Rupert Brindley says it doesn't make sense to mark pension liabilities to gilts.
The impact of Brexit on reported UK funding levels is dramatic. Yields have fallen dramatically, the Bank of England has signalled further easing and markets are pricing in little or no movement in policy rates for some time.
No doubt there will be calls to better hedge liabilities against further downward movements in interest rates.
However, does it really make sense to mark pension liabilities to gilts, and should that measurement choice dictate your investment choices?
Many UK pension funds set their technical provisions and funding plans using a "gilts + x%" formula for the discount rate. If you define your liability values by reference to gilts values, then gilts are the only perfect answer to the problem of how to stabilise your balance sheet.
However, if your funding plan requires you to deliver an investment return of gilts + x%, then investing in gilts will fall short of that target.
UK pension funds have accordingly been skewered by a Morton's fork1 . This has driven them towards barbell strategies that have effectively excluded any assets that neither perfectly match assets nor offer equity-like returns. Instead, they have been drawn into buying an increasingly squeezed long-dated gilts market.
Much of the issuance that provides the hedging required by UK pension funds is already locked up, and the capacity to access the desired exposure through the derivatives markets is declining.
As UK pension funds become cashflow negative, they will increasingly need physical assets rather than leverage to service those cashflows. The abandonment of George Osborne's target to reach a surplus by the end of 2020 may offer the prospect of fresh issuance, but it is by no means guaranteed that this will be long-dated or inflation-linked.
We don't believe negative or zero interest rate policy can last forever. We also believe that central bank policy is close to reaching its limits. It is probably true that rates could go lower from here, but we believe this will be increasingly incremental before an eventual trend upwards.
Against this backdrop, broadening the opportunity set to include a wider array of assets to help secure cashflows and allow more cost-effective management of the liability cashflows, is a rational strategy.
This means taking more meaningful steps into the wider credit spectrum, as well as into more illiquid cashflow generative assets such as property and infrastructure. Some of these trends are under way already.
If that is to be the strategy, then it throws into question whether we can find a reasonably transparent and objective means of valuing the liabilities that is more consistent with the broader opportunity set.
After all, one of the principles laid down by guidance is that the means of valuing the liabilities should be consistent with the means of valuing the liabilities. Yet at the moment we are valuing liabilities based on nominal yields that are pricing in deflation, real yields that are pricing in inflation, and relying on assets that have already priced in growth to repair the resulting deficits.
Brexit may well be the trigger for the industry to look again at their liability valuation and funding mechanisms, and make greater use of the flexibilities available to them.
Rupert Brindley is EMEA pensions advisory and solutions managing director at JPMorgan Asset Management
1 A Morton’s fork is a piece of reasoning in which contradictory observations lead to the same conclusion. It is said to have originated with the collecting of taxes by John Morton, Archbishop of Canterbury, in the late 15th century, who held that a man who was living modestly must be saving money and could therefore afford taxes, whereas if he was living extravagantly then he was obviously rich and could still afford them. In our gilts + x% context, well funded schemes can afford to buy gilts, but poorly funded schemes can’t afford not to.
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