The rosier funding position for UK private sector DB schemes marks a massive shift from 2019, when there were 3,089 schemes in deficit and 2,361 schemes in surplus, according to the PPF index.
— Josephine Cumbo (@JosephineCumbo) May 9, 2023
Over the last 7 yers, First Actuarial published its FABIndex which explained that using “best estimate” actuarial valuations , rather than “marked to market” accounting valuations, the defined benefit pension schemes sponsored by corporate employers were not running deficits but were in rude good health.
Rather than the volatility shown by the accounting method’s estimates of surplus and deficits, the actuarial method shows that the PPF 7800 schemes under scrutiny have consistently been in surplus and that surplus has hardly out of a range of £20-30bn.
While FABI is less noisy and less newsworthy, it makes sense of pensions to the ordinary person in a way that the FRS17 accounting standard doesn’t.
There are few fundamental changes to the amount pension schemes are on the hook to pay their pensioners. We heard at yesterday’s Pension PlayPen coffee morning, that the anticipated improvement to life expectancy over the period hasn’t materialized and that there is likely to have been a slight reduction in how long the current generation of pensioners are likely to get their pensions. But this Covid-dividend is of relatively small import.
What has happened over the period, which has turned accounting deficits on their head has been the end of QE , the reappearance of inflation, the increase in gilt yields and the increase in the discount rate that governs marked to market liability valuations.
While these factors have also been recognized in FABI, they are much less pronounced in terms of impact and could have meant that – had assets maintained their value, pension schemes would now be so much in surplus that they would be once again a national treasure.
Sadly, the yield dividend was wiped out by over £500bn of real asset losses resulting in part from poor investment conditions in 2022 and in part by the impact of the LDI blow up in Sept/Oct.
So has it all come up roses?
The story that defined benefit schemes were in desperate trouble and were likely to drag our larger companies down with them was one that gave birth to the de-risking fever that gripped consultants and trustees in the years following the financial crisis. It was a story that the Pensions Regulator was only to happen to go along with, de-risking made for a chance to show off TPR’s powers to extract deficit payments from employers.
Employers were able to justify coercion to get members out of pension schemes as prudent. ETV and PIE “exercises” meant that members lost their pension rights for a cash equivalent and many members did. Low discount rates meant for high transfer values and over the period between 2016 and 2020, over £100bn of pension promises were swapped for cash paid to retail pensions by Trustees.
Meanwhile, deficit contributions to DB pensions meant that DC pension contributions were kept to a minimum, investment in R and D, plant and machinery and in the innovation British companies needed to compete was swapped for massive pension contributions to meet the cost of all this de-risking.
It now turns out that they need not have bothered. The most solvent funded DB pensions are those that had no need to de-risk, the schemes such as the Local Government Pension Scheme that did not over-purchase gilts using the derivatives market but invested for the future without thought of any end-game.
They are now seeing everything coming up roses. They are the schemes that can afford to invest in productive capital for the benefit of Britain’s economic future and they are now in the fortunate position of being less of a burden on their sponsors (both employers and members).
The opportunity cost
Employers will look back on the past decade with regret. They will ask whether they should have adopted pension strategies which led to such massive exposure to collateral calls when their borrowing strategies went wrong, they will asked why they paid so much to de-risk liabilities relative to the transfer values of today and they will rue the opportunity to focus on growing the assets of their pension schemes , rather than worrying about fake deficits on their balance sheets.
First Actuarial pointed this all out throughout the period when schemes were being herded into “de-risking”. They pointed out that the PPF, in whose name , TPR and Trustees were demanding deficit repayments, was in rude health and they were right. The PPF is now embarrassingly over-funded. Corporate pensions have not folded and – as this article shows, project fear is now exposed as project fake.
All this de-risking has been at a massive opportunity cost to schemes, to members and ultimately to the UK. We will look back at the past twenty years of DB pension strategy as lost years in which pensions played a substantial part in the UK’s poor economic performance.
To read how one consultancy stood out against the trend – here is the link to FABI and First Actuarial’s monthly briefings/
Let me urge caution over the PPF estimates. Last year they revised scheme assets down by £50 – £60 billion and even then appear very high by comparison with the ONS survey results. It seems likely they will revise down again this year. There are also some concerns over their liability estimates though smaller in amount.
Iain Clacher and I estimated the PPF year end of 136.5% to be in fact correctly 114.4%. A small surplus for schemes overall.
This comment is from Laurie Edmunds= I am posting on his behalf
Exactly right, Henry. The financial economists winning the argument always felt wrong to me. I was taught, at a very young age, ‘pensions aren’t about money, lad, they’re about meat and potatoes. It’s not how much money you’ve got, it’s what it will buy. And if you want to be able to spend your money on real things, the best place to invest it is in real things’.
The drive out of equities into bonds to match the money liabilities has done – as it was bound to – the exact opposite.
Schemes might be healthy financially, but pensioners aren’t. Buying out (or otherwise just covering) strict liabilities means that, at a time when pensioners are most exposed to inflation, way above the estimates in the funding calculations a short time ago, the historical response by trustees – discretionary pension increases – can’t happen.
Woe betide any pensioner who does not have a hard coded inflation increase. I suspect there are lots of them. And even with an RPI commitment, most are capped at 5% or 3%. With the downgrading from RPI to CPI on the near horizon
It may be coming up roses for pension schemes – or, rather for the employers who have to fund them – but the garden is not so sweet for the members.
It would be wrong of me, though, to not give a shout out to Phoenix Group, who are an exception to the rule. Bless them. I have always been a lucky whatnot, and one example is that my main pension ended up coming from Phoenix. A few months ago, I got a letter telling me they were making a discretionary increase. On top of a capped RPI link. Only a small percentage but it’s the thought that counts, and we all know how every single percentage point is priceless, with compound interest. I almost fell off my chair – I thought that discretionary increases were an extinct species.
I don’t know how many other employers are taking this line. Not a lot, I fear – and in the strait jacket of ‘matched liabilities’ with virtually no chance of equity upside, there can’t be many, can there? What employer is going to put new money in, to maintain the living standards of people who left their employment years – possibly decades – ago? In the welter of statistics which abound, does anyone know the incidence of discretionary increases?
I was nevertheless surprised to see the scale of the fall in liability estimates at a time of continuing high inflation (whether RPI, CPI or LPI).
Incidentally, is 31 January 2023 the latest version of the FAB and FAR indices? We are now in May 2023.
First Actuarial’s own explanation is as follows:
“We leave the asset [marked-to-market] data unchanged. However we do modify the liability values, and for good reason.
“Firstly, we allow for full scheme benefits, rather than reduced PPF benefits.
“Secondly, the PPF 7800 Index values a pension scheme’s liabilities on the basis set by the PPF assuming the employer became insolvent and the scheme entered the PPF. This is based on gilt yields.
“With the FAB Index, by contrast, First Actuarial values liabilities using a discount rate which reflects the assets that the schemes actually hold. We then make a reasonable assumption about the future returns of those asset classes. And in our view, it’s reasonable to assume that ‘growth’ assets such as equities will return more than gilts in the long term.
“We reflect that by using a higher discount rate. Every month we calculate our best-estimate discount rate. We look at market yields at the end of every month, and using the asset splits we calculate a weighted average best-estimate expected return.
“To produce the FAR Index, we also use this data to calculate the discount rate needed to make the value of the liabilities equal to the value of the assets. If the assets achieve this level of return, then in the long run schemes will be fully funded in aggregate.”
The expected rate of return has clearly gone up, presumably just because of rising gilt yields and market interest rates. Is this increase in expected real returns (allowing for higher inflation being currently experienced) justified?
What would be interesting to go alongside of this would be some information on how DC based Pension Funds have have faired…