The surplus issue , like Mansion House speeches, does not open doors in the way that Pension Freedoms did to the retail “pension” market. I put pension in italics because George Osborne released retirement savings from the last link to pensions – the requirement to annuitize the pot.
Mary McDougall, writing in the Financial Times points out that the surplus in UK DB pensions is ephemeral, it lasts as long as favourable gilt rates and when gilt yields fall, the surplus falls away. The point is simple, pension strategies should not be based on such ephemeral advantage. For many years I was educated by Con Keating for whom there was an underlying return that schemes should set.
I was reminded of this when a DB trustee chair explained that the scheme set out year on year to return a positive investment return and has done so throughout the 20th century. He explained that he was not keen on managers that thought they had done well for beating a market that fell 29% by returning minus 27%. That scheme now has a £130m surplus , more than 10% over funded. It avoided the worse of LDI carnage by not borrowing to increase gilt holdings.
Common sense rather than concept is what is needed, The concept of “de-risking” drove many DB schemes to be conceptually well placed for October 2022, only for them to find themselves without the liquidity to meet the calls of those who lent the money. Concept failed to deliver what common sense saw as obvious.
What has happened to schemes since 2022 has been the valuation of liabilities has decreased (making the funding target lower) and the value of the scheme’s assets has increased. But this change has no reference to the underlying growth in value of the assets and doesn’t mean that people like me and maybe you are likely to die soon. Con’s target return assumed that people would live longer and was a measure of whether there would be money on the final day of the scheme to meet its obligations.
Here is the point, one I’d like Mary McDougall of the FT, to promote.
It’s not that surpluses are windfall benefits that can be spent while they are around. What is worth promoting is a long-term investment strategy along the lines above. It is a strategy that looks at opportunities to invest in fast growing assets where the money can accelerate growth over the long term. Pension fund managers need to be comfortable that they are investing in such assets while accepting that assets may be mispriced – and liabilities too.
This does not mean being oblivious to the numbers, but the numbers are simply an indication of the market’s mood and these moods may be ephemeral. This is a message that needs to be encouraged within the Pensions Regulator. This is not the time to knock TPR around for following ephemeral concept rather than fundamental strategy.
The Bank of England has adopted a strategy of purchasing 100% of the scheme in gilts that match what it needs to pay in future years. This is where a concept leads to a contribution rate of more than 50% of salary.
This is reasonable for BOE but not for many others! It may be what TPR considers the ultimate de-risking strategy and one that it would like employers to agree to but it ignores the speculative approach that drives companies to be successful. Most companies want to see contribution rates based on investments of past contributions meeting part of the cost and expecting that return to continue.
This is where the concept of “de-risking” clashes with the needs of the company (unless the company is the Bank of England). Many companies have been led away from the upside of paying pensions to staff at reasonable cost. De-risking has led companies to agree for their pension scheme to be bought out by insurers with payments equivalent to the pension , being paid as annuities.
But this is an expensive way for a company to dispense with what could be considered an asset. If companies had an attitude towards a pension scheme that was based on paying staff with 100% certainty, they might start looking at investment as a positive, not just for members but for the company too.
This is why the target of getting a pension scheme surplus is no bad thing. It is something we could and should aspire to – if we are involved in funded occupational pension schemes
If we are only indirectly involved then we should be encouraging those who are to step up and aspire!
As Sarah Smart pointed out in the VFM podcast, actuaries modus operandii is to analyse the past to try to evaluate the future. This normally requires analysis of multiple past events to establish trends and patterns, most clearly apparent in mortality tables. However in the case of valuing the present value of the future liabilities of a pension scheme, the model uses a value (the gilt yield) at a single past point in time (the valuation date) and assumes that will prevail for the duration of the liabilities.
The second likely distortion is that future inflation (RPI) is usual based on the Bank of England gilt-implied inflation curve. This is derived from the index linked gilts market, where 80% of the assets are held by pension schemes. Is the stability of this measure over the past 20 years plus nothing more than the market pricing adopting the same assmption!
Blimey! That’s really got me thinking – I will have to sit down and work it all out! – thank you
Thanks. Can you (or anybody) please please explain why they use the (highly variable) gilt yield rather than a scheme-specific discount rate (related to the actual investments – which they are legally allowed to do according to the regulations)?
Trustees accepting the only advice given by many scheme actuaries, who in turn seemed to crumble under pressure from TPR?
Despite the “trustee toolkit” regime for teaching TKU, which was of course set by TPR in effect marking their own homework, many trustees after 2005 were blissfully unaware of the (“flexible”) option in the Investment Regs to use a prudent discount rate based on expected investment returns instead of a gilts relative one.
Actuaries briefly highlighted the potential differences when reporting under TAS300 v1.0 between “prudent”
and “neutral” (arguably “best estimate”) assumptions, but they dropped this requirement from TAS300 at the first opportunity.
Ignorance (by many trustees at the time) was bliss for TPR who could then concentrate on reining in the outliers who had read the 2005 Regs.
Is there a real surplus? Markets are 40% above fair value according to a Cambridge professor of economics.
What would be the “surplus” be when the 40% plus below fair value as ir was 25 years age?
The current overvaluation is due to the ‘Magnificent 7’ (MAG-7) leaders in technology: (NVIDIA, Apple, Microsoft,
Google, Meta (FB), Amazon and Tesla
I have some new data which has been analysed by two of our top people on this and the news is not good. It’s not just the issues you point out, it’s more fundamental. The TPR numbers appear to be out and not as good as the published ones appear to be. More to come
Age= ago
As the Government is seen as safe for those who want income promised why not have the DMO sell a differed index linked annuity?
Proper LOL. Not surprised. Has the ‘Industry’ got to Mary at the FT?
Trustee chairs suggesting they keep the surpluses as a “comfort blanket”, goes to the very heart of the issue – the disconnect between the ‘trust world’ and the real world, forgetting that actually all pensions have to be paid by the real world economy in the future. Such attitude just widens the intergenerational gap on wealth and attitudes. Only one way that ends!
Trustee valuations (which are inherently prudent) are not meant to over fund, building up buffers for unknown unknowns. It’s a selfish and irresponsible attitude to suck money out from wages, employers and the economy when not required, compounded also by ‘investing’ the funds in low growth low aspiration type of assets. These are a major part of the reasons we are chronically under invested and with such poor productivity actual and prospects.
If not members or sponsors or govt, who could possibly benefit from over funding and surpluses trapped in DB pension schemes….?
Inflation-linked bonds derive their returns from three components, two of which are shared with ‘conventional’ fixed income:
1. Income (the ‘coupon’).
2. Capital gains or losses.
3. Inflation accrued over the holding period.
Inflation-linked gilts are interest-rate sensitive bonds, first and foremost; they act as a form of inflation protection only second.
Maybe 95% of the time, their capital value moves in the same direction as conventional gilts.
A problem of recent years is that bonds and inflation do not tend to get on well. Inflation encourages central banks to tighten monetary policies and raise interest base rates. When interest rates rise, bonds fall in value.
For a typical UK pension fund, a 1% rise in interest rates equates to a 20% capital loss.
Consider these returns for periods to 31 December 2024:
20 years
>5 year ILGs 3.4% pa
RPI 3.7% pa
So far so good, well not too bad anyway …
but over shorter periods, not so.
10 years
ILGs minus 1.1% pa
RPI plus 4.3% pa
5 years
ILGs minus 8.3% pa
RPI plus 6.1% pa
3 years
ILGs minus 17.9% pa
RPI plus 7.5% pa
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I am old enough to remember when mingling corporate and pension fund finances led to abuses – funds run as a financial services subsidiaries of the employer, window dressing accounts and balance sheets, contribution ‘holidays’, generous redundancy programmes and ‘benefit improvements’ which all crashed with the 2000 to 2002 bear market leaving schemes under water. As a TPAS volunteer, I dealt with two cases of members unable to retire as promised because the employer wound up a fund in deficit. I sent the details to the DWP and shortly after employers were prevented from doing this. And what guarantee is there that drawing down surplus – the difference between two sets of discounted cash flows – will actually result in investment and not financial manipulation? Actually Reeves and Starmer don’t understand the process. Growth and investment are demand led. You need consumers to have the money to buy goods and services, as Keynes told us a long time ago.
Appreciate the reference to Keynes. And you’re right.
Pension Regulation the last 2 decades coerced schemes into gilts and bonds, against the merits of investment fundamentals, and with scant regard to concentration risk, eschewing the free ride protection of diversification, and all conveniently in satisfaction of DMO mandates. All aided by an actuarial ‘profession’ unable to lift its eyes of their spreadsheets.
This created a massive State induced mis-allocation of capital, and the most enormous bubble in gilts/debt, which has yet to burst !
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