4.2Pension funds

After their retirement from employment, most people in the UK can expect to receive

some form of pension. This comes in one of three forms: a at-rate pension paid by

the state to everyone above a certain age; an occupational pension provided from

a fund to which the employer and employee have contributed; a personal pension

paid from a fund to which the individual has made contributions. As we shall see,

only the second and third forms strictly involve nancial intermediation. This is

because the rst of these operates on ‘pay as you go’ principles, while payments

under the latter are made from an accumulated fund of savings.

Funded pension schemes:Schemes where payments to pensioners are made out of

the income earned by a fund of savings which has been built up in earlier years by

(usually regular) savings contributions.

Unfunded pension schemes:Schemes where payments to pensioners are nanced by

simultaneous contributions from those in work. Such schemes are often called ‘pay as

you go’ or PAYG schemes.

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4.2 Pension funds

Consider rstly the at-rate state pension. This is paid for out of general taxation

and although those drawing a pension may feel that they have contributed to its

cost by virtue of their earlier contributions, the state scheme in fact operates on

a ‘pay as you go’ (PAYG) basis. The current level of contributions is set at whatever

level is necessary to pay for the current number and level of pension payments.

Each generation of workers is in effect paying for its predecessors’ pensions, in the

hope that the next generation will pay for theirs. Crucially, no pool of investible

funds is created.

Other pensions which are organised on PAYG principles include most public

sector occupational schemes like those for teachers, the Civil Service and National

Health Service employees and the state earnings-related pension scheme (SERPS)

which began in 1978.

However, the PAYG principle is not thought to be suitable for private sector

occupational schemes. In the public sector, the government can be relied upon always

to raise the funds necessary to honour its pension obligations through taxation.

Private rms, by contrast, might nd their existing workforce too small to pay for

their existing pensioners or they might even go bankrupt. Therefore, the practice

with the private sector is for employers and employees to make contributions to

a fund at a rate which, combined with judicious investment of the fund, should be

sufcient to meet obligations to current employees at some point in the future. Since

the fund is kept strictly separate from the rm’s own assets, employees’ pensions

should remain secure even if the rm ceases trading. The scandal surrounding the

late Robert Maxwell’s group of companies is based upon the fact that he approved

the (mis)use of pensioners’ funds by the companies themselves. We return to this

later when we discuss the regulation of nancial activity in Chapter 13.

Pension schemes of this kind are referred to as ‘funded’ schemes and crucially

for our purposes they involve the accumulation of a fund of assets. These assets are

someone else’s liabilities. Hence funded pension schemes are involved in channel-

ling funds from savers to borrowers: directly if the fund buys newly issued liabilities;

indirectly if it buys liabilities issued in the past, from their current holders. We shall

say more about whose liabilities are held by pension funds in a moment. But notice,

before we go on, that an occupational pension fund can be condent of the source

and scale of its contributions since these are a contractual obligation for employer

and all employees. In this sense a pension fund is very different from a bank or

building society where the inows of funds are entirely at savers’ discretion and tend

to be ‘residual’, i.e. made after all other types of saving expenditures. There are two

types of funded scheme and the difference has become extremely important in the

past few years.

The rst type of arrangement is known as a ‘dened benet’ (DB) scheme

because the rules of the scheme specify at the outset what a pensioner can expect

to receive, provided he or she maintains the required level of contribution. For

example, most DB schemes award a pension equal to some proportion of ‘nal

salary’. ‘Final salary’ might be dened as the average salary of an employee’s last

three years of employment. The contract might then specify that each year of service

entitles the employee to, say, one-eightieth of that gure. There may or may not be

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Chapter 4 • Non-deposit-taking institutions

a provision for periodic ination-related reviews or even for index-linking. Given

then that the fund’s future obligations per retired employee are known, its total

obligations are a matter of actuarial calculation, involving the current size of the

workforce, its age distribution, the average life expectancy after retirement, and other

factors which are largely predictable – including the rate of return on, and thus the

growth of, the underlying fund.

The idea behind a DB fund, therefore, is that contributions (from employer and

employee) are set at such a level that they will build up a savings fund over the years

which will be sufcient to provide the dened benets for the pensioner. Notice,

however, that the growth rate of the fund does not depend solely upon the level

of contributions. It also depends on what happens to the value of the assets in

which the fund invests. Until the 1930s, it was common for pension funds to invest

largely in xed-interest government bonds. These provided a nominal rate of return

of 3–4 per cent p.a. and, with the low ination of those years, a real rate of return

of 2–3 per cent. After the Second World War, with ination running at much higher

levels, pension fund managers switched increasingly to holding company shares

because the market value of the shares should increase with the growth of company

dividends and these in turn should reect both the rising level of prices and the

growth in rms’ productivity. They might be riskier than bonds, but risk could be

contained by diversication (see Appendix I). By the 1990s, experience suggested

nominal rates of return for a well-diversied fund could be 7–10 per cent p.a. Indeed,

during the 1990s, some funds grew so quickly as a result of rising stock market

values that employers took ‘pension holidays’ – short periods in which they stopped

making contributions to the fund because the contributions were not necessary.

Alas, when markets collapsed in 2000 and continued to fall in 2001 and 2002, the

value of the invested funds shrank dramatically and it quickly became clear that the

principle of a funded pension scheme was in danger of being undermined. A new

expression entered the language of the pensions industry: the ‘pension fund decit’.

This was calculated as the difference between the current value of the fund and the

size of the fund that would be required if the rm were to cease trading and still be

able to meet all its current pension obligations. This decit was a liability of the rm

and had to be declared as such on its annual balance sheet statement. This in turn

reduced the value of the rm and the value of its shares. Understandably this caused

a great deal of alarm among rms operating such schemes. We return to this later.

For now, the important thing to note is that the sharp decline in stock market values

was a powerful reminder that under DB arrangements the risk attached to making future

pension payments rests with the employer.

The second type of funded scheme, known as a ‘dened contribution’ (DC) arrange-

ment, places the risk largely upon the employee. This is because the scheme lays

down the contribution rates for employer and employees but makes no stipulation

about the level of benet which will be forthcoming at the point of retirement.

As in a DB scheme, the contributions go together to build up a fund which grows

at a rate determined in part by what happens to the fund’s investments. When the

employee retires, however, he receives a lump sum which is his share in the value

of the fund, whatever it may be at that particular time. In recent years, someone

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