Pensions – The Missing Factor

We are told (for instance here and here, the major reason increase in the real cost of pensions (and the consequent demise of private sector final-salary pension schemes) over the last few years are

1. The increase in life expectancy.

2. Changes to accounting rules, meaning that companies have to include future pension liabilities in their balance sheets

3. The low returns from the stockmarket since 2000 – exacerbated in the current recession.

4. In the UK the 1997 Gordon Brown tax on the investment income of pension funds.

But the biggest cause of the rise of the pension deficits is the fall the long-term real rate of interest. This not only impacts on the compound returns to the pension “pot”, but also the size of the annual annuity that can be purchased on retirement. As a consequence, a fall of just 1% in the rate of interest might increase the contributions by 50% to obtain the same size pension. Always low interest rates benefit borrowers to the disadvantage of savers. Like sub-prime, pensions are another long-term hangover from the low-interest party since 2000.

In the UK, as a consequence of the low interest rates and high government spending we now have the following problems.

EITHER – We have low interest rates, meaning those working now have to save more for retirements

OR – We have higher interest rates, meaning higher taxes to fund the ballooning national debt and a steep fall in house prices.

The short-expediency of boosting the economy by low interest rates and deficit spending has reduced living standards for the elderly in the long term.

Politician’s Remuneration – From Brazil to Blighty

Yesterday I blogged about a paper that claimed that higher salaries for politicians resulted in more educated, experienced and hard working politicians. From my own experience of Brazil, I tried to show that that the results could be interpreted as encouraging political dynasties and patronage.


In the UK, there have been two aspects of politician’s remuneration that have been in the news recently.


The Home Secretary’s 2nd Home Allowance


It is alleged by Guido Fawkes, Iain Dale  (and back up by the Sunday Times & The Mail on Sunday) that Ms Jacqui Smith MP is incorrectly claiming which of her two places of residence is her 2nd home. It would appear that the Home Secretary’s primary residence is with her sister in London, and the 2nd home is with her husband and two children in the Redditch constituency. Furthermore, Jacqui Smith’s website biography states


            Jacqui grew up in Malvern, Worcestershire before moving to Redditch in 1986.  She still lives in Redditch with husband, Richard and sons James (13) and Michael (8).


The Daily Mail is making similar allegations about the Chancellor of the Exchequer, Alistair Darling.

Allegation of sleaze (covert corruption) undermined the last Conservative Government, contributing to suffering, in 1997, the biggest defeat of any government since 1832. Yet, the sleaze did not extend to the Home Secretary (in charge of the nation’s police forces) or allegations of financial impropriety extend to the Custodian of the State’s finances.


Pensions for Failure


The Sunday Times (Hat-tip Iain Dale) reports that MPs are pushing for a substantial increase in the “Parachute Payments” when that they receive when they fail at a general election to get re-elected. Furthermore, this is to be extended to those who resign or retire mid-term. I can understand and sympathize with someone who has to step down through ill-health. But to compensate those who resign due to incompetence or worse is not in the public interest. Furthermore, to make politician’s terms and conditions better when unemployment is forecast to rise by a million in the current year, is not exactly showing solidarity with the working classes.

I admit that MPs are not paid as much in relative terms as their counterparts in Brazil. A British MP has a basic salary of just 6.5 times of a full-time worker on the minimum wage. In 2004, their equivalent earned over 38 times the minimum salary. However, in neither country to they have any shortage of applicants for the posts, which tends to suggest they are a might overpaid.

Gordon Brown to Raid Pensions (again)?

In one of his first acts as Chancellor, Gordon Brown raided the UK pension funds. Now as John Redwood MP points out, this might be happening again. 

Just Posted to John Redwood’s blog in response to this comment on 8th December


There is something else to be worried about pensions. With the government forcing down real interest rates, the returns on pensions will also go down. That is the pot accumulated to retirement will be much less (due to compound interest) and the returns that the annuity will give will be much less.


Those pension funds holding bonds will get a one-off boost every time the interest rates go down, but the impact of pension funds having to hold ever-larger quantities of their funds in near zero-return assets will create the following problems.

1) The pension deficits will balloon, just as companies see operating profits plunge with the recession. The government will have to nationalize the pension funds, to save the businesses.

2) Many people will try to put off retirement, just as the workforce is shrinking. The government will have to subsidize people’s pensions

3) Many financial institutions will be unable to meet existing annuity payments (if those funds are affected), so may offload this onto new annuity quotes, or ask the government to bail them out.


The general thinking that we should be lowering interest rates to near zero should be re-visited. With plunging house prices, and the prospect of losing their jobs, folks are not going to buy houses, or incur more debt at the moment. You are right, Mr Redwood in saying that we should reverse the VAT reduction early. However, along with a few spending cuts, this may be much too little, too late.


I would like to substantiate this view with a quick calculation.

How much will annuity rates be affected if the average return was changed. I did a quick spreadsheet calculation, looking at the annuity rates for a £100,000 lump sum for different rates of return.


I came up with this table.


    Return % Annuity % Income £
    1% 3.29% 3,287
    2% 3.71% 3,708
    3% 4.16% 4,159
    4% 4.64% 4,637
    5% 5.14% 5,142
    6% 5.67% 5,673
    7% 6.23% 6,226
    8% 6.80% 6,801




     The assumptions are listed below, but the basic point that I want to illustrate is that if the average long-term rate of return diminishes, then so will the average payout from the annuity. (The returns do not decrease as quickly, as an annuity eats up some of the capital each year.) If the weighting of lower-yielding, secure bonds is increased and the yield on the new bonds is decreased, then returns on annuities will decrease alarmingly.

In the long-term, if interest rates then go up after a few years of low rates and increasing proportions of bonds to equities, then the value of the pension funds will drop with the fall in bond values. This will more than offset the short-term boost that they got when the interest rates fell.


   The old fashioned method of resorting to the printing presses will come none too quick. According to Guido Fawkes the government is already laying the ground for this eventuality.



The assumptions are

1)     25 year assumed span.

2)     One payment annually and one fixed return at end of the year.

3)     Rate of return is constant.

4)     Income rises by 3% per year.

5)     Management fee of £200 rising by 3% per year.