author boardman fulcher2

To overcome the challenges facing the pension industry, market practitioners need to stop debating theories and engage more meaningfully with the political issues, writes Paul Fulcher, Head of ALM Solutions, EMEA and Richard Boardman, Co-Head Solutions Sales, EMEA.

With interest rates at historic lows and high profile corporate failures leaving schemes unable to pay benefits in full, pension deficits are currently headline news.

Meanwhile, within the pension industry, a debate is raging between two camps with seemingly opposite ways of looking at defined benefit (DB) pension schemes, their assets and liabilities, and the risks they present.

The first camp, which could be described as traditional in outlook, argues that pension schemes should invest for the long-term in real-return-generating assets, such as equities, and that the value placed on a pension liability should reflect long-term return expectations. Ultimately, today’s ultra-low market yields on UK government-guaranteed index-linked gilts should be largely irrelevant when valuing pension liabilities unless pension schemes, unwisely in the view of this camp, choose to buy such assets.

The opposing camp argues that pension benefits are a promise of a series of inflation-linked payments and index-linked gilts are a similar promise from the UK Government. So their market price should be used to value pension liabilities, and should also be used as the benchmark for liability-driven investment in assets acquired to back it.

The first camp retorts that it is precisely this way of thinking that has driven up the price of index-linked gilts to uneconomic levels. And so the debate goes on…

The purpose of this article is not to declare victory for one side. Arguably both camps have the correct answer – but to different questions.

Over the last 25 years, a series of changes in accounting, funding regulation and minimum benefits have fundamentally changed the nature of pension liabilities. These changes have helped to create a situation where, crucially, the following two statements are not contradictory.

  • Equities are better than index-linked gilts as a long-term investment to finance an aspiration to provide inflation-protected benefits, assuming strong support from the sponsoring employer, and policed largely via actuarial discretion

  • Equities are worse than index-linked gilts as a short-term mark-to-market match for a contractual promise to pay explicitly RPI-linked benefits, which ultimately should be self-sufficient from the sponsor, and policed by an external regulator.

Political decisions

For all the theoretical arguments on both sides, ultimately the solution to the pension dilemma is political, and political decisions require prioritisation of competing objectives followed by theoretically imperfect compromises.

A judgement must be made about inter-generational fairness, for example. How should past promises to pensioners and former workers be balanced against the risk that contributions to DB schemes threaten the ongoing health of the employer and therefore the employment prospects of current workers, many of whom do not benefit from generous DB pensions?

And what role does the government want pension funds to play in the financing of the economy or the budget deficit?

There are lessons here from the recent introduction of Solvency II regulation for life insurance companies. It involved a similar shift from a long-term perspective to a short-term market-consistent framework, with the additional requirement to hold capital against a one-in-200 year market crash.

The originally proposed, theoretically pure, version of Solvency II would have seriously harmed the ability of life insurers to continue to offer long-term guarantees to their customers and to play an economic role as long-term investors. Had it been in force at the time, the proposed Solvency II would have magnified the 2008 credit crunch and 2011 sovereign debt crisis.

In practice, a messy but pragmatic political compromise prevailed – the long-term guarantee package – which remedied the original version’s problems using a variety of solutions.

In the UK, this included the introduction of a matching adjustment, allowing firms that insure the pensions of DB scheme members to take advantage of the liquidity premium associated with being a long-term buy-and-hold investor in credit.

Implications for pensions

Taking into account the need for political compromises and the experience of the life insurance sector under Solvency II, what can be done to improve the position of the UK pension sector?

A compromise between the two camps might include the ability for pension schemes to choose to fund and invest for the long-term. But the pension promise would be backed by an industry-funded insolvency scheme. Contributions to this fund would be determined by a risk-based framework that takes into account the current market cost of an insurer buying out the benefits, the factors driving this cost, the mismatch between assets and liabilities, and the credit risk of the sponsor.

But this – broadly speaking – is actually a description of the current UK system. It would seem that evolution, rather than revolution, is the best way forward. But what shape might evolution take?

The Parliamentary Work and Pensions Committee has suggested that pension schemes could gain the power to suspend inflationary increases to members during challenging periods. ‘Conditional indexation’, as it is known, could be a useful tool to help pension funds invest for the long-term. However, it may prove politically toxic to apply such a measure retrospectively.

Instead, we suggest that the following changes should be considered:

  • Strengthening the power of the Pension Regulator:

    Allowing the Regulator to proactively intervene in corporate activity at an earlier stage would help to address concerns about security of pension benefits.

  • Altering the design of quantitative easing (QE):

    While the merits of low interest rates can be debated, QE has resulted in very low yields on ultra-long-dated bonds, which have no clear benefits yet present significant challenges for pension schemes. Instead, QE could be altered to focus on medium-term assets, such as 10-year maturities, allowing the long-end of the curve to steepen.

  • Utilising pension funds for infrastructure investment:

    The UK’s twin issues of under-investment in infrastructure and low yields for pension funds could be addressed by large upfront infrastructure spending by pension funds supported by government guarantees covering the future price of services provided. Moreover, the higher yield on such assets could be recognised in funding valuations in a similar way to the Solvency II matching adjustment.


To read more on this topic, download these short reports from our European Rates Strategy team: The BoE's Big Package and PPF7800 = PPI meets LDI? or contact Richard Boardman directly.

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