UK Pensions: Eyes on the real world
Investment decisions should be made with a long-term, realistic view of the world, argues Carl Hitchman
The subject of UK defined benefit pension deficits has repeatedly hit the headlines of both financial and mainstream media in recent months. The numbers involved are vast and rather volatile which, understandably, has ignited a lively debate over the appropriateness of pension scheme funding approaches.
So what has caused this recent period of elevated volatility? The explanation lies in the way pension scheme liabilities are valued to arrive at a present value. Most UK defined benefit pension schemes calculate a present value of their future expected benefit obligations with reference to the yield on Gilts or similar ‘risk free’ assets (for example, high-quality corporate bonds).
On this basis, a declining Gilt yield would, all else remaining equal, require pension schemes to hold more assets now to meet their future pension payments. In recent months, and particularly in the aftermath of the EU referendum when rates plummeted to record lows, Gilt yields have been volatile, causing the dramatic fluctuations in reported pension scheme deficits.
Many industry participants argue that using such an approach to assess the level of liabilities is reasonable, as Gilts most closely represent the characteristics of a pension scheme’s liabilities and therefore this measure reflects the cost of securing those benefits. This rationale is used to underpin the construction of often complex liability-driven investment portfolios that seek to hedge a significant portion of liabilities with the aim of mitigating interest rate and inflation exposure (and which will have performed extremely well in recent years, owing to the relentless downward path of yields).
However, various commentators have raised questions about the above approach. They are mostly driven by concerns relating to the distorting effect it has on pension scheme funding and company balance sheets. In addition, they are concerned about the risk that it poses to the overall condition and robustness of the UK pensions industry, corporate behaviour and the UK economy in general.
Proponents of this view argue that many pension schemes are in a position to accept investment risk because the benefit payments will stretch out for many years. As a result, trustees are offered the opportunity to embrace strategies that present higher return potential with an acceptable risk profile. Allowing for these higher expected returns paints a materially different picture. From this perspective, it can be argued that the quoted size of pension deficits is, at best, misleading. At worst, it is damaging to financial markets and the institutions that rely on them to inform future investment decisions.
In practice, deficits are calculated on a number of bases reflecting the purpose for which they are intended, something that seems to have been lost at times in the debate. In particular, the deficit calculations used to determine how much to pay into a scheme are, in our experience, typically based on assumptions that make some (but not full) allowance for expected returns being higher than those on Gilts. The calculated deficit on this basis will be less than that on a Gilts basis. However, even this figure is not ‘the deficit’, which is something of an elusive quantity as noted below in our closing comments.
From an investment perspective, it is important that investment decisions are driven off a realistic view of the world. This should include the period over which the pension scheme assets are likely to be invested. The challenge arises in that the deficit metrics referred to above are typically incorporated into the investment objectives. While this is understandable, it has led to an undue industry preoccupation with short-term mark-to-market liability valuations that has served to distort investors’ behaviour. This limits the investment options considered suitable and driving the ever increasing allocations to liability hedging strategies.
Paradoxically, the demand for Gilts by pension schemes has helped to drive their yields even lower. This worsens the quoted deficits for many schemes and increases the appetite for more de-risking (and further Gilt purchases). One commentator referred to this episode recently as “a misallocation of capital on a truly heroic scale” (Anthony Hilton, ‘Our mad approach to pension-fund deficits’, London Evening Standard, 14 September 2016).
Consideration of pension scheme investment should be founded upon the following two fundamental questions:
• What investment returns does the scheme require from its assets in order to meet its future expected cash flows?
• Can the assets be invested in a manner such that the trustees have a high degree of confidence that the required returns will be achieved?
This assessment is not driven by the movement in Gilt yields, other than to the extent the scheme holds Gilts, but on an analysis of the return expectations for various asset classes. The investment strategy derived from this analysis can then be overlaid to reflect the client’s need to control mark-to-market volatility. This will bring a different perspective to the overall assessment and highlight the structural issues underlying the volatility of pension scheme deficits. An improved understanding should, in turn, lead to better decisions.
To conclude, our key concern with the current debate relates to the message it is sending. We are not arguing about the accuracy of the buy-out deficits – these are simply a statement of fact. If you want to buy-out today, that is what you would have to pay. However, for many pension schemes the period to buy-out is likely to be some years ahead. The deficit that needs to be covered by the sponsor will depend on the investment returns achieved and the movement in buy-out pricing during the intervening period.
The challenge, of course, is identifying what number to put on these variables, which will be different for every pension scheme. So while we are all for transparency it is not possible to put a single figure on the industry deficit. We are concerned that the deficit numbers currently being quoted, if taken out of context, will drive actions and investment behaviours that are not in the interests of scheme members or the sponsoring company.
Carl Hitchman is head of fiduciary at Stamford Associates