A hidden cost of Osborne's pension reform?

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As you may remember me mentioning before, one of the big reasons why the US economy recovered faster than the UK and European economies after the 2008 crash is that America is much less dependent on banks for credit.

Only about 20% of loans come directly from banks in America, with the rest being supplied by investors who buy debt that is parcelled into bonds and sold to them.

In Europe, by contrast, 80% of loans come from banks.

So when the West's banks were hobbled in 2008 by the crisis, this was much more devastating to the supply of credit and the functioning of economies on this side of the Atlantic than on the other.

The flow of funds to companies and individuals recovered much faster in America than in Europe, because - spurred by unprecedented money creation by the US Federal Reserve - the credit tap was kept open by investors in the way it wasn't to the same extent by banks.

That is why quite a lot of the thrust of government policy here is not only to strengthen banks, so that they can supply precious loans needed by businesses and households, but also to encourage the establishment of other sources of credit, to reduce the potentially disastrous dependence of our economy on banks.

But here is the thing (as I am apparently wont to say).

The Treasury's proposed pension reforms could significantly reduce the supply of credit to companies and to the government from a source other than our banks - it could shrink what little competition there is to the banks in the UK in the business of credit creation.

Here's why.

Under the current rules, those who retire and have been saving in defined contribution pension schemes buy around £11bn of annuities every year.

Now of this £11bn, the vast majority is invested in bonds, and something like £7bn flows to companies through purchases of corporate bonds.

So if sales of annuities were to collapse after the government abolishes the requirement on retirees to invest in them, there would be a fall in the supply of credit from this source to companies - and a reduction in credit provided to the government, to infrastructure projects, to social housing and property.

That would be what economists would call the static effect. And, many would say, it would not be benign.

However there are many who believe that the flow of funds into defined contribution pension schemes could actually increase, as and when savers know they have more freedom over what they can do in retirement with their accumulated pot.

So the dynamic impact of the changes could be to increase the size of pension schemes, and some of this additional saving could be directed into credit for businesses and households.

That said, the dynamic and positive impact would be rather less certain than the static and negative impact.

And there's another thing.

There would be a much more serious and graver shrinkage in the supply of credit from pension funds - especially credit supplied to the government - if savers in final salary schemes were to convert their pension pots into defined contribution schemes, to take advantage of this new freedom to take the money and run on retirement.

For example, of the £1.1 trillion pounds of assets held by private-sector final salary schemes, some £290bn is held in government bonds and £200bn in corporate bonds. These holdings represent something like a quarter and a half respectively of the entire market for these bonds.

So as the government points out in a consultation paper, even relatively small numbers of savers saying they want out of final-salary pension schemes could could make huge waves in the market, if those funds were forced to cut their holdings of government and corporate bonds: the cost for the government and for companies of borrowing could rise pretty sharply, and could stay elevated, if pension funds' appetite and capacity to lend to them were permanently reduced.

Which is why in giving additional freedom to those in defined contribution schemes to do what they like with their money, the Chancellor is minded to give rather less freedom to those in defined benefit schemes - he has signalled he will probably ban members of final salary schemes from switching to defined contribution funds.


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