ECONOMICS: PENSIONS ARE in the news for all the wrong reasons. Three-quarters of private sector defined benefit schemes – the classic good pension – are broke and/or closing, while pending spending cuts put public-sector pensions under the microscope as well.

Much of this is self-inflicted – a simple change to the rules governing fund valuation could dramatically reduce pension deficits while at the same time boosting Government funding and increasing the return on assets invested.

Some pensions are funded in the sense that money is put aside to be drawn upon post retirement. Big private sector funds typically have a large pot which they invest to garner extra income and from which they pay out pensions to retirees.

Smaller funds generally buy an annuity from an insurance company so that the retiree gets a guaranteed stream of income for life. The cost of this annuity is determined by long-term interest rates, ie government bond yields.

Some pensions are not funded at all; the Government simply promises to pay retired public servants a pension for life funded by the taxes it hopes to collect in the future.

The reasons for the deterioration are familiar: disastrous investment returns and greater life expectancy which increases the number of years in retirement; a demographic change which affects funding by altering the ratio of workers to retirees and last, but by no means least, interest rates.

Back in the 1980s, we had a crisis that went largely unnoticed as trustees simply took a long-term view and assumed, correctly, that their funds would recover in time.

However, in an example of how better regulation can sometimes have perverse effects, we subsequently introduced the Minimum Funding Standard (MFS).

The MFS requires the scheme’s actuary and trustees to value pension fund assets and liabilities, the presumption being that it has enough assets to pay pensions to all members, retired and currently working, if the firm goes bust in the morning.

If there is a deficit, the trustees and the employer are required to quickly come up with a plan to rectify the situation. Normally, the deficit is made good over a three-year period but this can be extended to 10 years, depending on the severity of the situation.

However, in practice, the deficits are so big that many employers are closing down the schemes rather than trying to meet the Minimum Funding Standard. Instead, they are resorting to hybrid or defined contribution schemes that have the potential to impoverish a generation as future pensions are insufficiently funded.

The upshot may well be a working life which extends into one’s 70s as the State is unlikely to be able to shoulder the burden.

The tragedy is that the MFS is exacerbating the situation. The calculation of the cost of funding pensions for existing workers in a hypothetical wind-up situation is based on purchasing German annuities, the risk-free benchmark from an insurance company perspective.

Since German yields have fallen sharply, the cost of funding an annuity based on them has risen alarmingly and is now far above what it would be if Irish yields were used instead. A €1 million fund yielding 2.5 per cent produces a pension of €25,000 a year. The income from a similar fund at 6.5 per cent is more than 2.5 times higher.

This prompted the Society of Actuaries in Ireland, one of the most conservative and responsible bodies in the State, to team up with the Irish Association of Pension Funds and propose a switch to Irish bond yields.

The proposed change would by no means solve all the problems but it would go a long way. It would, for example, increase typical active member pension values from 40 cent to over 70 cent in the euro, still well short of the 100 per cent mark but close enough to give hope of a recovery.

It looks like a no-brainer but the official response has been strangely muted.

Two weeks ago, the Minister for Social Protection finally promised legislation by July 1st, 2011. This will “look at issues regarding the governance of defined benefit schemes, the basis for the funding standard (including areas such as risk management and smoothing out effects of changes in the bond market) and strategies for transitioning schemes to a new defined benefit model”.

This kick to touch may have been influenced by insurance companies which fret that they could somehow be left short- changed in the unlikely event that we were to leave the euro and devalue against it causing them to end up with a mismatch between assets and liabilities. This seems extreme.

Irish public servants rely on a promise from the Government to pay their pensions in the currency of the day. Irish banks rely on the Government for a guarantee for their very existence. At a time of national crisis, Irish insurance companies and pensioners should be entitled to no more than that anyone else.

Legislation could be introduced to provide that assets and liabilities of those concerned will be in the same currency when an annuity is calculated by reference to an Irish Government bond. Such a move could have significant other advantages.

At present, Irish pension funds hold about €20 billion in government bonds, only €4 billion of which is in Irish bonds. While it is open to trustees to seek to benefit from current high returns on Irish bonds, they are slow to do so and any such move will likely be limited in the absence of more radical change and official encouragement.

In time there is potential for a shift of pension fund monies out of foreign and into Irish Government bonds of, perhaps, €12 billion, ie half of next year’s likely borrowing requirement. Never was the need greater.

The prudent man rule directs trustees “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested”.

A prudent funding rule would dictate that domestic sources be maximised before the NTMA again ventures into the international bond markets in the new year.

Pat McArdle is a former pension fund trustee.