Scheme Actuaries and their Gilty Conscience…
A title that can be attributed to the merciless humour of those Christmas cracker one liners fresh in the memory, and the need for some respite from the depressing familiar story of low gilt yields and the persistent rise in pension scheme deficits. Please accept my apologies!
Background
When Scheme Actuaries sit down to draft their assumptions papers for scheme valuations, invariably it is difficult to move from the approach used to determine the present value of the defined benefit obligations by deriving a “market based” discount rate wedded to a “gilts plus a margin”.
The margin typically allows for some asset outperformance over the gilt yield, the need for prudence and the sponsor’s strength. However, in the current climate we see the valuation of Technical Provisions at unprecedented levels. With funding levels linked to gilt yields and in an attempt to reduce the volatility of future funding levels, trustees can feel pressured into pouring assets into premium priced gilts. This isn’t fiddling whilst Rome burns, it’s actively adding fuel to the fire!
This is an issue that has been persistently debated and consulted upon in recent years, but the magnitude of the problem will inevitably force the industry into action – The Work and Pensions Select Committee is now looking into “the balance between meeting pension obligations and ensuring the ongoing viability of sponsoring employers”.
What are the alternatives?
One obvious solution to the problem would be to simply increase the “risk margin” (or to allow for gilt price reversion – “they must fall surely, it’s just too painful if they don’t”). If the margin is increased by the recent fall in yields, then overall return assumptions do not change and the impact on the Technical Provisions is nil. But, perversely, this also fuels the argument that the discount rate is no longer “market
based”, but instead a subjective and increasingly arbitrary figure.
It can also be argued that this masks the crucial consideration for sponsors and trustees – can we afford to pay for our members’ benefits?
The Work and Pensions Select Committee is now looking into “the balance between meeting pension obligations and ensuring the ongoing viability of sponsoring employers”
The Pensions Regulator insists that there are flexibilities within existing legislation to tackle the low gilt yield environment and one of those is by adopting a discount rate based on a prudent assessment of the expected return of the scheme assets i.e. not using a rate that is simply a function on gilt yields.
However, for all of the reasons above, looking beyond the link between liability valuations and yields and instead concentrating on cash-flows and member outcomes seems like a pragmatic approach.
Consequently, we would expect many future funding conversations to lead to an interconnected approach as follows:
• Funding – liability values calculated using an estimate of longer term returns that suitably reflect the scheme’s investment strategy, with a view to avoiding inappropriately volatile funding positions and possibly unnecessary cash calls on the sponsors.
Considering payments from the Scheme as “short” and “long” term rather than the more traditional “pensioner” and “non-pensioner” is more appropriate. Some of the future pension payments for “younger” pensioners are not expected to be paid for another 30-40 years. Locking in assets now to meet an obligation so far into the future seems excessively prudent.
• Investment – adopting (or at least considering) a type of Liability Driven Investment (LDI) strategy that gives due consideration to the timing of future scheme cash-flows. This will balance protecting schemes from the effect of further falls in gilt yields on near term liabilities and provide a structure to protect the position of far term liabilities in future as gilt yields rise.
Alternatively, we expect investment managers/insurers to issue products that
provide cash at certain points in the future to match relatively short term benefits payments. These will reduce the scheme’s exposure to short term market fluctuations and allow other assets to be allocated to sectors with a longer investment time horizon.
• Sponsor covenant – increased scrutiny of the employer covenant, coupled with a “joined up” sponsor and trustee conversation about cash-flow requirements and how the business may support these, possibly via a tailored recovery plan.
Matching benefit payments with income from the sponsor, to the extent possible, can free up assets to be invested with a longer term time horizon. Subject to appropriate checks and balances, this could allow a more aggressive investment strategy, and hence funding strategy, to be applied for benefits payable over the longer term.
This closer correlation between investment strategy, funding plan and employer covenant should sound familiar to all trustees. Trustees are now required to consider the interaction of risks associated with each of these factors on the overall financial strength of the scheme…is it possible that we could have an integrated solution that optimises the opportunities that a situation affords a scheme? It’s difficult for an actuary to say this, but there might be an upside and we might be able to take advantage of it…is it possible a Scheme Actuary’s “Gilty Conscience” could become a “Gilty Pleasure”?
Kanishk Singh