In a tangle on pension 'promises'

JOHN RALFE, the consultant who in a former post masterminded the switch of the Boots pension fund from equities to gilts, once remarked that the lessons of Equitable Life as outlined in the Penrose Report were more applicable to defined pension funds than to insurance companies.

Unintentionally adding to the debate, Financial Services Authority chairman Callum McCarthy said in a speech to the insurance industry this week that 'it is inherently unlikely that a product can be offered which offers policyholders guaranteed returns and a high exposure to volatile assets at the same time'. In English, that means if you are offering a guaranteed sum of money to a customer, go easy on the investment in equities or make sure you have enough of them.

McCarthy in turn was building on remarks made the day before by FSA insurance specialist David Strachan, who reminded his audience that the point of changes being made in the way life companies report is 'no more complex than to ensure that firms ultimately have enough capital to be able to honour the promises they make to their customers'.

We have got into this tangle because the financial services industry makes subtle distinctions between what is a promise and what is a guarantee. What has changed in recent years is the tolerance of customers, politicians and thence regulators for this sophistry.

The policy now is that if customers have got the impression from custom and practice or from what they were told in the sales process that a bundle of goodies is coming their way, the industry had better be prepared to put its money where its salesman's mouth is. It is no longer allowed to have a disconnect between what it tells policyholders and what they get.

The FSA does not regulate occupational pensions but if it did, it could only be uncomfortably aware that similar issues arise. Company funds normally promise to pay a pension linked to final salary. Now that public expectations have changed so that insurance companies have to honour their promises, expectations have also changed for pension funds.

For too long they have given the impression to members that as long as the employer continued in business, the employees would get their pension. Only in the small print did it say that the legal liability of shareholders was to provide significantly less than the company was publicly promising.

If the regulator were to demand a guarantee that funds have the capital to meet their 'promise', the implications would be profound. Indeed, one of the country's top actuaries told me privately last year that if pension funds were made to account like insurance companies, nine out of ten would be insolvent.

We will soon know how close is his guess. Starting later this year, actuaries will be required to quantify the shortfall in pension schemes if they were required as of now to buy cover for their liabilities in the open market. And this information should be made available to the scheme members.

That underlines the way the world is moving. A Government edict last June said that employers could no longer walk away from pension scheme deficits but had instead to arrange to buy the appropriate level of benefit in the open market. More recently, it said it would be legislating to set up a new regulator of pension funds as part of its plan to overhaul the whole of pension law.

Presumably this will soon be upon us and then it seems likely that matters will move quickly to a head. Government will insist on the Pension Protection Scheme being properly funded and that all funds covered are properly funded, too - not in accordance with some comfortable actuarial assumption but on a similar robust basis as has been applied to insurance companies.

This does not mean they have just to invest in gilts but, if they are to commit to equities, they must have sufficient extra in there to cope with the sudden ups and downs of the market.

This is potentially very threatening for some companies - notably most of those that had British in front of their name, used to be in the public sector and have far fewer employees now than they did in the past. The pressure goes much wider and deeper than that narrow band, however, and there is scarcely a company of any size which is not vulnerable and which would see profits significantly reduced for some considerable time.

A move to proper funding would be too much for many to swallow all at once - they simply do not have sufficient resources - so the key question is how many years' grace they will be given to sort things out. I suspect 10 years to be the maximum, which does rather put a damper on equities for the next decade.

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