Kevin Wesbroom looks at the issues the industry faces around liabilities
I do wonder if I am totally mad as I observe the daily pensions news. Or can I do 'doublethink' and hold contradictory opposing views?
POINT: In latest ‘research' consultant X states that the combined deficits of UK defined benefit (DB) pension schemes have increased by £Xm/bn etc over the past month/day etc, driven by the reduction in long-term interest rates to their lowest ever level this week/this year etc.
COUNTERPOINT: Don't be silly. Real liabilities don't change this much. Interest rate changes are not the same as changes in long-term pension fund obligations stretching into the future. This is the wrong measurement tool.
I fear that ‘lower for longer' applies not just to bond yields but to investment returns generally.
I recognise the calculations inherent in the Point camp. The numbers result from adjusting liabilities by the change in (long-term) interest rates. They work on the assumption that liabilities are calculated by reference to investment returns relative to the new, even lower, level of interest rates.
They calculate liabilities using some variation of the 'gilts plus' method – where the plus is a fairly fixed addition. So if long-term gilt rates drop from say 4% to 2% and equities yield 4% more than gilts, returns on equities will reduce from 8% to 6% per annum. The Equity Risk Premium – the amount by which equities are expected to outperform bonds – is assumed to remain broadly constant.
Those in the Counterpoint camp appeal to common sense – long-term pension obligations are not the same as highly-liquid traded bonds. When the bond markets are increasingly owned and dominated by the pension funds themselves, interest rate reductions become a self-fulfilling prophesy.
Lower rates mean higher liabilities, meaning a need to hold even more of these (higher priced) liability matching assets. If those in the Counterpoint camp argue that their equities will continue to earn 8% then you will have to call it 6% more than bonds, not 4% more.
The Point camp is clear – liability-matching assets are essentially these (over-priced?) bonds. Their case is strongly argued by proponents of hedging interest rates. Those who hedged have done very well recently. Those who have not have taken a huge bet on the direction of interest rates, and it has gone wrong.
The Counterpoint camp disputes that liabilities and bond yields are directly connected. Liabilities are long and illiquid. Bond markets are volatile and daily traded. Pensions may be bond-like – but they are not bonds.
So am I mad – or is everybody else as well? If you want to build a portfolio that delivers your pension cashflows with a high degree of certainty, it will have lots of bonds. So bond prices are relevant. If you want to settle your liabilities, insurers will generate their prices from consideration of bond prices.
But then in these days of ultra-low interest rates, how else can you match your pension fund's future cash payments? With buy and hold strategies that are not affected by subsequent yield changes? By looking at income from equities, not capital values, or by considering asset categories like infrastructure? These seem valid considerations, especially for mature well-funded schemes moving towards their endgame.
The key issue is to decide to what extent the Equity Risk Premium stays broadly constant over time – and I fear that 'lower for longer' applies not just to bond yields but to investment returns generally. More radically, we would stop asking about assets and liabilities and ask the more fundamental questions. Given the expected cashflows from our liabilities and our assets, what is the chance that we can pay the expected benefits? And how bad is it if we get it wrong?
Kevin Wesbroom is a senior partner at Aon Hewitt
The views above are the author's own, not necessarily that of his employer.
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