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PENSION FUND ASSESSMENT 1 Summary 1) Pension funds successfully achieving long-term compound investment growth of 5%-6% pa or better can be confident of being able to meet all pension obligations as they fall due. Section 5 below sets out the reasoning. Confirming in particular no 'deficit' exists. Sections 57 & 58. 2) Sustained growth at modestly higher rates 7%-8%, enables pension increases arising from inflation and longevity to be funded. 3) Above ~ 8% inflation-protected / proofed pensions become possible and improved pensions. 4a) A simple Interactive Spreadsheet Model is now available(via Contact Us section), enabling you to experiment with key aspects of pension fund behaviour, longevity, inflation, etc. The outcome is significantly different from general understanding of how pension funds work, as will be apparent from what follows. 4b) A more complex model enabling existing pension Funds to be studied is also in use. Sections 38, 39, 48-56 below. Fund-Protection Longevity is not a problem for the well-structured fund. The aim is to ensure the fund lasts longer than the life of its longest living member (however long that may be), which requires only a small increase in annual rate of investment growth. A typical fund-protection scenario, based on this principle, is set out in sections 6, 7 & 8 below. This unexpected feature arises from the non-linear nature of compound growth. 6% annual compound growth builds fund value 33% faster than 5%. 7% 66% faster. 8% twice as fast. Section 5. Build-up of investment growth, and thus fund-value, accelerates sharply at higher levels enabling sharply higher levels of commitment to be supported, including improved pensions. As a consequence Defined Benefit Pension Schemes offer a particularly robust, healthy, efficient and secure form of pension provision - at moderate cost to the Employer - once guidance along the lines of this website is followed. 5) On the downside, funds growing at less than around 5% pa during their formative years face certain failure, unless quickly changing strategy towards achieving higher investment returns. Most bond- and gilt-based funds fall into this category, needing to switch to equities, or equity-based equivalents (CASH in a downturn) to accelerate growth to a sufficient level. Again compare sections 6, 7 & 8 below. Illustrated by Pension Model at 1 4a) above. 6) Contributions (including lump-sum capital injections) benefit the scheme only once, when first made, and play little role thereafter. As a result, only an insignificant part of any successful fund can originate from contributions, typically under 10%. Example given at foot of table in section 5 [including figures in square brackets]. Illustrated by Pension Model at 1 4a). See Stop Press at 26 below 7) In contrast Investment-appreciation a) goes on working year after year b) on the whole of the scheme's assets c) the growth percentage operating on increasing fund value, compounding the benefit. Eg section 8 below. This 'triple whammy' ensures that as a fund accelerates towards maturity, up to 90% or more of eventual fund value typically comes to originate from investment appreciation. See example at footnote to table in section 5 [in particular figures in square brackets]. Illustrated by Pension Model at 1 4a). Ineffectiveness of later Contributions / Lump sum Injections After the first few years of a member's involvement, subsequent contributions - including any further capital injections by the Employer - are no longer materially able to affect eventual fund size as demonstrated by the Pension model at 1 4a). Once the core fund is in place (for which healthy initial contributions are needed), because the influence of contributions declines so sharply as investment performance builds up, employer and employee contributions can be scaled back and/or stopped altogether once individual members reach a pre-determined age. Which can happen in as little as 15 years, ie by age 40. Derivable using the Pension Model at 1 4a). Such a move is desirable anyway to avoid harming the Employer's trading operation any more, or any longer, than strictly necessary. Contributions, while they continue, increase the Employer's operating costs - harming competitiveness, profitability and market share - drain off resources that would otherwise be available for use in the business and weaken the balance sheet. 'Preserving balance sheet strength' is a particularly vital aspect where the Employer is, for instance, a bank. The well-being of the Employer's operation inevitably ranks above that of the pension fund. There is little point trying to provide generous pension benefits if the Employer is commercially damaged or driven out of business in the process - hardly to the benefit of its employees or pensioners. Or indeed the UK Economy. (Particularly in the current climate.) Asymetry Explained Readers who possess a copy of the Interactive Spreadsheet Model mentioned at 1 4a) above, will see from the attached spreadsheets that year 1 (age 25) contributions enjoy 40 years of compound growth, year 2 39 years and so on. Each of the first 15 years thus averages 32.5 years of compound growth. The last 25 years average only 12.5 years. Given the nature of compound growth (eg Section 5 below), it is no contest. The first group wholly eclipses the second, to the point where the latter become irrelevant to any final outcome. Importance of (Compound) Investment Growth. Strong Investment Growth is the key determinant of successful pension fund operation, accelerating growth and creating the all-important 'risk offsetting' mechanism needed to 'hedge' pension growth. The 'Hedging' Principle. The 'hedging' aspect arises because inflation and longevity, whilst unfavourably increasing pension commitment, favourably increase investment growth, enabling the two to be matched. In practice strict 'matching' would be far too risky. A cushion is needed. Investment growth needs to outpace pension growth by a comfortable margin, which by an fortunate quirk, higher-growth funds automatically achieve. 'Perfect Hedge' The 'perfect hedge' can be made to result. The same factor (inflation) that creates the problem (increased long-term pension commitments) simultaneously creates an 'equal and opposite' compensating solution (higher long-term investment growth). The two move in step. If inflation runs at say 10% both pension commitment and fund value increase by up to 10%. But because fund value (say £100,000 per example given in last paragraph of section 8) is much larger than annual pension commitment (say £5,000 last paragraph ditto), annual commitments go up by £500 but fund value by up to £10,000, providing significant extra 'cover'. For say a £200,000 fund the extra 'cover' is an even more impressive £20,000, versus £500 pa. For the well-run fund, inflation improves funding adequacy - which almost certainly is the reason why most old-style pension funds so successfully came through the high inflation years of the late 80's / early 90's. Illustrated by Pension Model at 1 4a). Similarly, longevity (requiring pensions to be paid longer) simultaneously produces further years of compounding investment growth, again ensuring fund value increases at a greater pace than extra pension need. Again by a lucky quirk, investment growth in money terms, whatever the annual rate in a particular year, is at its best late in the cycle as fund value reaches peak (again see 'perpetual fund' scenario described in section 8 below). Illustrated by Pension Model at 1 4a). Eventually pension membership levels off as members die and get replaced by younger members. But no such levelling off need happen to investment growth, which can be made to power on indefinitely. 'Self-Correcting' Mechanisms Recently introduced methods, for instance for measuring 'pension deficits' (section 57), may ignore, overlook, or inadequately recognise the critically important 'self-correcting' mechanisms entrenched in operating procedures throughout the commercial and financial world - pension funds, companies, banks, finance companies, hedge funds, insurance companies etc. If the new methods interfere with the proper working of these systems, danger looms. See Growing Worry section below. Digression A digression on how self-correcting systems work, including the hedge fund principle, is provided in this italicised section. If not of immediate interest, please move on to the Growing Worry section. Self-correcting mechanisms use 'negative-feed-back' [confusingly, a negative term for a positive feature] similar to that used to ensure guided missiles hit their target - notwithstanding rapidly-changing and for the most part the unpredictable, unforeseeable and unforecastable environments in which they (inevitably) operate. The mechanism automatically locks on to wherever is the selected target of the moment, detects deviation from course and automatically corrects for it. 'Negates' it. (Note: no forecasting is involved, which would be impossible anyway), The hedge fund industry* crucially depends on such methods. As does industry itself. Similarly of course pension schemes, banks, insurance companies etc. Note. 'Positive feedback' [a positive term for a negative feature] does the reverse, throws the chasing missile still further off course. Peaks and troughs get accentuated instead of being smoothed, leading to 'motor-boating'! Ever wider swings occur, until disaster strikes as the chasing missile breaks up under the stress. (Hopefully not making too uncomfortable a parallel with what may be happening in the world economy at the moment.) As may be known, the equivalent economic terms are 'counter-cyclical' and 'pro-cyclical'. 'Positive feedback' and 'pro-cyclical' are thus undesirable, in making bad situations worse. 'Negative feedback' and 'counter cyclical', rectify adverse trends. The terms are the opposite of common understanding (when for instance talking about good or bad feedback from a seminar or marketing exercise). * 'Hedge Fund' is a widely used (and abused) term. Not all Hedge Funds embody the genuine hedging principle including being able to hedge the all-critical solvency and liquidity risk which is causing so much difficulty at the moment (particularly in banking). Properly-structured funds automatically achieve whatever restorative action is necessary. In the case of pensions, extra investment gain produces extra resources. (Turning those resources into CASH, the liquidity aspect, usually presents little problem. Section 14.) Hedge Funds incorporating the genuine process should emerge relatively unscathed from the current turmoil. Those that don't are less likely to do so. Current turmoil will establish which Fund falls into which category, although it can usually be done in advance by identifying whether the genuine hedging process is in place within the Fund.] Growing Worry A growing worry is that recently introduced methods, eg for correcting the perceived 'pension deficit' problem, may be damaging to the smooth working of these automatic systems. Construction of a successful pension fund critically depends on achieving investment growth (over a 40 year period) of between 3 times and 10 times total contribution commitment [figures in square brackets in section 5]. Quantified by Pension Model at 1 4a). Yet all urging seems to be towards getting pension funds to switch from equities into low yielding gilts and bonds (eg FT front page March 7th 2008). The opposite of what is needed to build a successful fund. Awareness of this problem, fortunately, is now becoming better acknowledged, hopefully before it is too late. It is of course vital that existing feed-back mechanisms do get clearly identified and positive steps do get taken to prevent them becoming diluted or damaged by misguided policy. 2 Misplaced Alarm Such factors may be the cause of misplaced alarm that seems to exist about Defined Benefit Pension Schemes. As already mentioned, in reality well-structured DB schemes offer a particularly robust form of pension provision - providing generous benefits at contribution levels sufficiently moderate to avoid harming the Employer's trading operation or competitiveness - the over-riding aim of course. Fortunately, after the initial surge needed to create the nucleus of any new fund - the 'pump priming' aspect - contributions can be reduced to the point where the Employer's commercial competitiveness becomes the over-riding consideration, without endangering the Pension Fund or members' pension prospects. As illustrated by the Pension Model at 1 4a). This favourable outcome is of course conditional on healthy investment performance continuing. Lapse into poor investment performance and it again burdens and endangers trading competitiveness and members' interests alike. 3 Target Benchmarks As indicated, the surprisingly moderate level of 6% compound growth per year is sufficient to create a viable Defined Benefit Pension Scheme. 5% is the prime need. 6% provides 30% safety margin to cover factors like inflation and longevity. 8% provides twice the safety margin. And, thereafter, as shown in section 5. UK Market Investment growth over the last 27 years has averaged 11% pa section 13. Over 40 contribution years, between ages say 25 and 65, compound growth of 11% pa builds Fund Value to 5 times Minimum Need, section 5. Creating a substantial buffer against adversity. Given the good investment performance of recent years, most funds are likely to be in, or heading for, substantial surplus. 4 Below 5% however: 1) Unduly high contribution levels are needed from the Employer (and even so, result in small benefit, as explained above). 2) The Employer's success, jobs, even commercial survival become threatened. 3) Inflation has an undue impact 4) Increased pension obligations resulting for instance from increased longevity become difficult if not impossible to fund 5) Only meagre pension levels can be supported, at best The reverse, of each of the above, applies for Funds successfully operating at higher than around 5%-6%. 5 Characteristics of Pension Fund Behaviour. The following table is helpful in exploring the issues. £1,000 contributed each year for 40 years, between ages 25 and 65 (£40,000 in total) at the annual rates of investment appreciation shown, grows the Fund to the following size by year 40: 1% pa average annual compound investment growth (dividends + capital gain) builds the Fund to £50,000 by year 40 (39% or 1/3 of minimum benchmark requirement, see under). 2% £63,000 (49% ~ 1/2) 3% £79,000 (62% ~ 2/3) [x 2 Total Contributions, see footnote] 4% £100,000 (78% ~ 3/4) 5% £128,000 Minimum Threshold Benchmark (sections 6, 7 & 8 below) [x3] 6% £165,000 x 1/3 larger than Minimum Benchmark [x4] 7% £215,000 x 2/3 [x5] 8% £281,000 x twice [x7] 9% £370,000 x 3 [x9] 10% £488,000 x 4 [x12] 11% £647,000 x 5 [etc] 12% £860,000 x 7 13% £1.2 million x 9 14% £1.5 million x 12 15% £2.0 million x 16 16% £2.7 million x 22 17% £3.7 million x 29 18% £4.9 million x 38 19% £6.6 million x 51 20% £8.8 million x 69 £40,000 in each case derives from Contributions. The rest from Investment Appreciation. Thus only 8% of the £488,000 Fund originates from contributions, 92% - [x12 total contributions] - from investment gain. For real life investment fund achievement see section 19 below. Also sections 13 and 15. And real-life pension modelling 1 4) above. 6 Selection of 'Minimum Threshold' Target Fund Size On a £10,000 pa salary, benefits at age 65 would be say £25,000 lump sum plus £5,000 pa pension, which Peak Fund size of around £128,000 (per £10,000 of annual income) would adequately finance (pre higher-inflation, longevity etc considerations, as dealt with in section 3). Marked bold above, which accords with general pension fund experience that an individual earning say £40,000 pa needs to build up a Fund of around £500,000 by retirement to secure an adequate Defined Benefit Pension. 7 Benefit Payment Period Minimum Fund size of £128,000 would allow the pension to be maintained for 20 years (ie to age 85) even if zero investment return is generated after retirement. If some investment return continues, significantly further pension years can be supported. 8 'Tilt-Point' If full investment return continues, the Fund is taken beyond its 'tilt-point'. Income generation each year begins to outpace pension commitment giving the Fund indefinite life. Able therefore to support pensioners however long they live. Aircraft need to attain a certain critical speed in order to get airborne. Only fractionally above and the plane lifts effortlessly into the sky. Only fractionally below and disaster results. So with pension funds. Establishing the point at which this 'take-off' rate of growth occurs, and specifically monitoring whether the Fund has yet reached that point - or how far it still has to go - is a critical aspect of pension fund operation. Like pregnancy, there are no half measures. It is all or nothing. It is the factor for instance Regulators most need to focus on - "is the Fund achieving 'take-off' rate-of-growth or better?" And "is it doing so quickly enough?" Timescales in the early years are particularly critical. Illustrated by the Pension Model at 1 4a). Similarly, at the far end of the scale set out in section 5, once Peak Fund is safely in place, if lump-sum payments on retirement reduce the Fund by say £28,000 to £100,000, just 5% annual investment return maintained in real terms thereafter would provide the whole £5,000 annual pension, the Fund remaining intact indefinitely. The 'Perpetual Fund'. 9 Needlessly Alarmist Talk Which provides interesting comment on views like "there is no obvious way for any company to hedge longevity risk" (FT 27th November 2006). 10 Pension Fund Comprehension Needlessly alarmist talk, reflecting possibly fairly general misunderstanding about how pension funds work. And the true nature of Pension Fund 'Risk', section 44. 11 'Redundancy' The unexpected features set out in section 5 can be used to build considerable hidden 'redundancy' into pension funds. Much can subsequently go wrong before the Fund is unable to meet its obligations as they fall due. See section 13 below. 12 'Margin-of-Safety' The quicker and the more ahead of need the Fund can be built up the greater the margin of safety available to underpin periods of poor investment return; or lighten the contribution burden on the Employer company, for instance to see it through a bad trading patch, as envisaged in sections 34 and 35.. 13 Market-Average The UK stock market has averaged 11% pa sustained compound growth over the last 27 years since 1980; and 11.4% pa over the past 10 years. As already mentioned, 11% compound growth maintained for 40 years would produce five times Minimum Fund Size needed, per table in section 5 above: 1) Enabling pensioners to be offered, in theory at least, up to five times normal (DB) pension terms. 2) More than comfortably accommodating any unexpected or enforced pension-increases arising for instance from inflation or increased longevity. 3) Permitting stock market falls of up to 80% to be taken in their stride, before ability to meet pension commitment is endangered (an unexpected comfort in the present climate). 14 Downside Protection The latter scenario of course ignores Trustees' ability at any time to protect against downside, literally at the touch of a button, by switching investments, or switching into CASH, long before any such scale of loss is reached. 15 Actual Returns If 11% sustained growth seems ambitious, bizarrely actual performance of many funds over the past few years has well exceeded such returns. A typical well-managed fund might have produced say 17% in 2003, 12% in 2004, 20% in 2005 and say 16.5% in 2006. Compare with table in section 5. Take together, these rates increase Fund Size by a massive 83% over the four years in question, more than twelve times greater than a standard 5% pa would achieve. Robust investment performance dramatically accelerates attainment of Peak Fund, in this case bringing it forward by 8 years. And providing a robust safety margin to see the Fund through even prolonged periods of downturn before it is endangered (again a welcome and unexpected feature in the current climate). 16 'Periodic' Success Good investment performance thus need occur only occasionally in the 65+ pension life-cycle (40 contribution years, 25+ pension) in achieving a fully-funded scheme. 17 Most Funds likely to be adequately funded The healthy investment performance of most pension funds in recent years means few are likely to be in 'deficit' - unable to meet their pension obligations as they fall due - unless of course Trustees have for instance invested in low-yielding stock, section 21 below. 18 Compound-Growth Performance 5% pa compound growth rate grows a single contribution of £1,000 to £7,000 over a 40 year timescale (the contribution lifetime of a typical member, between ages say 25 - 65). 10% compound rate grows £1,000 to £45,000. 19 Market High-Flyers Fidelity's Special Opportunities Fund has averaged 19% pa compound growth over the last 27 years, growing a single £1,000 contribution to £100,000 over that time. Maintained for 40 years, another 13, would produce £1 million, equivalent to 1,000 contributions of £1,000 each. Giving rise for instance to the implications set out in section 34. 20 Fund Failure But, returning to the table in section 5, note the downside. Accumulation rates of 1%, 2%, 3% or even 4% are wholly inadequate to build a Sufficient Fund. Any Fund so structured must fail. NB Increased contributions are not able to compensate, sections 27, 28. 21 Weakness of Gilts and Long Term Bonds For every £1,000 invested, the 50 year gilts average of 1.7% pa produces only £963 extra value over a 40 year period (in eroding money). Gilts and bonds offer minimal capital appreciation, the initial £1,000 stake eventually being redeemed at par, in depleted currency, having lost much of its real value. With: 1) minimal yield 2) absence of capital gain 3) erosion of lifetime value by inflation gilts and bonds make the worst possible pension fund investment. 22 'Negligence' Pension fund trustees investing in long term bonds and gilts thus run the very real risk of being sued for negligence (perhaps gross negligence) once pensioners come to realise the scale of their loss, particularly when compared to the benefits alternatively on offer, per section 5. 23 Defined Contribution Funds likely to offer Derisory Pensions This may also be the outcome of switching to Defined Contribution Schemes offering say well under half, a quarter, or less of Defined Benefit levels - which may, unfortunately, be the way it turns out. 24 'Defined-Benefit' versus 'Defined-Contribution' Schemes - Trustee Liability. Once Defined Benefit Pensions are being honoured, trustees self-evidently have met their obligations in full. The same is not true of course of Defined Contribution Pensions, where it will always be open to pensioners to compare performance with what is happening elsewhere, and take action if they think they have had a poor deal. 25 Legal Consequences Legal redress is likely if Defined Benefit schemes get replaced by Defined Contribution schemes, offering substantially lower benefits, especially when later shown to have been misguided, under the mistaken impression for instance that a 'deficit' exists, section 58 below. 26 Higher Levels lead to Surplus-Funding Economic Consequences Significantly above 5%-6% the Fund begins to build ever more rapidly towards surplus-funding. This runs the danger of needless waste of resources if resources continue to be drawn from the Employer in the form of contributions or lump-sum injections. Which (costless) resources would otherwise be available to the Employer for additional capital investment, improving competitiveness, keeping operating costs down etc ; further benefiting the company, its employees, their pension and job prospects, suppliers, customers and the UK economy as a whole. See for instance last paragraph of section 45. Illustrated by Pension Model at 1 4). Stop Press. The Pension Model at 1 4) shows contributions, made by and on behalf of individual members, after about year 15 (age 40) contribute negligibly to the final fund, merely serving to build up needless waste and surplus - whilst continuing to burden the Employer's trading operation. So can / should be dispensed with. This is because the first contribution (age 25) compounds over 40 years of growth. The last at 65 only 1 year. By age 65, investment growth on the first 15 years or so of contributions overwhelmingly comes to dominate the final fund. In relation to which the last 25 years contribute minimally. Illustrated by Pension Model at 1 4). 27 Contributions Alone Play a Surprisingly Weak Role The key aspect. Contributions, as such, are not able to create viable pension schemes - by a considerable margin. See for instance footnote to table in section 5. 28 'Contributions-only' Fund Attempts to build a fund solely from contributions, with no investment appreciation, requires annual contribution levels running (in very broad terms) from around 64% of salaries, assuming zero inflation, to 109% at 3% inflation. Clearly a non-starter. And likely to put any Employer rapidly out of business. 29 'Investment-only' Fund Conversely 13.5% pa maintained investment return might allow contribution levels to be scaled back to as little as 1%. And 16% to as little as 1/2%. 30 'Better Pensions at less Cost'. The better the investment return the better the (effectively cost-free) pension promises that can be made to members. 31 Effects of Inflation 'Contribution-only' / low yielding schemes are seriously affected by inflation. 'Investment-only' less so, or least. Healthy investment performance protects against Inflation. 32 Effects of Longevity Longevity seriously affects contribution-only / low-yielding schemes. Higher-yielding schemes however can accommodate the extra commitments with little problem. Healthy investment performance protects against Longevity. 33 Easing the Contribution Burden on Companies Obviously, the better the investment return the lighter the contribution burden placed on the Employer company - again helping market competitiveness (in terms of lower employment costs) job security and profitability. Viz section 26 above. 34 Pension Protection in the Event of Employer Company Trading Problems This also means that once a Fund, for instance, reaches the favourable position set out in sections 36 & 37 below, if the Employer company does get into trading difficulties, contributions can be cut right back or even stopped altogether (eg in the event of outright trading company collapse) without necessarily endangering pension provision. See also section 40. 35 Employer Company Protection High contribution rates threaten jobs, commercial competitiveness, even company survival. The more vulnerable the company's trading operation, the lower contribution levels need to be set (not the other way round) which again, it should be emphasised, need not affect ability to honour pension commitments, eg Section 29 and next two sections). 36 Growth Potential Growth potential from Investment returns - once it gets into its stride - is many times more powerful than growth potential from Contributions. And as the fund builds, becomes increasingly more so. The bigger the fund, the greater the influence of even modest rates of annual investment return and the less the influence of Contributions. 37 Funding 'Self-Sufficiency' Eventually funding self-sufficiency is reached - the point at which investment appreciation alone becomes sufficient to build Peak Fund. Contributions can, if wished, be scaled down or even stopped altogether. The role of the Employer ceases. 38 Investment Return v Contribution Levels - Produced by Pension model at 1 4b) Until build-up of the fund begins to move ahead of minimum requirements, the following broad minimum relationships typically need to be maintained between investment returns and contribution rates: a) Contribution levels of say 25% (of pensionable salary) typically require minimum sustained investment returns of 4% pa. (Far from challenging of course for equity markets, but likely to be out of range of bond markets.) b) Contribution levels of 20% require 4.5%. c) " 15% " 5.5% d) " 10% " 6.5% e) " 5% " 10% 39 'Real-time' Fund Operation Such information enables pension fund trustees to decide, on a real time basis, how successfully they are building up towards Peak Fund and take action accordingly. If 5.5% pa investment return is being achieved, contribution levels of more than ~ 15% indicate faster build-up towards Peak than strictly necessary. Less than ~ 15%, slower than strictly necessary. Conversely, if contribution levels are running at say 15% of salaries, investment performance better than 5.5% will ensure faster Peak achievement; worse, slower. And so on. But conversely of course if build-up is too slow. Higher contribution levels are needed - but not the most desirable way forward. Because of the weak influence of contributions in relation to investment gain, damagingly high contribution levels rapidly become required. (Solution provided in last paragraph of section 46.) Individual funds differ in detail, depending on the size and age of the Fund in relation to its pension commitments, but general behaviour is unlikely to differ materially from the above. The bigger the Fund (in relation to its pension commitments) and the better its investment performance, the lower the matching contribution percentages can be reduced to. And the more rapidly they can be reduced yet further year-by-year with further investment success. Section 19 is a vivid illustration of how just one single £1,000 contribution, given sufficient investment appreciation, can do the same work as 1,000 individual £1,000 contributions not benefiting from investment appreciation. 40 Pension Fund Strategy After an initial period of relatively high contribution rates (say 20%-25% of pensionable salaries) - the 'pump priming' needed to build the nucleus of any new fund (when do we reach that point? Trustees ask) - successful investment return plays a progressively greater and greater part in building up the fund; and contribution levels lesser and lesser, until a point is reached where the Peak Fund can be achieved - and maintained - almost entirely, or entirely, from investment appreciation alone. See section 29. 41 Actual Pension Fund Experience A relatively small capital sum was put into a new fund in 1992 (with no contributions thereafter). A small number of higher-gain, stable-growth, stocks were chosen (the Warren Buffet approach), which by March 2000 had built the Fund to 10 times initial value, in 8 years. When the market (inevitably) nosedived that month, a 20% stop-loss strategy ensured 80% of fund value was preserved and retained as cash. Bonds were considered far too risky. In the general downturn, excess demand was creating artificially high prices, depressing yields and making longer term capital loss a virtual certainty as prices fell again to more normal levels (as indeed is now happening). The cash earned a steady 4% pa throughout the 3 year downturn ~ 30% pa in relation to original investment. When the market finally bottomed out in May 2003, 3 years later, normal investment resumed. 42 'Saw-Tooth' Behaviour. 'Risk-Offsetting' Strategy Pension investment is saw-tooth in nature. With hopefully fairly long periods of steady, if unspectacular growth, followed by often abrupt reversals, which the above risk-offsetting strategies address. Including the opportunity, at any time, to insulate against downturn by converting into CASH. 43 Growth Targets for a Viable Fund Relatively Easy to Achieve Conversely, and unexpectedly, the relatively modest levels of growth required appear a good deal easier to bring about than commonly supposed. As already mentioned the UK investment climate, however seemingly changeable and unpredictable, has been able to sustain 11.0% pa compound growth over the 26 years since 1980; and 11.4% pa over the last 10 years. Section 13. 'Risk' produces Opportunities as well as Threats. It is a question of willingness to embrace Risk, whilst having risk-offsetting and risk-protecting strategies firmly in place, to protect against (inevitable) downturns. 44 The Real Nature of Pension Fund 'Risk' Pension 'risk' lies not: 1) in lack of liquidity (quoted stocks can be turned into cash at the touch of a button) or 2) sudden market downturn (ditto) or 3) escalating pension levels (due to inflation, inflation-proofed pensions, longevity etc) but: Failure internally to grow Fund Value fast enough. As will be appreciated from the above, growth in Fund Value is highly sensitive to Investment Growth rates. As mentioned earlier, 6% pa growth produces 30% greater Fund Value than 5%. 7.5% produces twice necessary Fund Value. 10% nearly four times Fund Value. 45 'Capital Injection' / 'Increased Contributions' Misconception. It is commonly supposed that where a Pension Fund is deemed to have inadequate resources (however defined) it should, indeed must, be put onto a sound footing by: 1) increasing contributions and / or 2) seeking a capital injection from the Employer (however commercially damaging - and it may be highly damaging). Unfortunately this 'solution' overlooks one key aspect. Contributions alone, however extensive, can never provide an adequate Fund. Internal Capital Appreciation is not only essential but needs to produce several or many times greater Fund Value than Contributions alone can provide (per table in section 5). Contributions alone "which benefit the Fund only once, when first made and thereafter play no role" can never do so. The role of Contributions is not to provide funding as such, but to provide, during the initial years, the 'pump-priming' nucleus for investment growth to 'bite' on. Once Capital Appreciation kicks in - and once it reaches sufficient levels (~ 5% +) - it rapidly overtakes and eclipses anything Contributions can provide. Which then cease to have a meaningful role. To continue, particularly at previous levels, is resource waste. Section 19 illustrates the point. At 20% compound growth, just one single £1,000 contribution - the first for year 1 - unaided - builds a Sufficient Fund as early as year 27, going on to reach 12 times Sufficient Fund, £1.5m, by year 40 (underlying calculations available). The other 39 years of contributions, plus associated investment gain, are then needless waste, per Section 26. 46 Role of Internal Investment Growth Rate. There is no point propping up Funds with additional Contributions and / or Lump Sum injections unless Internal Investment Growth is running at ~ 5% or better. It is likely to be money down the drain; unlikely to 'save' the Fund. There is a parallel in banking and investment work. There is no point in putting money into a company until management have got the basics right (margins, cash flow, breakeven etc) as discussed in other sections of this website. Conversely, once management have got the basics right, increased amounts of funding can productively be put into the company almost without limit and get well used. The message seems to be: beware putting additional funds into any pension fund, regardless of whether it is achieving 5% or not. It is either money down the drain (in the second instance); or needless resource waste (in the first)! The problem with 'under-funded' schemes (however defined) lies not in lack of assets, but in inadequate rates of internal Investment Growth. The (fairly painless) solution lies not in injection of more assets, but ensuring Investment Growth Rate(s) are successfully brought up to the (relatively modest) levels required. It is not a question of whether it can be done, but how; for which considerable (long-term) opportunity seems to exist in the investment marketplace. Sections 13 & 15. 47 Purpose of this Website This site is for Pension Fund Trustees and all involved with pension funds, Actuaries, Associated Companies, Employers, Employees, Pensioners, Pension Protection Board members, Regulators, Standard Setters, who seek answers to questions of the following nature: A) What Peak Fund do we need to build up to ensure all pension promises can be met in full as they fall due? B) By what date does Peak need to be in place? C) Are we building up towards the Peak fast enough? D) If not, how much faster do we need to go? E) Ideally we need to be building up the fund faster than strictly needed, to allow for contingencies. Are we doing so? How much faster? Is the rate-of-improvement speeding up or slowing down? F) When can we safely ease back? Further assisting the position under sections 34 and 35 for instance. By how much? Over what period? To what target? G) How much of the fund should be built up from contributions and how much from investment returns? As demonstrated through this website, the latter is many times more influential than the former. 48 Pension Model - Section 1 4b) The influence of such factors can be explored using a specially-developed spreadsheet Model - based on one critical consideration - no assumptions of any kind can be used - otherwise the assumptions affect the outcome, rendering the model inoperative. (A universal Measurement Principle.) Such a Model has been successfully developed and produces the (unexpected) conclusions set out in this website. 50 'No Assumptions'? The statement frequently gives rise to puzzlement, so is worth exploring. Real life behaviour contains no assumptions. So accurate Models of real life behaviour cannot contain assumptions. It is not necessary anyway, as explained in section 54. Any Model incorporating an assumption would only be applicable in the one specific situation to which that assumption applies and no other. Whereas the purpose of a good Model is to provide, eg Pension Trustees, with all possibilities and all choices, to help them choose the optimum way forward, and identify and react, on a real time basis, to changing circumstances, as they happen. 51 'Nautical Chart' The parallel is a nautical chart. The entire scene is 'mapped' enabling users to see at a glance, on a continuous real time basis: 1) Precisely where they are at the moment 2) Precisely where their destination lies (particularly when continuously changing) 3) The best route to get there (ditto) 4) The extent of progress along the route 5) Re-routing options - as soon as difficulties occur 52 Facts only Such a Model cannot use assumptions. It must be, and remain, strictly Factual. Consider how little use - indeed how positively dangerous - a nautical chart would be if it contained assumptions, of whatever nature. 53 'Simple' 'Understandable' The Model must be clear and simple in what it shows - ie be immediately understandable to the non-specialist. Similar principles of course apply to all successful company operation - per Index and Service pages. 54 Assumption-Free Pension Model (see 1 4b) Any successful Model must be based on CERTAINTIES only. Two Certainties exist: (1) contribution level(s) and (2) pension levels - both unambiguously defined by Scheme Terms. The problem can then be inverted (the scientific approach). Instead of having to guess an annual investment appreciation rate (which is changing all the time under the influence of day-to-day events and will therefore always be, perhaps wildly, wrong) the average annual rate of investment return NEEDED to produce Peak Fund on time can be arrived at by CALCULATION. Certainty (3). This can then be compared to actual rates being achieved, per examples in Section 15. The most helpful Model will go further and list all combinations of Contribution Percentage and Investment Return Percentage that achieves Peak Fund on time. Examples given in section 38. 55 It is often helpful to express issues in as familiar everyday terms as possible. The resulting boundary line - a 'Coastline' in nautical terms - can then be plotted on a 'Chart', a curved line running from top left to bottom right. The area below and to the left represents 'land' - caused by low Contribution levels / and (of dominant significance) poor Investment returns. Venture there and you get 'shipwrecked'. The 'Certainty of Failure' area. Above and to the right is 'open water' - higher Contribution levels and (again dominating) higher Investment returns. The 'Certainty of Success' area. The further from the boundary 'coastline' in the north-easterly direction, the better the winds and the faster the rate of travel. Ie the quicker Peak Fund Value builds up; and the quicker it does so ahead of time. At the boundary it builds up on time. Neither faster or slower. Trustees are provided with a continuous real time view of the success or otherwise of their efforts. And what still needs to be achieved, going forward. 56 Early Warning System The exercise is repeated every year, using latest employment etc data (which tends to change the position of the line only marginally, if at all) giving often considerable advanced warning of issues looming ahead - sometimes years ahead. The process is more immediately useable, on a month-by-month and year-by-year basis, and more accurate and reliable than is possible with present (eg 3-year actuarial) methods - which also suffer from the (in practice fatal) flaw of being based on assumptions. 57 'Internal' Fund Valuation versus 'Buyout' Valuation. The 'pension deficit' method is not designed to establish whether a Fund is adequately resourced - as commonly supposed - but solely to provide an external value for fund-disposal purposes (which inevitably involves 'closure' of the Fund). 58 Desirability However, most sponsoring companies, employees, trustees and pensioners want pension arrangements to continue; and even get enhanced. Which can happen provided: 1) the Fund does not start getting into financial difficulties and does not 2) come to endanger the Employer company's balance sheet or commercial operation or competitiveness. Avoiding the Dangers The first danger is avoided by adopting a higher-gain investment strategy, as set out in section 1 above. The second by ensuring contributions get scaled back, and eventually cease altogether, as soon as it is safe to do so eg section 2. [Guidance of a good Pension Model is helpful in identifying when and where the necessary thresholds occur.] Fund 'Flying Blind' Trustees and others of course need regular guidance on whether the Fund is building up fast enough, which the 'deficit' calculation does not measure. In its absence, the fund is flying largely blind. External Sale External Fund sale currently requires a premium of between 25% and 40% to attract prospective buyers. In other words, 'buyout' valuations tend to be substantially higher than 'internal' valuations, which inevitably gives rise to overstated 'deficits'. Or the appearance of 'deficit' when the fund is actually in 'surplus', on an ability-to-pay basis. 'Volatility' of Deficit Calculations. The 'discounting' method also produces large, highly unstable, valuation swings, unconnected with any ability-to-pay. If interest rates rise from say 2% to 3%, notional capital values ('assets' / 'liabilities') immediately change by 50% - whereas actual pension commitment, for instance, will remain entirely unaffected. And movement from 2% to 1% changes notional values by an equally illusory 50% the other way. Real ability-to-pay remains remarkably stable over prolonged periods of time - years if not decades. At root a simple 'yes' or 'no' question - "will we have sufficient resources, by the time payment becomes due, to honour all commitments in full?" Undesirable Outcomes The 'discount' approach causes actions to be taken that might/would not otherwise be contemplated, like closing final-salary schemes or outright disposal of the Fund, which may well not be in the best interests of Employer companies, employees or pensioners. 59 'Dynamic' Pension Fund Models It is possible to construct a simple, reliable, model of real-life Pension Fund behaviour. Section 48 onwards. By routinely updating the model (principally annual contribution and pension levels, through to the time of death of the last surviving member) the Chart described in section 51 can be drawn up for your own Fund, accurately measuring the contribution / investment trade-offs, per section 38. And enabling trustees to establish, unambiguously, whether their Fund is genuinely in 'Deficit' or (much more likely) is heading towards a comfortable or more than comfortable surplus. 60 Minefield Seemingly self-imposed, a minefield seems to lie in wait for all concerned with Pension Funds. In the main arising from insufficient appreciation of the internal rate-of-growth-in-Fund-Value even relatively modest levels of Investment Appreciation can/must bring about. Defined Benefit Schemes have worked successfully for many years, offering good pension levels, at relatively modest contribution rates, and therefore doing least harm to the Employer company's trading operation. Little has happened in recent years to change this. Indeed until recently the climate for success could hardly have been more favourable eg section 15. When sound calculation methods are applied to Defined Benefit schemes, far from achieving 'deficits', DB schemes are seen: 1) as a healthy repository for safe value eg Section 5 2) capable, if need be, of supporting higher pension benefits than typical DB schemes offer eg section 13 3) fully able to cope with longevity, inflation and other pension-increasing factors eg section 9 4) well able to preserve value, however turbulent the markets in which they are operating eg section 44 5) well able to keep contribution levels down to within what Employer companies can reasonably afford (typically say 10% or under of pensionable salary) without damaging commercial competitiveness, sections 33, 34 Of course Pensioner Protection needs to be put in place for the occasional - inevitable - pension fund / Employer company failure. Which has now been valuably introduced with the setting up of the Pensions Protection Board. However, if the features mentioned in section 34 are present, or potentially present, or can be made to happen, such outside assistance may be unnecessary. Avoiding burdening the Pension Protection Fund - and pension funds contributing towards it - with higher premiums. A unexpectedly large number of Funds seemingly in trouble may be retrievable in this way. B. C. J. Warnes MA (Oxon) Natural Sciences (Physics), FCA, FRSA Managing Director