Pensions World

Anthony Hilton, Evening Standard, on the urgency of replacing the huge losses in the financial system with fresh capital

For a business which is so dependent on the price and availability of capital, there has been surprisingly little deep thinking about what the financial crisis means for the pensions industry.

The huge losses in the financial system have somehow to be replaced and that will require vast amounts of fresh capital. According to the International Monetary Fund, all the bank bail outs we have seen so far equate to roughly 40% of the amount that will eventually be needed, though not all of the remainder will have to be injected from outside. The manipulation of interest rates by the authorities is delivering vast and virtually risk free profits to the banking system which will also help considerably with capital replenishment.

Scarce supplies

This is indeed the point. Capital which is going into banking is not available for use elsewhere. Once the central banking interventions in the economy have come to an end, capital will still be scarce and, once no longer manipulated, its cost will rise – the more so because the sovereign wealth funds of the countries with surplus capital, mainly in Asia, are becoming far more choosy about where they put it. The implications for the financial services business are profound.

Financial services firms use a lot of capital so there will be fewer of them. Some financial products use a lot of capital so there will be fewer of them, too, and what is available will cost more. This is already clearly visible in the domestic mortgage market where a scarcity of funding for first time buyers has deflated the whole sector. Less commented upon is the fact that similar pressures could also make annuities fundamentally more expensive and that this re-pricing when it comes will fundamentally affect the pensions business. Currently in the defined contribution (DC) world all the emphasis is on accumulation, with the focus on the ultimate size of the pensions pot. There is a general lack of awareness that the old assumptions about how big a pot should be might easily turn out to be far too low.

Weakened system

This is not the same issue as the problem with Solvency II, which is the EU directive currently under negotiation, and which as drafted will require that the capital provision for annuities should be calculated using the risk free rate of return. The extra capital needed to move to the risk free rate might easily add 20% to the cost of an annuity, so the amount of income which can be bought with a pension pot of given size will shrink by a fifth.

No one knows what the final shape of Solvency II will be, but the British insurance industry is alarmed that the imminent arrival of a Euro-sceptic Conservative administration could weaken the UK’s hand at a crucial point in the negotiations.

None of this looks good. On the supply side, the upwards re-pricing of capital because of the financial crisis and a bad result from Solvency II could result in a serious upward revision in the cost of annuities and will inevitably lead to several of the weaker players leaving the market. At the same time the rapid movement towards DC schemes, to say nothing of the development of Personal Accounts from 2012, is going to increase quite significantly the amount of money coming forward for annuity purchase and probably much faster than people think.
Vastly increased demand meets severely constrained supply. We are heading, as the Americans would say, for a train wreck.

Anthony Hilton is financial editor, Evening Standard; anthony.hilton:standard.co.uk