Jon Hatchett, head of corporate consulting at Hymans Robertson, explores the defined benefit pension system and the priorities that finance directors should consider in 2017
Defined Benefit (DB) pensions have risen rapidly up the corporate agenda this year due to high profile scheme failures and headlines reporting record deficits. Unsurprisingly, company analysts are asking challenging questions of scheme sponsors. Those companies facing record funding deficits in 2017 valuations will feel the heat even more. Many sponsors will be asking how they’ve got into this situation, particularly as they’ve contributed hundreds of billions towards schemes in recent years.
The recent Work and Pensions Select Committee inquiry into DB pensions re-energised old arguments on valuing liabilities, and the forthcoming green paper on DB pensions will add further fuel to the debate. Some would argue that these deficits are “phantom” – in other words, the product of actuarial methodologies rather than reality. More specifically, they argue that the “gilts plus” model, which is commonly used to value schemes, is broken.
The former chair of The Pensions Regulator, Michael O’Higgins, sits firmly in this camp. In his view, flawed methodologies for measuring scheme obligations are causing UK businesses to misallocate cash to pension schemes at the expense of wider business needs.
He believes there must be a better way to assess the liabilities, i.e. the pensions promised to employees. Currently, gilt yields are used as an indicator of the expected future returns a scheme is likely to achieve on assets. The more yields fall – and they’ve been falling spectacularly due to increased demand for bonds from pension schemes, amongst others, and as a result of the Bank of England’s monetary policy measures – the more money a scheme needs to meet future obligations. That’s why deficits have reached record highs and companies have been called upon to commit more cash.
So is O’Higgins right? Is the “gilts plus” model broken?
Yes and no. Either way, as it affects the livelihoods of 11m people and the allocation of £1.4tn in assets, it’s a pretty important question to ponder.
Why ‘gilt’ or ‘buy out’ deficits matter
Gilts deficits do matter. They give a good sense of the cost of matching the benefit payments with one of the lowest risk matching assets. They are also a proxy for buy-out costs – in other words, the cost of securing all scheme liabilities with an insurer. And they move in similar ways. There’s no getting away from the fact these are an indicator of what it could cost a scheme to largely de-risk and deliver benefits with a low risk of members losing out. For sponsors, it’s the price of exiting from the DB merry-go-round.
Tragedy of the commons
But while gilt deficits do matter, there are simply not enough of the right type of gilt assets to go around. So while some schemes can de-risk in this way, not all can – regardless of how much money sponsoring companies pours into their schemes. We do risk a “tragedy of the commons”, where sensible decisions taken by individual schemes is contrary to the common good of the industry as a whole.
There is no economically credible rationale for the behaviour of long dated UK forward rates. Similar behaviour cannot be observed in the Euro markets, for example. Essentially UK pension schemes seem willing to pay ever higher risk premiums for gilt assets, meaning demand is running way ahead of supply. According to Schroders analysis, 80% of long-dated index-linked gilts are already owned by pension schemes and demand is almost five times the size of the market.
This continued bidding up of long dated gilts is having a perverse impact on both funding and investment decision making. It contributes to a focus on the balance sheet presentation of the problem – in other words, the deficits.
Don’t be distracted by deficits
Scheme deficits are inherently volatile with aggregate swings of £200bn not uncommon. Obsessing solely on deficits can lead to significant cash calls on sponsors and distract from what is important: meeting the symbiotic objectives of ensuring there’s a good chance of paying benefits to pensioners in full and that the there’s a healthy business sponsoring the scheme. A balance needs to be struck, and deficits are part of the picture, but to maintain a healthy business pension contributions need to be kept affordable both now and in future. And if we do that, schemes are less likely to fall into the Pension Protection Fund (PPF), where members lose £45,000 of benefits on average, employees lose jobs, and businesses are broken.
For many employers, their schemes remain affordable, although there are rightly debates about how much cash should flow into them in current market conditions. Throwing more cash at schemes is unaffordable and can redirect funds from valuable business investment. A strong business means a strong covenant. And, as a strategy, simply pouring more money into schemes hasn’t worked for the last 15 years so it is not obvious it will work over the next 15.
“Gilts plus” funding approaches will be right for some schemes – particularly those that are more mature, better funded and have “de-risked” to some degree. However, for those that are far from investing in this way now or in the medium term future, there are better approaches.
Cashflow driven funding – a better approach?
A better approach would be to value liabilities prudently based on contributions and assets of which the joint income stream matches future pension payments. This could be described as “cashflow driven funding”. It comes from the philosophy of “assets should back the cashflows”, where schemes invest in assets that deliver the income needed to meet pension payments. The right assets will vary by scheme depending on their maturity and funding positions. If a scheme invested solely in gilts, then naturally they would use a gilt measure of liabilities.
Taking a “cashflow-driven” approach doesn’t mean deficits should be ignored. This should sit naturally alongside balance sheet snapshots. Both cashflow and balance sheet risk management in combination lead to better decision making, better strategies and better outcomes. They are complementary rather than mutually exclusive.
Doing both improves the probability of schemes meeting their objectives while controlling the risk of unexpected future costs to schemes and sponsors. It gives much greater certainty of the cash requirements that schemes need, improving trustee and sponsor confidence in funding plans. Not only does this meet integrated risk management requirements, it improves investment decision-making by moving away from a one-dimensional gilts plus view of funding where this is not appropriate.
More creative thinking to deliver the DB promise
While gilt deficits are an important measure, and ultimately “gilts plus” funding approaches will be right for some schemes, the fact remains there aren’t enough gilts to go around. The industry as a whole cannot de-risk. Trying to do so will lead to lemming like behaviour that will keep forcing long dated gilt prices up beyond any fundamental assessment of value. We need more creative thinking to deliver the collective DB promise. We think cashflow driven funding has a key role to play.
Priorities and next steps for 2017
Finance directors thinking about pension funding this year should prioritise the following:
- Have clear financial objectives for their DB schemes: whether that be buy-out, stabilising funding, or something else. This will assist decision making and ensure time and money spent managing the scheme is focused in the right areas;
- Engage positively and proactively with trustees: experience tells us that by building collaborative relationships, and driving the agenda, corporates can gain much greater and longer lasting influence over pension scheme strategy;
- Look across the whole balance sheet and risk profile when assessing schemes. For most companies, pension “debt” is the cheapest debt on the balance sheet. On the other hand, companies face an asymmetric risk profile in relation to their schemes. They suffer 100% of the pain of any downside, but will struggle to access any upside. They should take this into account in their decision making.
Market conditions are challenging, and the regulatory backdrop is changing yet again. However, asset values in general and transfer values in particular are near record highs, yields on alternative credit have remained resilient, and there are ever more de-risking options available. The year 2017 brings as many opportunities as risks for those willing to seek them out.
Jon Hatchett is head of corporate consulting at Hymans Robertson