defending public sector pensions, it is true that the public sector has an advantage in that it can run “unfunded” pensions (ie pensions that do not have their own investment fund but instead put their contributions and payments into the general public spending pot). Instead of investing in the assets that other pension schemes do, they can instead rely on the long run growth of the economy to guarantee future increases in tax income. This means that they can assume a greater return on their notional investments than funded pensions and also avoid the volatility risk of conventional investments .

Index-linked gilts are one way of extending some of this advantage to other pension scheme members and pensioners both to help underpin annuities and as part of the invetsments held in a pension fund.

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