Most schemes use a gilts plus discount rate for funding valuations. But, as Ben Gold explains, these can be poor predictors of scheme returns and explores three alternatives for trustees to consider.
All sorts of assumptions impact on the liability value calculated within the funding valuation but the single most impactful assumption is the future investment return assumption or discount rate.
For 12 years, the majority of defined benefit schemes have used the same method for estimating future investment returns. Returns are assumed to be a premium or discount to gilt yields. This gilts plus approach results in liability values being aligned to gilt returns, which are volatile. This pushes schemes who can't stomach volatility towards hedging this risk. They do this by buying gilts and adopting liability-driven investment. With a limited pool of assets available for investment, this has contributed towards falling gilt yields.
Moreover, gilts are a poor predictor of equity returns (as a proxy for growth assets). This has caused issues because the objective of gilts plus is to effectively estimate future investment returns.
However, schemes don't have to follow this method. The appropriate approach for each scheme should be consistent with the long-term objectives, the investment beliefs of the trustees, and the investment strategy in place.
Three alternative approaches schemes could use are as follows:
- Cash plus
Future investment returns could be estimated starting with an alternative risk free rate to gilts, such as cash. This might be relevant for schemes with a portfolio of well-diversified assets. The strategy could be thought of as targeting an absolute or cash plus return.
Cash returns are more stable than gilts so the liability value would be less volatile. This means funding volatility is much more driven by the variability of the asset value.
- Fundamental premia
Here, future investment returns are estimated by building up from fundamental building blocks. This would typically be done for each asset class separately. For example, the expected return from property could be built up by adding up the current rental yield, expected rental growth and expected appreciation before subtracting running costs and void periods.
Different asset classes are not always as diversified as you might think. Using this approach to investment and funding decisions can lead to a more genuinely diversified portfolio, as diversification across return drivers is likely to lead to lower volatility. However, trustees would need to engage in some detailed academic analysis to follow this approach.
Further, consistently and accurately predicting returns is unlikely, at least over shorter time periods. This means the funding position can still be quite volatile and this is hard to hedge.
- Portfolio minus
Under this approach, expected returns start from the return inherent in the portfolio held. The minus reflects an allowance for the risks to achieving those returns.
This method lends itself particularly well to a portfolio where the returns are well known. This means portfolios with lots of contractual cash flow assets. That is assets that are contractually obliged to pay the investor a stream of cash flows. This includes bonds, property and infrastructure. The minus primarily reflects the risk of default on the contractual cash flows.
This approach is the best predictor of future returns, but only if you hold the right portfolio of assets. This methodology can lead to very low levels of funding volatility.
Overall, we do not see any of these approaches as clearly better than another. That said some do lend themselves more to particular scheme circumstances and so we urge schemes to think about this very carefully.
Historically many schemes have automatically used the gilts plus approach. The focus of attention has been on the plus; it is important as it drives the size of the deficit. However, the method for estimating future investment returns taken drives the volatility of that deficit and therefore should get a much higher level of attention - and is something all trustees should consider carefully as part of their next valuation, if not before.
Ben Gold is Leeds head of pension investment at XPS Pensions Group
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