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
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
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.
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
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,”
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.