Pensions Accounting: Numerology signals
Seventy. Zero. Minus-80. We are probably going to be seeing and hearing a lot about those numbers in the coming weeks. Just as 666 is said to represent The Beast, 70, zero and minus-80 look set to epitomise monster pension deficits and the dawning chasm between IAS 19 scheme deficits and the reality of stewarding a pension scheme.
The problem is partly down to falling bond yields, explains Simon Robinson, a consultant actuary with Aon Hewitt. “At 31 December 2015, a typical IAS 19 discount rate in the UK would have been around 3.8%, with long-term ‘break-even’ inflation of around 3.1% per annum – a net annual rate of 0.7%, which is the important figure for discounting,” he says.
“By 30 June 2016 [post-Brexit referendum], these stood at roughly 2.8% and 2.8%, which is a net rate of nil. Over the summer, they have changed again to 2.0% and 2.8% – a net rate of negative 0.8%. To put this into context, the change from a net rate of positive 0.7% to negative 0.8% would increase the typical IAS 19 DBO [defined benefit obligation] by around 35%. UK equity markets have returned around 10% over the same period.” Worse still, Robinson tips yields to fall further. Few would bet against him.
Lane Clark Peacock partner Alex Waite certainly recognises the numbers. And for him, they point to a widespread problem of under-hedging. “There are lots of people taking comfort from the fact that they can say ‘we have some hedging’. But there are several real problems with this,” he says.
“First, most schemes haven’t fully hedged all of their assets, so they are still exposed. And even where they have fully hedged all their assets, if they have a deficit – and most have – they haven’t fully hedged the liability. So the deficit element is still an exposure.
“Finally, and this is the killer recently, what they have hedged against will have been a fall in Gilt yields. That first basis point drop that we saw in the first half of the year was a fall in Gilt yields, and so that was fine to the extent sponsors had hedged.
“But the killer is that a lot of the fall in the second half of the year was in credit spreads. So that is not just Gilts, it is AA-rated bonds getting closer to Gilt yields. I am pretty confident that virtually no-one has fully hedged that. Even more than that, it is fiendishly difficult to hedge against a falling AA-rate spread. To discount under IAS 19, you come up with a Gilt yield and add on the extra credit spread between Gilts and AA-rated bonds.
“That gives you the interest rate for IAS 19. Now, when Gilts go down, the yield that you use for IAS 19 goes down. You might well have hedged that. But when the credit spread goes down, your yield for IAS 19 also goes down, and I can pretty much guarantee that virtually no-one has fully hedged that.” This is partly, Robinson thinks, because AA-rated spreads are outside the focus of trustees.
But some of the blame inevitably rests with the Bank of England. “Thanks to QE,” says Waite, “we are seeing a situation in which the Bank of England is buying up corporate debt, which pushes up the price so that no-one else can afford to buy. This means that potential bondholders look at infrastructure, say, because it makes the relative attractiveness of that investment look better. And if there is a willing buyer at a high price, bondholders have an incentive to sell at that price and invest in infrastructure.”
And, adds Waite, there is expert fatigue. Many scheme trustees are sceptical about those who have tried to call the top of the bond market in the past.
“Back in 2008, he notes, base rates were at 5% and long-term yields were higher. Then they fell to 2%. No-one had seen yields that low before and some people were saying they couldn’t go much further. How wrong they were. And, understandably, we now have trustees asking how anyone can know that this is the top of the bond market.”