Looks interesting: the future of pension scheme assets

FTSE-100 pension scheme assets are worth £65bn less now thanks to investment returns averaging minus 17% last year. Big numbers, and painful, leaving UK schemes in deficit to the tune of £130bn, according to Deloitte.

But it’s not all bad news. As John Finch, investment consultancy director with HSBC Actuaries and Consultants, explains, FTSE-100 finance directors may be taking a hammering as far as their scheme assets are concerned, but this is counterbalanced to some extent by the fact that their liabilities are also being depressed by that same market volatility.

This is because scheme liabilities are calculated using the yield on AA-rated, investment grade corporate bonds as the discount rate. Today, with the market bracing for a large number of corporate defaults as a result of the recession, bond yields are higher than they have been in years. As a result of this widening spread over gilts, Hymans Robertson calculates that FTSE-350 pension schemes have, in aggregate, benefited by almost £180bn.

The index most commonly used, the iBoxx AA-rated 15-year-plus bond index, shows a yield in excess of 7%, a huge spread over government long-term gilts which are currently around 4.4%. It is highly unusual for the spread between AA-rated corporate bonds and gilts to be more than 50-75 basis points ­ not something approaching 300. (In fact, for the last four or five years fund managers have been annoyed at the fact that AA-rated bond prices behaved as if there was virtually no risk differential between a government bond and a corporate bond.)

Moreover, the big picture is likely to get even worse before it gets better. But Finch points out that the Governor of the Bank of England has already said the Bank will use unconventional measures in its attempt to get liquidity flowing again. One of the strategies it intends to deploy is to allow corporate debt as collateral from banks.

“Two of the things that would stop an investor from going in to corporate bonds in the current market is a fear that the company would fall over and that if it wanted to sell the bond, there would be no liquidity in the market and no takers, so they couldn’t get out,” Finch says.

“However, if the Bank is prepared to soak up corporate bonds, then why not buy into them? The market suddenly has a bottomless pool of liquidity to draw on.”

Moreover, the payout to equity holders in the wake of a corporate collapse is usually nothing at all. But the average corporate liquidation pays out somewhere above 40% to bond holders. In this environment, good quality corporate bonds could have attractions that are yet to be fully appreciated. Finch believes the market is listening to its fears rather than thinking sensibly. “The spreads on AA-rated bonds at present would require a very high failure rate of premium corporations to justify it,” he says.

In normal circumstances, this would cause corporate bond yields to shift downwards, but these are not normal times. As the recession deepens, bond yields could well head further upwards, which means pension deficits will get “massaged” downwards still more.

Moving the goalposts
This is starting to annoy some auditors who are trying to move the goalposts for companies and get them to discount the “irrational” upward movement in corporate bond yields so that their fund liabilities are not “understated”.

“Through a quirk in accounting rules, pension liabilities are linked to the value of AA-rated bonds,” Pension Capital Strategies told the Financial Times recently. “The economic crisis has crippled values of AA bonds, but it doesn’t logically follow that pension liabilities are also correspondingly lower.”

Finch argues that this is a profoundly wrong-headed approach. If you are going to adopt mark-to-market policies with AA-rated corporate bonds when those bonds are “irrationally” failing to reflect any risk premium at all, it is hardly fair to complain when you find that same market “irrationally” overpricing a fear of failure.