12.1 Borrowing and lending problems in nancial intermediation

l	transparency – the prices at which units or shares in a stakeholder MTIP fund are bought and sold must be the same, and the price should be published daily; in thecase of smoothing MTIPs, managers must make available information about their policies on smoothing and charging.

This all sounded very good. However, until now at least, the nancial services industry

has largely ignored these products. Only a year after their launch, the Financial Services

Authority (FSA) announced an inquiry into why the products had not taken off. According

to the industry, the products were not attractive to providers because of the low limit on

the charges that could be levied. The industry association, the Association of Independent

Financial Advisers (AIFA), argued that there were high initial costs in the provision of

advice on stakeholder products and thus large economies of scale. The provision of

advice and the recommendation of stakeholder products would therefore only become

worthwhile if nancial advisers were convinced that there would be a large take-up of

these products. This was not expected because of the lack of nancial education among

the target groups. The problem then is to decide how to break into this apparently closed

circle of lack of knowledge and information, low savings and low take-up of products

designed specically to encourage people to save and invest.

The pensions problem came to a head in a very specic form during the 1980s. As

we noted in Chapter 4, pensions can be paid either on a pay as you go (PAYG) system

or a funded principle. In the former case, current pensions are paid for by transfers

from those currently in work. With an ageing population, and one which was living

longer after retirement, the problem for PAYG schemes was that the contributions

from those in work (usually in the form of taxes) were becoming unacceptably large.

We saw towards the end of section 4.2 that, starting in 1988, legislation was passed

to encourage people to take out their own private pension schemes. But this resulted

in the sale of many pension products which were unsuitable for savers. Eventually,

compensation was agreed but it took a long time for it to be paid (see Chapter 13)

and this particular scandal undoubtedly played a part in discouraging people from

taking out long-term saving deals.

If the trouble began with PAYG schemes in the 1980s, it spread to funded schemes

in the late 1990s. In particular, problems emerged for dened benet schemes. These,

it will be remembered, were schemes which were intended to accumulate a sufciently

large pool of invested funds that they would be able to guarantee a pension which

was a set proportion of salary at the time of retirement. With the sharp fall in stock

markets in 2001 and 2002, however, many pension funds suddenly revealed large

‘black holes’ – actuarial estimates that suggested that the present value of their assets

was far below that of their present commitments and future obligations. Workers

and trade unions were angry in cases where rms had, when asset prices were high,

reduced or suspended their contributions to their pension funds on the grounds that

the funds were in surplus.

In the case of rms, large pension fund decits frequently had an impact on the

rms’ equity prices, on the valuation of rms for takeover calculations, and on the

ability of rms to raise funds for future developments either through share issues or

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Chapter 12 • Financial market failure and nancial crises

borrowing. Firms could, of course, attempt to slowly ll the hole by adding to the

fund but only at the expense of current prots. As long as the cash ow from the

assets in the fund was sufcient to meet current obligations they could also choose

to do nothing and hope that the problem would be solved by higher equity prices

and interest rates in the future.

However, particular problems arose when rms went out of business. Shortages

in the pension funds of these rms meant that full pensions could not be paid and

employees could nd that their hopes of a comfortable retirement were dashed. The

present government came under pressure to provide assistance to pension funds with

dened benet schemes and, under the provisions of the Pension Act 2004, the Pension

Protection Fund (PPF) was set up. It is a statutory corporation the main function of

which is to provide compensation to members of eligible dened benet pension

schemes when the employer becomes insolvent and where there are insufcient assets

in the pension scheme to cover the level of compensation set by the PPF. The PPF

became operational on 6 April 2005 and applies only to rms becoming insolvent

after that date. The PPF is to be nanced principally by compulsory annual levies

imposed on all eligible pension schemes. The PPF can also intervene to assist rms

to restructure to prevent insolvency being caused by pension scheme shortfalls.

Box 12.2 provides an illustration of diverse responses to pension fund problems.

Box 12.2

Responses to pension fund problems

We look here at two different responses to actual or potential difculties for dened

benet pension schemes.

Restructuring with the help of the Pension Protection Fund

In May 2006, Pittards, a Yeovil tanning rm with 240 employees, became the rst

company to survive a nancial crisis with the help of the Pension Protection Fund. The

company had an accounting decit of £39.2m in its pension scheme, sufciently large to

be regarded as an insurmountable obstacle to future development of the rm. It seemed

likely that the rm would be forced into administration and probable closure. However, it

chose instead to restructure. The PPF took an equity stake of 18.5 per cent in the com-

pany. This allowed the company to raise an additional £2m through a placing of shares

with a Swedish investment company. The shareholding of the founding family was

diluted from 29 per cent to 3 per cent but the rm was able to continue trading.

For further details see: David Blackwell, ‘Protection fund helps Pittards survive crisis’,

Financial Times, 22 May2006.

Soldiering on in the hope of a brighter future – the USS

An actuarial valuation in March 2005 of the Universities Superannuation Scheme (USS),

the UK’s second largest pension fund, showed a decit of £6.6bn (assets of £21.7bn

against liabilities of £28.3bn). The large decit was in part blamed on the fact that the

fund held 80 per cent of its assets in equities, going against the standard advice that

payments to existing pensioners should be made from income derived from bonds and

property since that represents a reasonably close match for outgoings. In the USS’s case

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