Anthony Hilton: Calculated way to ease pension masochism

Last August, the combined pension deficit was estimated at £413 billion

8 February 2017

In March 2011, according to the Pension Protection Fund, private-sector defined-benefit pensions in the UK taken as a whole were in surplus.

By last August, immediately after the interest-rate cuts the Bank of England put in place as a reaction to the Brexit vote, the combined deficit was estimated at £413 billion — the worst shortfall ever.

How can things have gone so badly wrong in just five years?

According to a recent research paper from Richard Jones, Chris Parlour and Helen Skinner of Punter Southall, the key driver of the collapse in the funding position of so many schemes is the fall in bond yields. No surprise there, perhaps, but it is worth probing a bit deeper.

The perception is that low interest rates have been with us for the 10 years since the drastic cuts put in place at the beginning of the financial crisis when the world looked as if it would plunge into a global depression.

What these actuaries remind us, however, is that rates have not just been low throughout the time the global economy was in trouble but, counter-intuitively, they have also gone significantly lower in the second half of the period when a recovery of sorts was supposed to be in place and global growth picking up.

Real returns in March 2011 were plus 0.6% a year, which is miserable enough. But by last August, they had fallen to minus 1.8%.

That number means investors are expected to lose money every year in real terms from investment in government bonds. We should not be surprised if pensions look unaffordable when conventional wisdom directs us to put today’s savings in places where they are guaranteed to fall in value.

A body of financial economics theory says this is a fact of life and, despite the evident pain, gilts should be the only basis for valuation because only they offer the risk-free return that will be certain to deliver on the pension promise.

But almost no funds are this purist. Instead, the majority in the private sector use what is called the gilts-plus approach, under which they look at what government bonds would give them and add a bit for the extra risk of holding equities or non-government bonds. They nod towards the purists but then ask to be cut a bit of slack.

The merit of this is that it allows the pension-fund valuation to take account of the higher returns delivered by the equities and property that are likely to be there with bonds in the actual portfolio.

To make it easier, most schemes assume returns for assets such as equities will be a fixed amount more than gilts, regardless of market conditions.

Unfortunately, they do not add enough. That extra amount is on average just 1% more than the gilt yield.

In the decades up to 2011, this did not matter much because the return relationships between asset classes were broadly constant and aligned, and very much higher than they are today.

But it matters now because bond yields have gone their own sweet way in the past five years as a result of the global savings glut, and this means the better returns generated by equities are ignored — although they are in fact very real.

Indeed, a recent valuation conducted by Pirc for local government defined-benefit schemes showed that for the past 10 years — a period that straddled the financial crash — they had in fact generated an average return of more than 8% a year.

Contrast this with what they assume they will get. Figures from the pensions regulator analysed by Punter Southall for 2005 to 2014 show the median gilts-plus-discount rate used to value pensions has dropped from 2.16% to 1.05%, with all the fall in the most recent years.

Punter Southall says the 1.09% fall in the discount rate increases the value placed on liabilities by about 25%.

Imagine how quickly deficits would vanish completely if the rate was anywhere near the 8% actually achieved.

One does not have to go the whole way — indeed, it would be advisable not to — but it is perfectly legal for funds to use such approaches.

The Railway Pension Scheme, for example, already use an inflation-plus calculation that sets an equity return linked to the expected rate of inflation rather than the bond yield.

A further alternative is the intrinsic-value approach, which seeks to derive the return on assets from information within those specific markets rather than the bond market.

Thus an equity portfolio will be valued on the basis of what is actually happening, and expected to happen, to equity yields.

This matters because, as already mentioned, an alternative approach can have a dramatic effect on the calculation of deficits — and therefore on the required level of funding.

Punter Southall says that even a tweak to the discount rate that delivered only a 10% reduction in liabilities would move about 25% of the schemes in the country from deficit to surplus while another 25% would see their deficits cut in half.

The problem with bad data is it leads to bad decisions. The perception derived from a slavish belief in the current method of valuation is that defined-benefit pensions are unaffordable, and funding those which still exist will put a monumental strain on companies’ finances for years to come.

Punter Southall has done a great service by breaking ranks with the rest of the pensions consulting industry to spell out that this is a view based on one selected version of the data.

Its research paper makes clear to pension scheme sponsors and trustees that it does not have to be this way.

They do have choices, and at the very least they owe it to themselves and their members to examine how much of their perceived problems are purely the result of masochistic measurement. Many of those who do will be pleasantly surprised.

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