It is an unquestionably difficult time for sponsors and trustees who have been left drowning in deficit by sinking yields. With the Bank of England’s prolonged Quantitative Easing programme and an uncertain economic landscape, it is difficult to tell when they will be able to come up for air. (https://quantumadvisory.co.uk/quantum-press/how-low-can-they-go/)
For many years now, the approach to calculating a scheme’s Technical Provisions has been wedded to “gilts plus a margin”. The margin typically allows for asset outperformance, the need for prudence and the sponsor’s strength. However, in the current climate we see the valuation of Technical Provisions at unprecedented levels. This in turn pushes trustees towards investing more in gilts, which are arguably at a premium price, in an attempt to improve liability matching and reduce risk. This feels counter-intuitive; and continuing on this path without question just doesn’t seem appropriate.
Perhaps, therefore, in the forthcoming valuation season alternative approaches to scheme funding should be considered. In particular, a key question for debate should be whether now is the time to diverge from established custom and move away from the “gilts plus” approach.
Of course, one obvious solution to the problem would be to simply increase the “risk margin” (or to allow for gilt reversion). 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?
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 calls for cash from sponsors. Considering payments from the Scheme as “short” and “long” term rather than the more traditional “pensioner” and “non-pensioner” is more appropriate. Some younger pensioners’ benefits are not expected to be paid for another 30-40 years. “Locking in” now for such a long timeframe 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.
- 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 neatly ties in with the Pensions Regulator’s view on an Integrated approach to Risk Management.
Our View: It is clear to us at Quantum that the introduction of IRM and current financial conditions means that the Scheme Specific Funding Requirement will, at last, become truly Scheme Specific. The need to consider the various key factors more closely, and place a weight on each, means that the range of possible solutions increases.
The need to generate a practical solution that is affordable and consistent with the resources of the Scheme is paramount.
This is likely to be a hot topic for discussion at Trustees meetings over coming weeks and months. If you have comments on this issue, please send them to quip@quantumadvisory.co.uk
The QuIP Team