It is now three months since we launched our First Actuarial Best estimate Index (or FAB Index for short). It has generated a significant amount of interest amongst our clients and across the wider pensions industry – and has even been quoted in Parliament.
What is the FAB Index?
The FAB Index is a monthly index showing the aggregated financial position of the UK’s 6,000 DB pension schemes, calculated assuming they continue to pay out benefits as they fall due and allowing for our best estimate of the future investment returns they will earn on their assets.
We are concerned that the focus of many of the funding updates covered in the press are either the position on buy out or the disclosed funding level in the employer’s accounts. Both of these assume bond based investment strategies and in times of very low bond yields, place a very high value on liabilities and produce very high deficit numbers. These worryingly high numbers are the backdrop against which proposals that we think are detrimental are judged – for example, closing schemes, allowing schemes to take away benefits from members, requiring schemes to buy more bonds, and asking employers to contribute more to the scheme reducing the money they have to invest in the business.
We think it is important in assessing these proposals to have a good understanding of the funding position of schemes assuming they continue to invest long term in a diversified portfolio of assets including a significant commitment to growth assets such as equities.
The following chart shows the FAB Index from 1 January 2008 to 30 November 2016, with the overall surplus shown on the left-hand side, and the funding ratio (assets divided by liabilities) shown on the right-hand side.
How is it calculated?
The FAB Index is calculated using publically available data underlying the PPF 7800 Index which aggregates the funding position of 5,945 UK defined benefit pension funds on a section 179 basis, together with data taken from The Purple Book, jointly published by the Pension Protection Fund (PPF) and The Pensions Regulator (TPR).
The liabilities are calculated by switching the data underlying the PPF 7800 Index onto a set of assumptions derived using First Actuarial’s in-house “best estimate” assumptions (see below), and adjusted to allow for full scheme benefits. The discount rate is set equal to the weighted average of the expected future investment return on the assets actually held by the 5,945 DB pension funds included in the PPF 7800 Index, using the average asset allocation published in The Purple Book as weights.
The assumptions adopted over the last three months were as follows:
|Assumptions||Expected future inflation (RPI)||Expected future inflation (CPI)||Weighted-average investment return|
|30 Nov 2016||3.7% pa||2.7% pa||4.3% pa|
|31 Oct 2016||3.8% pa||2.8% pa||4.4% pa|
|30 Sept 2016||3.4% pa||2.4% pa||4.4% pa|
What does it tell us?
The first three months’ results of the FAB Index are shown in the table below.
|FAB Index||Assets||Liabilities||Surplus||Funding Ratio||‘Breakeven’ (real) investment return|
|30 Nov 2016||£1,443bn||£1,147bn||£296bn||126%||-0.6% pa|
|31 Oct 2016||£1,438bn||£1,132bn||£306bn||127%||-0.7% pa|
|30 Sept 2016||£1,450bn||£1,092bn||£358bn||133%||-0.6% pa|
In other words, the FAB Index tells us that far from soaring deficits, there has been a relatively stable surplus of around £300bn in schemes overall.
Looking month by month, the FAB Index fell slightly over the month ending 31 October 2016 as a result of an increase in expected future inflation and the negative effect that a rise in gilt yields had on the market values of the bonds held by the UK’s DB pension schemes.
During the following month ending 30 November 2016, the FAB Index fell again slightly, however this was primarily as a result of new data on the average allocation of the UK’s pension schemes. According to the new edition of the PPF’s Purple Book, the average allocation to bonds has risen to over 50% for the first time as shown in the table below.
|Average Asset allocation of UK DB pension schemes||As at March 2015||As at March 2016||Change|
The higher allocation to bonds means that less money is invested in equities (which are expected to give better returns in the long-term). Therefore, although bond yields increased during November, the lower allocation to equities means that the overall expected investment return on assets actually held has fallen.
Even with these changes in inflation, gilt yields, and the significant change in overall asset allocations, the FAB Index has remained relatively stable during the three months, with the funding level only fluctuating by a relatively modest 7%. The PPF 7800 Index fluctuated by over 10% during the same period.
Schemes only need average (real) return of minus 0.6%
Our analysis also shows that the overall investment return required for the UK’s 6,000 DB pension schemes to be 100% fully-funded on a best-estimate basis – the so called ‘breakeven’ (real) investment return – has remained broadly constant for the past three months at around -0.6% pa.
This is by no means an unrealistic expectation for future investment growth, and suggests that UK pension schemes remain in a healthy position for so long as they retain an allocation to long-term, real-returning assets such as equities.
What FAB doesn’t do
It is very important to be clear about what FAB does and doesn’t do. So the following caveats are very important:
- The FAB Index does not include any margin for prudence in any of its assumptions, and so it’s not appropriate for Trustees to use as a funding basis.
- The FAB Index is based on aggregate scheme data. An overall surplus could mean a few large schemes in surplus and lots of small schemes in deficit – or vice versa. (The same is true of other reported indices.)
- The FAB Index assumes schemes retain their current investment strategy for the long term future. Some advisers would suggest that schemes – especially closed schemes – should buy more bonds as their members age and that advance allowance for this future reduction in investment returns should be made. Whilst it might be the case that some schemes will increase their bond holdings over time, allowing in advance for schemes to buy bonds at their currently ultra-low rates of return seems to us an unnecessarily cautious approach.
- For further information, please contact your usual First Actuarial consultant.
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