This month saw the end of an era in British corporate life. After decades of sending its employees to the most dangerous corners of the globe in search of oil — with only the thought of their families and the promise of a guaranteed income in their declining years to sustain them — Shell U.K. became the last FTSE 100 company to announce that it was closing its final salary pension scheme to new members. People joining in the future would no longer receive a fixed income based on their pay rate at retirement.
Only days later observers were reminded of why final salary and other defined benefit schemes are on their way out. The Pension Protection Fund, which is charged by the British government with keeping defined benefit schemes sufficiently funded, revealed a record combined shortfall for U.K. schemes of £277 billion at the end of December — more than four times higher than a year before.
Over the past decade U.K. pension funds have been hit first by unfavorable tax changes, then by plunging equity markets and finally by a rise in the value of U.K. government bonds. This has increased the present value of their liabilities, which is calculated using a discount rate based on gilt yields. Many companies have concluded that making up the shortfalls is too costly — leaving closure as the best option.
Shell’s scheme is — in contrast to many — in rude financial health: its last valuation showed a surplus. However, the company said the decision was taken “to reflect market trends in the U.K.”, notably the trend towards closing defined benefit programs to new hires. Shell no longer wanted to be the odd one out.
Despite this trend, Shell and many other U.K. blue chips still face the headache of meeting hundreds of billions of pounds of future commitments to workers who had already signed up for the defined benefit schemes before they were closed.
Analysts argue that most pension funds can afford to take a longer view of how to achieve this than many other institutional investors since their liabilities are stretched out over decades. In the aftermath of past recessions, this thought would have provided solace. After a few bumpy years, the world’s different asset classes were prone to return to their normal growth patterns, allowing a pension fund manager to make decent returns from a prudently diversified portfolio if given enough time.
But these days investors find little comfort in the thought that they are making long-term investment decisions. The notion simply multiplies their problems. Fears about future investment returns extend far beyond the next few years because uncertainty about the basic tenets of investing is perhaps the greatest it has been in more than half a century.
For example, it is at first sight tempting to invest for the long term once more in U.K. and other rich-country equities since despite extended periods of bearish performance, over the time span of a generation, stock markets have shown a marked tendency to rise.
However, this strategy assumes that developed countries will sooner or later return to strong economic growth, allowing companies to boost their earnings. Many analysts fear that, to the contrary, huge government and personal debt burdens could create a Japan-style syndrome across the developed world — a full generation of economic stasis.
A superficially attractive solution for U.K. pension funds is to invest heavily instead in emerging equity markets such as China and India, whose economic growth remains rapid despite the rich world’s malaise. However, many years of robust economic growth in China has not yet translated into consistently strong stock market performance. Moreover, the correlation between developed and developing-world equities has actually increased in recent years. In other words, the Chinese and Indian stock markets will, on past form at least, provide no refuge should western stock markets falter — a fact proved by their poor showing at the height of the euro zone crisis last year.
Government bond markets provide no easy alternative for pension funds. The euro zone crisis has left investors with two equally unattractive choices: relatively safe sovereigns, including U.K. gilts, that offer below-inflation yields, or countries offering attractive yields but real chances of default. This situation could continue for many years to come, since it is likely to take more than a decade for many rich countries to return to fiscal stability.
Faced with these unappetizing propositions, pension funds are seeking new frontiers, such as infrastructure investment. Developing countries will require massive outlays for port, rail and road over the coming decades. George Osborne, the U.K. finance minister, has recently announced plans to attract £20 billion from pension funds to improve Britain’s creaking infrastructure, including its notoriously temperamental rail system. Successful infrastructure projects have strong cash flow, derived from semimonopolistic power — a characteristic particularly appealing to pension funds, since it gives them a steady stream of income to match each year’s liabilities far into the future. They also offer low correlation with equities — a consoling thought indeed, only four years after stock markets crashed and took a surprisingly large number of other asset classes down with them.
