Are DB deficits on a downward spiral?

The combined defined benefit (DB) deficit decreased by £52.8bn over January to £51.0bn on a section 179 basis, according to the Pension Protection Fund's (PPF's) latest funding update.

The figures released 13 February showed liabilities for schemes in the lifeboat fund's 7800 Index fell by £66.2bn, a decrease of 3.9% over the month and a decrease of 2.2% over the year, while assets decreased by £14bn in January.

The aggregate funding level rose to 96.9% - one of the highest seen since 2014. Overall, there were 3,493 schemes in deficit and 2,095 schemes in surplus at the end of January, moving from 3,710 and 1,878 respectively at the end of December.

Price swings in markets helped bump up the funding level, as losses incurred from falling equity markets were offset by the fall in liability values as a result of rising gilt yields, according to BlackRock head of UK strategic clients Andy Tunningley.

Conventional 15-year gilt yields rose by 21 basis points (bps) over the month, while index-linked five to 15-year gilt yields rose by 26bps. Over the year to January, 15-year gilt yields were down by 4bps, while index-linked five to 15-year gilt yields were up by 33bps.

He explains that bond yields have marched higher in 2018, driven by a strong outlook for global growth and inflation as well as an expectation of tighter monetary policy. As a result, expectations for bond yields over the coming years is that nominal yields will rise due to global inflation and the economy picking up pace.

Tunningley added the funding level improvement would have been far greater had improving equity markets not given way to a severe bout of volatility towards the tail end of the month.

Volatility

Equity markets have experienced unprecedented periods of volatility since January with the FTSE All-Share Index falling by 4.6%. This put a big dent into the gains achieved over 2017, according to Aviva Investors investment strategist Boris Mikhailov. Over the year to January, the FTSE All-Share Index was up by 7.2%.

Not only will this have had a detrimental impact on funding levels, as the average pension scheme still invests some 30% in equities, but the recent spike in equity market volatility highlights the importance of having a robust investment strategy that is not over-reliant on a large single position, he says.

The recent figures beg the question: Is this the reawakening of market volatility or just a short-lived market correction?

Volatility in equity markets or small movements in long-term interest rates will continue to have a big impact on scheme funding positions, as they typically having large exposures to equities and significant under-hedged positions to interest rates, Mikhailov adds.

Action points

So, despite recent improvement in funding levels, scheme risk management should still be high on both trustees' and employers' agenda.

On average, the PPF 7800 schemes now have a 10% lower portfolio allocation to equities than they did five years ago. Tunningley says schemes should view recent movements in bond yields as an opportunity to hedge their liabilities, since those that have already de-risked are now less susceptible to equity market volatility.

In addition to investing in multi-strategy absolute return strategies with diverse return drivers, irrespective of their funding position, schemes should hedge liabilities and introduce or enhance their liability-driven investment strategies as soon as possible. "Not doing that risks further deficit volatility that may become ever more difficult to manage," says Mikhailov.

Schemes in poorer financial health may very well want to move away from the equity market and consider a more diverse approach to investing their growth assets, he adds.

Better-funded schemes looking to better match their liability cashflows may want to consider placing greater emphasis on higher quality income generating assets that could generate higher returns than bonds.

For example, private assets such as infrastructure or property can provide better cashflow characteristics and higher yields.

Tunningley says as allocations to bonds and private markets have risen, holding cashflow generative assets such as government bonds, credit and private market debt can help protect pension schemes during an equity shock like the one experienced in January.

He says for those looking at reducing funding level risk, "market conditions today look particularly favourable… whether or not volatility persists in global markets, these are attractive opportunities for UK pension schemes." 

Yoyo measure

First Actuarial founder Hilary Salt points out the deficit according to the section 179 measure is itself very volatile because 100% of those liabilities are assessed on bond yields and the assets are assessed at market value.

"It is a yoyo measure, and so we shouldn't be too elated by a reduction in the deficit, in the same way we shouldn't be depressed by an increase in deficit. What we should be concerned about is whether schemes have enough money long term to pay the benefits promised to members," she says.

According to Salt, long-term holders of real assets get better long-term returns than holders of bonds guaranteeing a negative real rate of return. "Why would that be a sensible way to invest the money of hard working members of pension schemes?" she says.

 

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• Topics
• Investment
• Defined Benefit
• PPF 7800 Index
• DB deficits
• gilt yields
• bond
• equity
• stock market index
• Pension Protection Fund
• Volatility
• Boris Mikhailov
• Hilary Salt
• BlackRock
• Andy Tunningley