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.

For Finch, a longer term “look-ahead” at the prospects for the position of UK final salary pension plans does not look all that depressing. In fact, he remains cautiously optimistic ­ and not just because in the worst case scenario, pensions cease to matter.

“Look at it like this. There is a tremendous international effort going on which should stop matters from getting much worse. If these efforts fail dismally, then pension scheme deficits will be absolutely the least of our problems,” he says.

In that kind of meltdown people have to live purely for the hour ­ there is just no place in chaos for thoughts of a well-funded retirement.

If gilt yields start rising, that would help restrict the rise in the value of scheme liabilities by limiting the absolute fall in corporate bond yields once the premium over gilts starts to unwind.

“We have seen short-term interest rates move from 4% to 1.5%,” says Finch, “but the long government bond yield today is above where it was at the end of 2007.” At that time, the 15-year government bond was yielding 4.35%. As of the end of January, it was 4.48%, up from a low of 3.8% at the end of December, so gilts are on the rise.

“The only way they will fall is if we have another ‘flight to quality’. If that happened, the impact on the global equity markets would be dire indeed. But, once again, if things get that bad we won’t be talking about pensions, but about how to survive today,” says Finch.

Inflation fears
However, rising yields could signal greater inflation in future which would increase scheme liabilities, at least partly offsetting the benefit from rising yields. On the inflation point, Finch adds that auditors need to be a little less rigid and formulaic when analysing the way companies are accounting for their pension liabilities.

“When you are projecting inflation over a 20 to 30-year period ­ over the scheme’s remaining life, in other words ­ a movement of one percentage point upwards or downwards in your inflation assumptions can move your liabilities by 20%.”

Christopher Clayton, head of pensions advisory at Close Brothers, is much less sanguine than Finch in saying the worst of the problems are now over for FDs. He says it is undeniable that many UK final salary schemes are now back where they were four or five years ago and all the hard work of boards of directors and trustees to plug the deficit gap has been wiped away. It is not just the market crash ­ longevity increases, too, have wrought havoc. There are just too many key figures in the scheme calculations that are heading off in directions that are bad news for scheme liabilities ­ the current movement in AA-rated corporate bonds being the exception that proves the rule.

“Take Babcock International,” says Clayton. “Looking at its 2008 annual report and accounts, what it says is that if the total life expectancy figures it uses in its scheme are wrong by as little as half a year, that will add £42.5m to its debt.” Clayton points out that it is important to remember that pensions and pensions planning have a contingent universe as their backdrop and anything can and might happen.

“The bigger issue ­ much bigger than fund deficits ­ is what happens to the insurance companies that have written the annuities that underpin the benefits of retired members and that will provide the annuities for those retiring in future, if longevity goes up sharply. If we all live to 110 they will simply not be able to afford to pay out on their annuity promises,” he says.

So forget plunging equity values, the one thing that really gets FDs worked up is longevity. “The classic push-back from a finance director is: ‘My employees will never live that long’. Actuaries, however, respond by saying, ‘You can’t be sure’. The point is that the numbers in the actuarial tables are based on the actual experiences of men and women whose youth lies 50 years in the past. Dramatic changes in lifestyle can throw out those numbers hugely.

“Buyout firms such as Paternoster tend to be very guarded about how they arrive at their assumptions for longevity, but, generally, the tables are based on actual increases in longevity and they underpin the assumptions people make. The assumptions are not based upon looking ahead to the technology in the labs,” Clayton says.

The nub of the matter, for finance directors, is that there is just too much that is unpredictable about all this and, as such, this is not a risk they want on their balance sheets. The National Association of Pension Funds says 25% of companies in the UK will close their schemes during the course of this recession. Clayton argues that this probably understates matters quite considerably. There’s certainly nothing boring about the pensions environment today, but FDs could do without the Chinese curse of living in such interesting times ­ and for so long.