Michael Bromwhich

The Long-Term Objective (LTO): introduction

Central to this consultation on the principles to be used by the new code is the new requirement that all DB schemes should have the same long-term objective (LTO)-that all schemes adopt as their LTO a self-sufficiency (SS) position called a low dependency basis (LDB) in the code at some horizon and to plot a journey towards this. This LTO ensures that schemes can be near certain of meeting liabilities at some time horizon from a low risk portfolio without any further support from sponsors.  The term LDB reflects the belief that even with this portfolio limited calls on sponsors may still be necessary in the event of unplanned problems. This approach is meant to protect the scheme from the risk of sponsor insolvency and the variability of growth assets but puts stress on the sponsor to provide adequate contributions.

The role of the code is to give guidance on how to comply with the law. Those following different approaches to the code need to show the Pensions Regulator that the legal requirements are satisfied. The code includes elements of the Pension Scheme Bill 2019-2021 which is currently before Parliament. Part of this extends requirements on trustees. Trustees must have a strategy to ensure that benefits over the long term can be provided specifying the levels of investment and funding that they intend to achieve at the relevant horizon with a long-term plan.  Much of the new code is founded on these requirements but seems much more prescriptive than the previous regulatory framework.

As it stands the Bill’s requirements are far less onerous than those in the Pensions Acts for the Statutory Funding Objective. There is no requirement to set a specific LTO and certainly not that advocated by the Regulator. Adherence by the Regulator to the suggested LTO may provoke legal challenges unless forthcoming statutory regulations confirm this requirement.

There are now two objectives: the statutory funding objective related to the Technical provisions (TPs) and the LTO in the code.  The latter is dominant as the TPs must be consistent with the long-term plan.

Aspects of the Code

The Suggested LTO

There seems to be a large gap between the Bill’s requirements and its characterisation as a specific LTO. No theory is drawn upon to support the chosen LTO. Rather it is regarded as providing both a standard of best practice and a benchmark for all schemes. The white paper preceding the Bill did give the SS basis as an example of a target for closed and mature schemes.

De-Risking

The code’s chosen LTO   requires de-risking. As part of de-risking the amount of risky growth assets that can be held is limited depending on both the maturity of the schemes and the Regulator’s intention to set maximum rates of return. Only immature schemes   those having lives of 20 or more years (50 percent of schemes in 2019, may be less in future years) are thought able to bear the risk of holding a significant proportion of high growth risky assets because they have time to be flexible in the face of the risk[2].  For many smaller schemes adopting this LTO offers a safe harbour from detailed regulatory requirements and from some legal responsibilities.   Schemes moving towards significant maturity may take some 15-20 years to reach this (some 40 percent).  The emphasis on de-risking substantially limits the freedom of trustees that wish to use growth assets during their medium and long lives prior to reaching LTO.

The drive to de-risk may not matter for  significantly mature schemes the future liabilities of which have a life of 12 to 14 years (less than 10 percent may be more later) which are aiming  for buyout or run off  and have already been de-risking.

Only immature schemes can factor the strengths of their covenants into their ability to carry risk but generally the strength of the covenant plays no role in the LTO’s architecture. Contemporary pension practice emphasises   the importance of a strong covenant especially in determining the ability to bear risk.  More generally in business analysis the strength of an organisation’s ability   to function as going concern over time is of great importance. The code seems to be throwing away information.

In the code Scheme maturity is preferred to reliance on covenant strength.  These are not equivalent. Maturity measures for how many years the scheme expects to receive contributions from the sponsor which can be used to pay pensioners with the emphasis therefore on pension payments. The covenant focuses on   the strength of the financial position of the employer and the consequential reliance that can be placed on the employer.

More importantly de-risking is very expensive both in terms of price, foregone returns and tax relief. Seeking to   reduce as many risks as is possible is always expensive in terms of foregone returns.

The usual view in capital markets is in the face of risk it is better to diversify than specialise in only one type of asset. The long view would suggest that assets be should be diversified between growth and near ‘risk free’ assets, the mix depending on risk attitudes. Against this is the view that the current low interest rate environment will be sustained over a further long period.  There is no plan B to deal with the, perhaps relatively sudden, unwinding of this setting placing schemes following the required LTO strategy in a very difficult position including large losses and forgone gains. There are already some views that the developing economic setting makes some degree of inflation possible in at least the medium term.

 Non-Empirical Valuations

All pension valuation bases (and such bases generally) are to a degree ‘constructs’.  That is, they all incorporate non-empirical estimates. For example, the markets for long-term liabilities   are imperfect and poor generators of prices. The promises made to members are known but their prices do require estimates.  The values of TPs are compared with investment portfolios based on actual market prices and discount rates are either based on the returns from these or on the redemption yields from bonds including gilts. Similarly, buyout valuations    are based on the estimated market cost of buying the promised benefits from an insurance company. In contrast, SS valuations are based on an asset portfolio which either does not exist for much of a scheme’s life or is entirely hypothetical (open schemes). Debates about such models are about beliefs not empirics.

Moreover, the model is counter factual. Even with fully closed schemes solvent sponsors are required to contribute to any deficit which appears over time or provide other support.    Sponsors of less mature schemes who wish to leave the scheme must pay their outstanding section 75 debt unless they are insolvent.

 Suggestions on the LTO

There are of course many approaches which could be used as the basis for a long-term strategy including the existing TPs based approach. Most of these options do not use the code’s LTO.

SS and TPs

The consultation gives neither any clear example of how the LTO   is related to the TPs nor of the journey plan from the opening TPs to the LTO.

SS valuations value liabilities after say year 20 using the low discount rate   generated by a low return but safe portfolio which substantially matches liabilities. The SS valuation of these   liabilities at year 20 (SS₂₀) is therefore substantially higher than the TPs valuation of the same liabilities at year 20. This gap can be closed in two ways.   One is by de-risking the portfolio during years one to 20, which will require extra contributions.  This   de-risking eventually generates a year 20 portfolio of assets (TPs de-risked₂₀) the return from which is equal to the SS discount rate thereby decreasing the TPs discount rate over time and increasing the value of the liabilities.   The gap can also be filled by requiring additional contributions expressed in real terms at year 20 from the employer(s) up to the maximum reliance that can be placed on the sponsor(s). This is the journey to the LTO   envisaged by the Regulator.

This baroque architecture is not necessary to ensure de-risking. The Regulator could determine the degree of de-risking required to be consistent with scheme maturities and which satisfy the Regulator’s risk attitude.  This would expose the Regulator’s views to debate. Another option is to allow schemes to chose their own LTO provided that the Regulator is convinced they satisfy the law.

Informativeness of the Technical Provisions and Self-Sufficiency Valuations

One further aspect of this approach   that has not been discussed is whether the use of SS yields better but uncertain signals about the future than those conveyed by TPs. This subject needs more analysis.  When two measures give the same information, given one measure, it should be possible to use an arithmetical operation to derive the other. The chart below gives an idea of the relationship using Universities Superannuation Scheme (USS) figures.

Source: Aon (2019), 2018 Valuation and Contingent Contributions, 27 February

There is clearly some correlation between the two deficit concepts as they roughly follow the same pattern but the TPs deficits are not full valuations as they   only take into account changes in gilts.

The chart below shows the SS and TPs deficits for the years 2014-2020 again using USS figures.

Again, this does show some relationship between the two deficits but is subject to limited observations. The SS curve seems incorporate a greater degree of smoothing than the TPs deficits. Some of the TPs deficits are not based on full valuations. Both deficits would be expected to be variable as they are products of   the differences between two large numbers, but the TPs deficit is likely to be the more variable. Provided that the patterns are not the result of noise the charts suggest that the TPs deficit   may generate the more useful signals in terms of earlier signals and better indications of the variability of the environment especially in the current environment. So, are SS deficits necessary for all schemes?

The above and other concerns about the code’s LTO with its consequent de-risking suggest a more liberal regime should be entertained for schemes LTOs. Following the code does not seem likely to   a provide a golden result for DB pensions.

[1] This is a second note out of three on the consultation on the code.

[2] Strictly liability life is defined as duration, the liability years weighted by their cashflows.