Keen followers of Anthony Hilton’s writing might remember his Evening Standard column lambasting how pension scheme deficits are calculated, which in turn are used to determine company contributions. In his view, the actuarial assumptions underlying measurement of pension scheme deficits are illogical and lead to distorted investment strategies that aren’t good for anyone – not pension schemes, not their sponsoring companies, not the wider economy.
It’s fair to say Hilton’s writing caused a stir. The kerfuffle that followed his tirade brought to light the level of dissent on an age-old question – just how do you value pension liabilities and then determine what is an appropriate amount for the company to contribute in respect of those liabilities (both past and, where relevant, future)?
While valuation metrics may seem a remote, actuarial argument to most, in practice they can make a real difference to pension liabilities and therefore contribution requirements. Prevailing doctrine has suggested that there is one common way of valuing these liabilities, but that is far from the case.
In reality, there are a number of approaches that can be used, and finance directors should understand the pros and cons of each in order to get the best outcome for the scheme, sponsor and member. As ever, the challenge is identifying which valuation approach best suits your company and your pension scheme.
For most schemes, the dominant method used to derive a funding discount rate has been to take the market yield on gilts (or swaps) and add a margin allowing for expected asset outperformance over this yield. This is known as the gilts plus method. In the Pensions Regulator’s June 2016 analysis of scheme funding statistics, it appears that the average discount rate across all schemes has routinely followed this approach since 2005. However, this is being challenged.
In September 2016, the Bank of England (BoE) announced new measures aimed at boosting the economy, including a tranche of quantitative easing (QE) and a 0.25% base interest-rate cut. The BoE’s monetary policy has had a knock-on distorting effect on gilts, driving the yield further down and pushing pension scheme deficits up. Despite the more recent pick up in gilt yields (potentially down to the “Trumpflation” effect), gilt yields remain stubbornly low in the context of recent history.
This has led to much focus on how DB pension liabilities are swinging wildly up and down in response to movement in the gilt market. Given that DB liabilities are to be paid over the next 60 to 70 years in most cases, the question for schemes is whether this traditional approach accurately reflects their long-term objectives. Although the gilts-based “market transactable price” may fluctuate wildly, this does not necessarily mean that trustees and companies have to agree their funding cashflow requirements on this measure.
Former pensions minister Ros Altmann recently claimed that ballooning pension deficits were damaging businesses, hitting company profits and leading to hire and pay freezes. Elsewhere, the Confederation of British Industry’s recently published policy paper also stressed the importance of “addressing the negative spiral created by a gilts plus approach to valuing schemes”. This has led many to question the suitability of a gilts plus approach to measuring liabilities in the current economic environment and to ask what other options are available.
The thrust of the UK’s current monetary strategy, which aims to drive investors into riskier assets by reducing returns on cash alternatives, has not been heeded in the behaviours of pension schemes. Indeed, the recent QE purchases by the BoE were extremely well covered and it was the earlier attempt to purchase longer maturity bonds (typically held by pension schemes) that failed to meet the £1.17bn target. This is despite the fact that over 50% of the available stock falls into this longer-dated maturity bucket.
The most important aspect of any investment strategy decision is the strength of the employer covenant (Craig Wootton)
In addition, initial findings of the Pensions and Lifetime Savings Association’s DB Taskforce claims that the level of herding in the DB pension sector investment is leading to capital market distortion, in particular index-linked yield suppression: 80% of index-linked gilts are held by pension schemes with DB sector investment contributing to pro-cyclical bond market pressures.
Pension schemes themselves then fall into their own vicious cycle when decisions are being made relative to gilt yields. Investment demand from pension schemes keeps gilt yields low (as evidenced by the recent gilt issues at record low yields still being over-subscribed with the majority of buyers being pension schemes). It is then these low yields that cause DB funding liabilities to be assessed as being so high.
So, with gilt yields near all time low levels, and with an increased focus on flexibilities in the Pensions Regulator’s code of practice on scheme funding, it is crucial that pension trustees and their corporate sponsors explore and understand that there are alternatives to gilts plus.
Alternatives to a strict gilts plus approach can offer a more transparent way of setting the discount rate in direct relation to the investment strategy. Using an alternative type of approach also removes some of the short-term volatility associated in funding caused by potentially distorted movements in the gilts market.
Alternatives always sound appealing, but it is important to stress that deviating from the norm isn’t the best way forward for every scheme. The traditional gilts plus approach often remains most appropriate for companies in a less-strong position financially as the funding target will move broadly in parallel with other measures such as that used by the Pension Protection Fund (PPF). It also works well for any company looking to de-risk their pension scheme through a buy-in or buy-out transaction in the short or medium term, as again the funding target will move broadly in parallel.
For pension schemes with a stronger employer covenant however, there is more flexibility in the funding approach, which may mean using the yield on assets actually held. For a typical investment strategy, this means taking into account dividend yields on equities. For three years, although gilt and corporate bond yields have reduced greatly, equity dividend yields remained stable, so this measure of liability would fluctuate wildly.
Where liabilities are measured on a gilts plus basis, the natural tendency is to want to “de-risk” into gilts or lock into interest rate levels through liability-driven investment (LDI) to reduce the volatility against this measure. For a strong employer covenant, the disadvantage of this policy currently is that it locks into what may be perceived as very low yields and removes possible upside to eliminate risk that could be tolerated.
Over the medium/long term, it would therefore be expected to cost an employer more, especially if return-seeking assets need to be sold to hold more physical risk-free assets directly or as collateral. The gilts-plus-based funding strategy is effectively driving the investment strategy.
Any move away from this mentality would mean trustees are not effectively forced to buy gilts at any price to reduce risk.
There is a balance to strike. The objective of your scheme should be the number one driver of a chosen valuation method. Where companies want a funding target that can be locked into – such as a buy-out – a gilts plus approach is appropriate. This measure does broadly track market pricing for settling liabilities and broadly tracks the liabilities that companies should disclose within their own accounts.
The obvious downside to assessing liabilities by reference to the yield on the actual assets held is that this is not something that you can obviously transact against. There is no investment product that locks into the current equity dividend yield for example and therefore the approach assumes you hold onto growth assets for the long term.
However, for a stronger employer this may provide a suitable long-term strategy balancing anticipated rewards from growth assets with the ability to support the benefit promise with contributions as and when required. Ultimately, there has never been a more crucial time for finance directors to work closely with their pension scheme trustees to fully consider whether the funding and investment approach adopted by the trustees remains appropriate.
Overall, funding volatility can be reduced where liabilities are measured on a gilts plus basis by investing in gilts or locking into yields with LDI. Alternatively, volatility is also reduced where liabilities are measured using say equity dividend yields and the investments are equity based.
The most important aspect of any investment strategy decision is the strength of the employer covenant. It should be driving the investment strategy, which in turn will inform the funding assumptions. Companies must understand the funding approach should not drive investment strategy decisions. There are alternatives to measuring liabilities by reference to gilt yields and to de-risking decisions that involve purchasing gilts or locking into current levels of yields.
Focusing on measuring liabilities purely by reference to gilt yields could hit sponsor cash flows and viability and lead to sponsors reducing DB provision for employees and replacing with DC arrangements. By making appropriate use of the flexibilities available in the funding regime, an approach can often be found that can minimise the only real risk that matters.
The prevailing sentiment on DB pensions deficits is one of negativity and confusion. This doesn’t need to be the case. Getting a better grasp on the ultimate goals and objectives of the company pension scheme can transform the way finance directors look at business risk in the round.
Equally, without taking control and properly assessing scheme-funding, companies risk making plans on shifting sands. Greater engagement in the valuation process could reap rewards for companies, and for pension scheme members.
Craig Wootton is principal and head of employer services at Punter Southall, and advises clients on selecting appropriate funding strategies within their defined benefit schemes