COMMENT & ANALYSIS The UK’s defined benefit pension funds are in worse shape than Alice in Lewis Carroll’s Through the Looking Glass. The Red Queen said she had to run fast to stay in the same place. Pension funds are running fast, only to go deeper into deficit. In the process, their sponsors are depressing business investment, thereby damaging themselves and the UK economy. This is self-defeating.
A number of analysts – among them Fathom Financial Consulting* and Lombard Street Research** – have described what is happening. Aggregate contributions to pension schemes by sponsoring companies jumped from £30bn in 2001 to £48bn in 2004. Over the same period, nominal business investment declined by £1.2bn, though real investment rose modestly, by £1.5bn. The share of business investment in nominal gross domestic product is at its lowest since records began in the 1960s. Companies also ran an aggregate financial surplus of more than 3 per cent of GDP in the third quarter of last year.
As companies shift into bonds, particularly long-dated, index-linked bonds, yields have fallen to breathtakingly low levels, even by today’s global standards: 10-year index-linked gilts are yielding 1.23 per cent, while 50-year gilts are yielding just 0.5 per cent. UBS Global Asset Management notes that the yield curve implies a real interest rate of 0.25 per cent 20 years hence. That cannot make sense, unless the world economy will have ceased to grow.
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Yet, as companies have failed to invest and driven bonds down to low yields, their pension deficits have actually risen. Mercer, the pension consultant, estimates that the deficit jumped from zero in 2001 to about £100bn last year. Meanwhile, weak investment damages the economy – in the long run, through its impact on growth and in the short run, via its depressing effect on demand.
This is the result of a self-defeating panic. Consider the plight of a company with a pension deficit. Its liabilities to its pensioners, actual and prospective, are a form of debt. It also owns assets in its business and, via its pension fund, in other businesses. If it holds government bonds, it owns claims on taxpayers as well.
Suppose the directors respond to their pension deficit by increasing their contribution to the pension fund, while slashing dividends and foregoing investment in their business, as now seems so common. The pension fund invests in the shares of other companies. Suppose, too, that the other companies are in the same state and, like lemmings, respond in just the same way. In aggregate, they all merely succeed in lowering the country’s capital stock.
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Would the decision to invest in government bonds, in order to achieve a better match between liabilities and assets, help them escape this trap? No, is the answer. As companies pile into bonds, they drive up their prices. This lowers the returns on bonds and increases the present value of their liabilities. Moreover, the liabilities of government are secured by future tax revenues, which depend, in the long run, on the country’s taxable income, which ultimately relies on investment.
Because pensions liabilities are a form of debt, the malaise I have described is similar to the debt-deflation that afflicted the Japanese corporate sector in the 1990s and early 2000s. As companies struggled to reduce their indebtedness by cutting investment, they weakened the economy as a whole. In Japan, the government had to fill the hole in demand with its massive and still continuing fiscal deficits.
So what are the solutions? First, companies have to look at their businesses as a whole. The pension fund is but a part of the business. They would be better able to meet their liabilities, in the long run, if they raised their net worth. When borrowing is as cheap as it is today and the net return on capital is 13 per cent, as recent government statistics suggest, they should be borrowing, to invest. Today’s low costs of long-term borrowing allow them to do just that.
Second, if businesses persist in refusing to do this, the government should step in, instead. As professor Willem Buiter of the London School of Economics has argued, it should at least be replacing its outstanding debt with today’s incredibly cheap, long-term, indexed-link gilts. But it should go further. At these interest rates, it can cheaply finance big infrastructure projects: a few new roads would be pleasant; so, for that matter, would London’s Crossrail link.
When the private sector fears investment, the public sector may simply have to step in. John Maynard Keynes recommended putting pound notes in bottles and digging them up. Surely, Gordon Brown can be far more imaginative than that.
* “Why is Britain not Investing?” January 27 2006, www.fathom-consulting.com; ** “Pensions crisis explains UK investment puzzle”, January 27 2006, www.Lombardstreetresearch.com
