How can we close the DB funding gap?

While defined benefit (DB) pension schemes have struggled with the impact of ultra-low interest rates since the global financial crisis, the uncertainty created by result of the referendum on membership of the European Union has caused pension deficits to soar to eye-watering new highs.

According to PwC, DB scheme deficits reached £710bn on a funding basis by the end of August, equivalent to an increase of £100bn from a month earlier. Over the last 12 months, deficits have risen by £190bn.

The Bank of England's decision to cut rates to 0.25% and to re-start quantitative easing (QE) caused yields on long-date gilt bonds to slide to historic lows, creating this further deterioration in pension funding.

Some say QE is creating a pensions crisis. The ex-pensions minister, Ros Altmann, has called for parliament to launch an inquiry into the impact of monetary policy on the funding level of DB schemes.

One possible solution would be use a less onerous discount rate to value their DB pensions. Different countries use different approaches. Paul Sweeting, professor of actuarial science at the University of Kent, says: "Some countries use a more insurance-based approach." For example, the Netherlands uses a swap-based discount rate.

But while governments and regulatory bodies can use different methodologies to allow pension schemes to value their portfolios to determine their funding valuations, they have no influence over the methodologies which are used to produce accountancy valuations. These are determined by accountancy standard boards.

While each nation has its own generally accepted accounting principles, in today's globalised world these have become less important than the International Accounting Standards.

Independent pension consultant John Ralfe, says: "Using a consistent and objective accounting standard allows investors to compare companies and view how their pension costs and liabilities have changed over time."

Sweeting agrees: "The primary purpose of the accounting valuation is to enable the shareholders to know what impact the pension scheme will have on the value of the company."

These standards facilitate the ability of an investor to allocate capital around the globe as these consistent and objective measures make companies from different regions comparable.

Accounting standards
It is accounting standard IAS 19 which determines how employee benefits, such as defined benefit pensions, should be valued in the company's report and accounts. This effectively treats the pension liabilities like a bond and uses a discount rate which is aligned to a high quality corporate bond rate.

DB pension liabilities are valued using a similar methodology as the one employed to determine a net present value (NPV) for a bond. Expected pension payments are forecast and then these cash flows are discounted to provide a present value of the liabilities.

Ralfe says: "Pension liabilities are just like bonds with the added complications of limited inflation-indexation and longevity."

The decision by accounting boards to value pension liabilities using a NPV calculation makes sense as a defined benefit pension scheme, like a bond, promises to make a series of cash payments.

JLT Employee Benefits director, Charles Cowling, says: "A guaranteed benefit with little or no likelihood of defaulting on payment should be valued the same way as a bond."

Over time the bond-like characteristics of UK pension schemes have increased. When schemes were open, they had payments in perpetuity. As the majority of private sector defined benefit schemes have closed, however, they now more closely resemble a bond with a fixed maturity.

Ralfe adds: "The International Accounting Standards Board has been refining its valuation of pensions for many years to represent the underlying economics. It is unlikely to change its views now."

One way to resolve both the valuation question and the funding crisis would be to remove the guarantees or reduce the benefits. Cowling says: "We could go down a similar route to the Dutch pensions and have promise to pay the best possible benefits, subject to adequacy of funds."

Removing the payment promises from the pensions, make it possible to change the valuation methodology. Cowling says: "If there are no guarantees, DB liabilities are less like a bond's so a less onerous valuation methodology could be used."

But it is highly unlikely the government would have the stomach to make this type of change. Cowling says: "It would be political suicide to revoke these benefits as it would be highly unpopular with pensioners, who are the part of the population most likely to vote."

Rather than worrying about accounting valuation methodologies which are unlikely to be changed, pension schemes should focus more on the steps they can take to prevent further deficit deterioration and improve their funding ratios. Cowling says: "Accounting valuations are blamed when this is not the problem."

Investment consultants have argued for the last decade that schemes should focus on reducing interest rate exposure as this is one of the biggest risks associated with a pension portfolio. Yet the improvements have been slow.

Hedging ratios

While there is no definitive data on how pension scheme hedging ratios have improved - this is the ‘holy grail' of investment data - there is anecdotal evidence that average hedging ratios hovered for a long period at around 30%, only recently improving towards 50%

It has been difficult to change old habits. LCP partner Richard Murphy, says: "There is a long history of looking at funding valuations as a budgeting exercise." Schemes did not hedge because they continued to run their scheme on the basis that they would get better returns elsewhere, he adds.

Trustees were also reluctant to make an independent decision. Murphy says: "Trustees were looking to the employer to give a steer because if they made the wrong decision, the employer would have to pick up the tab."

For many years companies viewed the pension scheme as a separate financial entity. Sweeting says: "While this is the legal definition of pension scheme, it is the employer that needs to compensate for any deficit." This makes the pension scheme an economic extension of the company.

Sweeting says: "Companies were reluctant to reduce the risks associated with a pension scheme because the benefits would not have been appreciated by financial analysts." In theory a company could reduce the risk associated with the scheme and take more risk elsewhere on the balance sheet, such as carrying out a debt-financed share buy-back.

Sweeting adds: "But companies doing this might find that the analysts simply focused on the increase in debt and penalised companies for this shift in risk priorities."

Many company executive committees were also reluctant to hedge when interest rates were so low. Murphy says: "There was a view that yields would improve - it did not make sense to hedge at such expensive rates." At the time, that was a reasonable opinion. Mercer partner, Deborah Cooper, says: "No-one anticipated interest rates declining to the current levels."

Over time, however, attitudes to interest rate risk reduction have changed. The persistence of the ultra-low interest rate environment helped to persuade more companies to see the benefits of hedging. Investment analysts are also becoming more sophisticated about the way they view pension schemes. But more could be done.

Cowling says: "Hedging ratios should be more in line with those at the Pension Protection Fund at 75% to 80%." This higher but incomplete hedging ratio would allow schemes to protect themselves from further decreases in interest rates while still profiting from any improvements in interest rates.

But despite these benefits, many schemes may well still be reluctant to increase hedging ratios further. Murphy says: "That will effectively lock in the current very low bond yields."

This would also lock in the current funding deficit which could force companies to stump up yet more money for the pension scheme. "In some cases, this could force a company into bankruptcy," adds Murphy.

There would also be an impact on pricing. If all schemes decided to improve their hedging ratios, this would cause index-linked gilts and interest rate swaps to become even more expensive.

The only real solution to the problem would be if there was a greater acceptance by pension schemes, employees, companies and investment consultants of the ‘new normal'.

It is unrealistic to expect all pension schemes to resolve their funding crisis. Cooper says: "Some pension schemes will fail. That will be terrible for the members involved but it is an inevitable feature of a market based economy."

There are signs companies are beginning to feel the pain. Plastic manufacturer Carclo has warned it might not be able to pay its last dividend of the year due to the increase in its pension deficit since the referendum.

The investment outlook is still arguably unrealistic as it is being shaped by historic norms. Cooper says: "Most investment consultants still expect equities to outperform bonds and interest rates to rise, but this might not to happen, so trustees should also consider looking for security elsewhere."

That security could come in the form of a company covenant. The regulator could determine companies must reduce the size of the pension deficit within a fixed time period. They could use the annual valuation each pension scheme produces for the PPF as the legal funding target.

This measure is based on a five-year smoothed valuation of assets and liabilities. The PPF also stress tests these valuations, adding to their robustness. Ralfe says: "Schemes could be asked to achieve 90% of this funding target within, for example, five years."

But whether such efforts to close the pension deficit funding would prove palatable to companies is questionable. It's likely that many might protest about having to pay more into the pension scheme given the current economic uncertainty.

 

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• Topics
• Defined Benefit
• Risk Reduction
• Deficits
• gilts
• PwC
• John Ralfe
• IAS19
• JLT Employee Benefits
• LCP
• Mercer
• Charlotte Moore