Funded pensions may feed bears when baby-boomer bubble bursts

`Projection of average fund growth of 8-12 per cent a year will be proved over-optimistic. Annuities bought will be much smaller than expected'

The City and most politicians believe that countries that fund their pension schemes are much better off than those that don't. But could this basic assumption about the future of pensions actually be wrong?

Worse still, could funding be storing up trouble, leading to a long bear market early in the next century that will drastically undermine the value of funds?

A belief in the great advantages of funding lay behind the report of the Commons Social Security Committee last week, which said the rest of the European Union was at a serious disadvantage.

Continental countries continue to rely more heavily than Britain on pay- as-you-go schemes, in which pensions are paid from taxes and no money is put aside in advance to help finance them.

Those countries would soon come to regret their short-sightedness, as they struggled to find the money to pay a swollen population of pensioners from the taxes of a diminishing number of workers.

This belief that funded pensions are superior to state provision has been the driving force behind government reforms over the past 10 years, and especially the promotion of personal pensions.

Yesterday, Benjamin Meuli, managing director of the top ranking investment bank JP Morgan, rocked the boat by suggesting in a letter to the Financial Times that far from being an unqualified benefit, funded schemes in the UK and the US " have simply laid the foundations of the longest and deepest bear market in history in the early quarter of the next century, as the retiring baby-boomers start to liquidate their savings". For those affected, it would be just as cruel a deception as default by governments on unfunded pension promises, he believed.

It is a frightening thought. Pension funds are pouring money into the stock market, one of the main factors driving share prices upwards. But when ageing baby-boomers start to retire, the huge equity investments they have built up in their pension funds will begin to run down, and the share price bubble will burst. The annuities bought with personal pensions will be much smaller than expected.

Mr Meuli backtracked a little from this devastating warning. He said there were other good reasons to prefer funded pension systems to unfunded ones. But they would not make the problem disappear.

There certainly are ways in which a mature economy such as Britain could avoid the bubble, even while relying heavily on funded pension schemes. A larger proportion of equity investment could go to emerging markets where there is potential for more sustained stock market growth than in the UK, during the 21st century.

People working themselves to death for low wages on the other side of the world would find themselves financing the retirement of British pensioners - just as in the days when we had an empire.

A simpler way would be to invest pension fund money only in businesses with a great potential for productivity growth, although that begs the question of whether you can identify the stocks and beat the market. Scepticism about funded pensions is unusual in the City. But economists have more varied opinions. An attack on funding is to be published next spring by the centre-left Institute for Public Policy Research. The author, Malcolm Crawford, sees funding as one more of the fashionable theories that have come to dominate macro-economic policy, just like monetarism in the 1970s. He, too, expects a market bubble that will burst, causing great damage to the value of retirement pensions.

Mr Crawford argues for a reformed state earnings related pension scheme as the best solution for the economy and for pensioners, and he believes the tax required to pay for it in the next century has been much exaggerated.

From the point of view of the economy as a whole, there is little difference between funding and pay-as-you-go pension schemes. Pensioners have a claim on part of the output of the country, and whether this is paid through taxes or interest and dividends makes little difference.

The only way pension funding can make it easier for a country to finance an ageing population is if it generates a higher level of savings and output than a pay-as-you-go system.

As Mr Crawford says, there is a vast literature, mainly American, on whether funding of pensions enhances economic growth. His view is that while funding may generate a small amount of additional saving, it is far less than the growth in size of the funds. Moreover, the gain for the economy is pretty well wiped out by the tax concessions that governments give to pension schemes.

If the age profile of the population were constant, there would never the less be no problem with funding (or with pay-as-you-go schemes, for that matter). When investments are sold to pay pensions they are replaced by new contributions and investment income.

But with an ageing population, pension funds as a whole will eventually become net sellers of shares, once pensions in payment exceed the value of new contributions plus investment income.

In 10 or 15 years, the sale of investments by final salary company schemes could be having a severe effect on share prices, producing that long bear market.

Companies running occupational pension schemes will find themselves under heavy strain, because they will be legally obliged to pour money into their schemes to top them up, in order to keep their promises to link pension payments to final salaries.

There will be another very large group of pensioners relying on the new personal pensions and company money purchase schemes, which are growing phenomenally fast. In these cases the cost of a fall in share prices is borne by the pensioners . They will simply receive much smaller pensions because their retirement funds will be lower.

This shift of financial risk to pensioners and away from taxpayers and companies is the most important single effect of the Government's enthusiastic encouragement of private funded pensions. If the sceptics about the benefits of funding are right, the government campaign for personal pensions could turn out to be a case of pension mis-selling, on a very grand scale indeed.