October 28, 2008  

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THE UK OVERVIEW

The year 2008 will be recorded in history for the financial shock.  While this shock will have an impact on pensions, the year 2008 is actually a quiet year in terms of the framework of UK pensions.  This is because major decisions about the framework for providing and protecting pensions were made in previous years.  As we explained in previous Newsletters, the framework decisions were:

a) The introduction of the Pension Protection Fund to ensure that pensions continued to be paid, with minimal reduction, even if the company sponsoring the scheme failed.  The Pensions Regulator and the rule that companies must top up a scheme's funds before they can wind it up are necessary consequences of having a Pension Protection Fund; they are needed to avoid companies gaining from underfunding and then dumping the scheme on the Pension Protection Fund.

b) The decision to link State Pension increases to an index of earnings instead of, as now, to the Retail Prices Index.  Economic conditions will determine whether this is an advantage or not, and whether the index used is a good match to the actual cost increases experienced by the elderly.  However, the existence of a policy agreed by Parliament makes it unlikely there will be big changes on the State Pension front in the short term.

c) The introduction of Personal Accounts, essentially a money purchase scheme for those on low incomes, administered nationally by the government.  The employer contribution is 3% of the employee's wage and the employee contributes 4%.  Eventually there will be debate about whether these figures are high enough - the comparable Australian scheme is stronger - but not until Personal Accounts are in play.

An overview of different schemes nationwide is in Categories of UK pensions schemes.

The "end-game" for Final Salary Schemes is an update on companies off-loading their pensions schemes.  (IBM schemes are not close to this stage.)

WHY WORRY?

There are those who feel that life is too short to worry about meteorite strikes, bank failures, or undelivered pensions.  On the other hand, meteorites have wiped out much of life on earth in the past, Icelandic banks have recently failed, and some people (even in final salary schemes) will get less pension than they expected as a result of the economic downturn.  So there will be those interested in what the chances are, whether or not they react to them or can do anything about altering them.

THE IMMEDIATE IMPACT

The downturn serves to emphasise the fundamentals of our pension arrangements. When we say "the employee takes the risk" with money purchase schemes that is brought home by the numbers showing reduced value of individual pension savings. (And there is an additional risk that when those savings are turned into an annuity, the annuity rates will be poor.) So there is a strong connection between market moves and how achieving the intended pension might mean more years of work or AVCs. The events also emphasise how important lifestyling (the planned conversion of assets to cash) is to those nearing retirement.   The consolation for M-Planners is that if they continue saving they will be investing in assets that, in time, may be seen to have been bought cheaply.

For final salary schemes we say "the employer takes the risk" and that is largely right, but there is some risk to the employee that the employer will degrade the scheme. In IBM's case, for the 2004-2006 situation the fund deficit rose to around £1 billion and was resolved by a contribution from IBM of a bit more than half of that, in conjunction with degrading of the scheme to account for the other part.

The current market downturn will have reduced the value of scheme assets. (That reduction is not quite the same as the deficit figure because the latter depends on guesses of future returns on investment.)  You can work out the amount of the reduction from the data on where the Fund keeps its assets (as shown in the Members' Report) and public data on the hits to the different categories.  The reduction is more than a £1 billion.

The 2006 Actuarial Valuation tells us about the sensitivity of funding levels to investment conditions.  A 20% decrease in equity values corresponds in the example to an 11% reduction in the funding level.   The last date for which the Trust has given you a funding level is "end of 2007".   From then to now, there has been approaching a 40% decrease in equity values.  The table provided in the 2006 Valuation goes no further than a 20% decrease of equity values but it notes "'Catastrophic' investment conditions which would produce significantly worse funding positions than those shown in the above table are also possible."   Thus what we have experienced falls in the catastrophic range.

The "health" of a fund is a combination of what it owns and the strength of the company's ability and willingness to contribute - known as the employer covenant. So how healthy you judge our fund to be will involve an assessment of IBM. Just looking at history, there is no great cause to doubt the company's ability to pay; over the past decade it has generated enough cash from its operations to spend something like $100 billion on buying back its own shares.

There are various ways of thinking about the robustness of a final salary scheme.

- The deficit figure is useful to the trustees, because trustees get a lot of associated charts of a "what if" nature.  Scheme members generally tend to give the deficit figure more credibility than it deserves.  It is the difference between two large numbers, the asset total and the predicted costs, both of which are uncertain.  The current value of shares may be known but their value will differ when sold.  The prediction of costs has great uncertainty - longevity, rates of return on investment etc.  The difference between two large and uncertain numbers is not something to have much faith in. (But it is better than nothing.)  Here is an example of the quirks that alter the deficit.

- The cashflow is based on more reliable numbers.  The fund gets cash from employer and employee contributions and from dividend-like income.  If that comes to more than is paid out in pensions then the scheme will not have to sell off any assets to keep going.  This indicator puts undue emphasis on "now" and too little on the future but it is simple.  In our case the rough figures are £200m to pay in pensions p.a (was £198.5m in 2007), £50m from contributions (£48.7m in 2007) and £100m from income (£103.8m in 2007).  The gap of 200-50-100=50 has to be covered by converting some assets to cash, but usually the growth in value of the assets will allow that to happen without the value of what is left being much less than at the start of the year.  We don't have the figures for 2008 or estimates for 2009 yet but the £200M will not change much (unless a lot of us die from avian flu or some other event).  The £50M contributions will not change because that is planned ahead of time. It is the £50m gap coupled with recession that will, unless changes are made, put the scheme on the downward path of consuming its capital.

- The Scheme Deficit to Company ratio captures the idea that a small pension scheme run by a big company is more secure than a big pension scheme run by a small company.  There is an established way to compute the size of company, the Market Capitalization.  This is the current share price times the number of shares in the company outstanding.  The ratio of the fund deficit to the capitalization is the indicator.  British Airways, for example, has struggled for years with a deficit nearly equal to the value of the airline.  In our case IBM Corp is worth some $123 billion.  That is much larger than the deficit in the IBM UK plan.  AMIPP does not know enough facts to compare with the sum of the deficits of IBM schemes worldwide.

- Another way of considering the future of a company is see whether the top executives are keeping their investments in the company.  Sam Palmisano took $71 million by selling IBM shares recently.

You should judge for yourself, but the current indicators suggest that the impact is very serious but that IBM can afford to absorb it.

THE RECOVERY PLAN

The trustees of a  pension scheme with a deficit are required to put in place a recovery plan addressing any funding shortfall.  The Regulator becomes concerned if that recovery plan covers more than ten years, and would like the period to be short.  We must hope our trustees are working on a realistic recovery plan, with as short a period as is practical.

RECESSION/DEPRESSION

As with the Actuary noting the possibility of catastrophic investment conditions, there is merit in considering worst cases even if those cases are not being predicted.

For most cash in most banks, the government has provided security.  State Pensions are most unlikely to be lowered - it is normal for social security type government spending to rise during economic downturns.  Insurance companies are more robust than banks.  If you have already purchased a pension as an annuity from an insurance company its delivery is relatively secure - in principle because FSA regulated companies are covered by the Financial Services Compensation Scheme and also because (to judge by recent precedents) the insurance company would not be allowed to fail.  If you are building up pension savings with an insurance company (e.g. are in the M-Plan) then (by the same reasoning) you are unlikely to see an event of failure - a prolonged falling  in the value of the investments the insurance company holds on your behalf is a more likely worse case.  For pensions already earned in a final salary plan (whether in payment or not) the regulations ensure delivery provided the company stays in business.  If the company fails, most of the pension then will be delivered by the Pension Protection Fund (PPF).   However, the PPF level of pension is not guaranteed - the regulations allow for the level of benefits to be lowered.  Having explicitly regulated this possibility it would seem likely that the government would let it happen, in preference to subsidising the PPF.  In other words, one can reasonably expect the PPF to function, but not necessarily to delivery as much pension as current claimants are getting.

AGE DISCRIMINATION

The Trust and IBM have finally agreed on implementing the avoidance of age discrimination, some 20 months after that became the law.  The key point to remember is that age discrimination was so deeply ingrained in the nation's pension schemes that prohibiting it entirely would have made schemes unworkable.  So the law introduces exemptions - scheme characteristics that are ageist but are not unlawfully ageist.  The most obvious example for us is in the comparison of the enhanced M-Plan with the regular M-Plan.   This is ageist because it favours the older employees who were eligible for the enhanced M-Plan, and it would be illegal if introduced now.  However it is not illegal because the enhanced M-Plan was both opened and closed in mid-2006, just before the anti-ageism regulations became law in December 2006, so it comes under an exemption.

After exploiting of the exemptions,  the main change to our schemes from the ageism regulations becomes increased company contribution percentages for older enhanced M-Plan members.   While this can be welcomed as an improvement of benefits, it is a touch unsatisfactory that the improvement goes to some scheme members least in need of extra benefits.

INFLATION

The Daily Telegraph reports inflation for pensioners is running at 13.7% p.a.  This is likely to fall as recent heating price increases drop out of the calculation.

LONGEVITY

It is tempting to use the age profiles of scheme members (which Pension Services has published) to deduce, from the difference in membership at different ages, what the rate at which members die is.  This is not sound because IBM did not always recruit at the same pace - the age profiles say more about when people joined IBM than they do about longevity.  For longevity one needs a table or graph like this.

INEXPERIENCED OFFICIALS?

Pensions Minister Mike O'Brien has now been replaced by former transport minister Rosie Winterton, who becomes the 16th MP to look after pensions since Labour came to power in 1997. (Two-thirds of us do not trust any political  party to solve the "pensions crisis")

SIR EDWIN NIXON

Following the death of Sir Edwin Nixon, former IBM UK Managing Director, a memorial service will be held in Winchester Cathedral on 2 December at 12 noon.  The service is open to any colleagues who knew and worked with Sir Edwin and would like to celebrate his life.
 

INCREASES FOR US IBM RETIREES

The US scheme does not provide any automatic increases for retirees.  Some increases were awarded this year.  The complicated details have not been published but the increases went to those who had been retired a long time.  The average was probably 6% but that is not 6% p.a. because there was no increase in previous years.

CONTACTS

The "Contact AMIPP" page allows you to email AMIPP officers.  You can also email people who contribute to the Forum, even if they used a pseudonym and you do not wish to contribute publicly. You do this through the "Private message" facility of the Forum mechanism.

DISCLAIMER

As always, nothing on the AMIPP website is financial advice.  Also, AMIPP is not responsible for the content of websites that it links to.

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