View from City Road: Painful prospect for the pension industry

Midland Global Markets this week claimed that Britain was shifting to permanent low inflation and interest rates, which would produce changes in the markets 'so profound they occur perhaps once in a working lifetime'.

Roger Bootle and his team are more bullish than most, but few dispute that it would be good to move back to the price rises seen in the 1950s and 1960s.

Unfortunately, the transition may not be smooth. We have seen the horrors disinflation produced in housing, with negative equity and a pervasive distrust of bricks and mortar as an investment.

The next painful problem, assuming the outlook for inflation really is changing, may well be in the pensions industry, judging by a debate now going on among actuaries and pension funds.

This is not a cheerful note on which to end a week of escalating scandal about pension sales methods. But in fact the ethical standards of sales forces have nothing to do with it. The problem, instead, is a result of the impact of a long-term fall in inflation on the way pensions are funded. It may well take much longer to work through the system than the housing crisis.

In the US falling inflation has produced a catastrophe for some large pension funds, such as General Motors, which last year was dollars 14bn short of the amount it needs to meet its commitments to pensioners - and by now considerably more. Companies are having to make enormous payments into their funds.

In effect, US pension funds assume pension cheques must be paid from the proceeds of investments in long-term bonds. The interest earned from bonds falls if the markets think inflation will stay low, so they have to set aside more money to provide for an unchanged pension benefit. Markets have boomed because they love falling inflation, but pension funds have been miserable.

In Britain nothing so dramatic has yet happened because pension funds are biased towards shares rather than bonds and they are allowed much greater freedom to 'smooth' their calculations over a number of years.

But the arithmetic of low inflation could still push them in the same direction, in that pension funds will have either to find more money to meet their commitments or cut back on pensions.

The calculations are not simple, but here is an example of a problem caused by low inflation. Payments to pensioners in final salary company schemes are not usually protected against inflation when it rises above 5 per cent.

At higher levels of inflation, such as we have seen for most of the past 20 years, pensioners are robbed as their purchasing power falls. Those still paying into the fund gain, because they get a higher return on contributions than if pensioners were fully reimbursed for inflation.

With permanently low inflation, it will no longer be safe for funds to rely on this switch of wealth from one generation to another. Pensions being paid will, of course, be protected better against inflation, which is an advantage. But in the meantime there will be costs as funds adjust to cope, probably by paying lower pensions.

Some actuaries believe the first step will be to cut pension benefits from one 60th of salary for every year of service to one 80th.

Proposals in the Goode report on pensions, which recommended a minimum solvency standard for funds, have crystallised these concerns. Indeed, they could make it harder to cope with low inflation, since the benchmark tests for the strength of funds would be based on bond yields - an echo of the US problem.

Some fear a big switch from shares to bond investment as a result. Shares have long performed better than bonds, so it would be costlier to maintain pension levels.

There could be just as many transition problems for personal pensions, although that is even more a matter of crystal ball gazing. Annuity rates, on which pensions are based, are linked to gilts yields and have fallen sharply with inflation. As a result it costs a lot more than four years ago to buy a given level of pension.

If inflation really is beaten, a lower pension that does not lose its purchasing power during retirement might prove a decent buy in the end. But those who are sceptical about the final defeat of inflation may prefer to grit their teeth and step up their pension contributions just to be sure.