For majority of Irish pension schemes, it is the employer and not the employee who has to make good any deficit arising
The extremely sharp falls in share prices in recent months are having widespread repercussions across the global financial system. In particular, the write-down in equity values is having a major impact on the insurance sector leading to a severe weakening in the solvency ratios of most insurance firms.
Another area of strain that has emerged relates to company pension schemes. In Ireland and Britain, the majority of schemes are defined benefit schemes. As many employees are aware, these schemes usually involve the company promising to pay a pension to employees based on their salary on retirement.
To fund this scheme, companies generally establish a separate fund, governed by a trust, into which contributions are paid. In Ireland and Britain, these funds have typically invested approximately 70 per cent of relevant assets in equities. By and large, this is an investment policy that has paid off handsomely over the past two decades.
However, the persistent weakness in equity markets in recent years has had a severe impact on the market value of Irish pension funds. The accompanying table shows the average returns of 17 group-managed pension funds run by the large insurance companies and investment banks. Over the 12 months to June 30th, 2002, the average return was -14.3 per cent and the bulk of this decline occurred during the second quarter when the average return was -10 per cent.
The figures in the table show that the longer term returns are now being negatively impacted by the recent market weakness. The annualised average return over three years is now zero though over five years it is a still respectable 7.2 per cent. Over the 10-year period, the average annualised return is 12.1 per cent which is still healthy, especially in the context of an inflation rate of approximately 3 per cent over much of this timeframe.
Since end-June, equity markets have fallen very sharply. The extent of these falls are sufficient to have led to a further fall in the value of pension funds of up to 10 per cent from their end-June values. This implies that the annualised three-year return is now negative and the annualised five-year return is probably just above the rate of inflation.
This fall-off in the value of Irish pension funds has already received substantial media attention. Some commentators are pointing to the negative wealth effect on ordinary individuals implied by the decline in the value of these pension assets.
While employees should be concerned about the value of their pension schemes, much of the media commentary seems to miss the fundamental fact that it is employers that are liable to meet these pension obligations in the first instance in the case of defined benefit schemes.
For most Irish pension schemes, it is the employer and not the employee that has to make good any deficit that may arise. Therefore, company profits will take most of the strain if equity values remain depressed for a prolonged period of time.
In Ireland the impact of declining equity values on consumers net wealth is very indirect. In the US, share ownership is more widespread and falling share prices do have an immediate impact on consumer net wealth.
The decline in the American market has now been so severe that there are fears that it will lead to a decline in consumer spending. Personal consumption accounts for approximately 70 per cent of US GDP and it was the resilience of the American consumer that has kept growth going over the past 12 months.
A falling stock market will undoubtedly act to dampen consumer spending. However, it is only one of several factors that determine trends in consumer spending.
Even in America, property represents a much higher proportion of individuals' net wealth than does equity holdings. The American housing market has been strong over recent years, thus offsetting the negative impact of falling stock prices.
Of even greater significance is the fact that personal income trends have remained positive and most analysts agree that growth in income is the single most important determinant of personal consumption. Therefore, as long as employment levels hold up, American consumers are likely to continue to spend.
On balance, the potential negative impact of falling equity prices on consumer spending is probably exaggerated.
Some negative impact on the real economy seems inevitable from falling share prices, but it is the negative impact on corporate investment plans that will probably do most damage.
The long bear market has heightened uncertainty and has caused companies to defer or cancel many investment projects.
Ongoing weakness in investment spending probably remains the key threat to global economic recovery.
In this regard, the recent sharp sell-off in the equity market could well delay the economic recovery through its negative impact on corporate investment plans rather than any negative impact on the net wealth of ordinary consumers.
