There has been considerable debate over the last 20 years or so on how the financial position of UK Defined Benefit Pension Schemes should be determined. The main issue is the valuation of the future benefit payments (the so called ‘liabilities’) and their relationship with the current market value of the scheme’s assets (‘the funding position’). The key variable is the interest rate used to discount future payments. In practice, Trustees have been encouraged/forced by legislation and regulation to adopt an interest rate equivalent to a small margin over the market redemption yields on government bonds. The legislation requires prudence in the choice of interest rate and allows for the ‘yield on assets held’ and ‘anticipated future investment returns’ to be used in determining an appropriate rate, but unfortunately such an approach has been heavily discouraged by regulators. Consequently, most schemes have adopted a similar long term investment strategy of investment in bonds – effectively prudence = herding!

Up until 10 years ago, there was a good case for a pension scheme to invest a substantial proportion of its assets in government bonds or high quality corporate bonds. Fixed interest gilts, with a redemption yield of 4% plus, offered a return in excess of the rate of inflation (both current and projected). Index-linked gilts also provided a real return. Gilts yielded more than equities, an important measure for cashflow purposes – the ability of schemes to pay benefits as they fall due. However, the main justification for having a benchmark linked to gilt yields was that gilts were ‘risk free’ and what could be more prudent than investing in risk free assets?

Unfortunately, the world changed in the aftermath of the 2008-09 financial crisis. Quantitative Easing (QE) moved the goalposts – not just a few metres down the pitch but right out of the ground! The gilt market has been distorted/rigged by the Bank of England’s aggressive buying of gilts alongside heavy purchases by UK pension schemes. Gilt prices have lost touch with economic fundamentals – inflation expectations are still around the 3% level of 10 years ago yet long term gilt yields have fallen to below 1% and index-linked gilts now ‘offer’ a real return of less than minus 2%! To be fair to the Bank, they didn’t expect pension funds to continue to buy gilts but to progressively reinvest money from gilt sales in equity assets as gilts became more expensive.

As gilt prices have been driven up and yield forced down so pension scheme liabilities have risen and deficits have grown. Scheme sponsors have been required to make up these deficits. Many schemes are becoming locked in a vicious circle or ‘death spiral’ as companies are having to divert more money to their pension schemes instead of investing in their businesses. The effectiveness of QE is being undermined so it has to last longer. No-one knows how long QE will last or how it will unwind. On that basis alone, modelling or benchmarking based on gilt yields no longer carries credibility!

With all the turmoil caused by QE, it appears to have been overlooked that gilts are no longer seen as risk free by international investors. The UK is now rated ‘AA-‘ by two of the three leading rating agencies, three notches below its previous ‘AAA’ risk free rating and at the bottom end of a ‘high’ quality bond rating – ten countries still retain ‘AAA’ ratings so the UK can’t plead ‘worldwide dislocation’. Clearly this has implications for corporate bond spreads in the UK – maybe the sterling denominated debt of the European Investment Bank or World Bank should be used as the ‘AAA’ benchmark! For UK pension schemes, it is time to rethink an appropriate benchmark for discounting liabilities.

Let’s consider a scheme with 30 year liabilities that is currently 80% funded at a discount rate of 1% (‘gilts + 0.25%’). If that scheme used a discount rate of 1.75% it would be 100% funded and at 2% there would be a 7.5% surplus. These rates are in corporate bond territory but more importantly how do they stand as a prudent measure of the likely returns from a portfolio that is diversified into equity investments? The FTSE 100 Index currently yields 4.5% and let’s assume the yield settles at 4% in the near term – most likely through further dividend reductions. That is a ‘running yield’ as equities being perpetual investments don’t have a ‘redemption yield’. However, we can calculate a ‘sale yield’ having made an assumption on future capital value. Firstly, we need to consider dividends – there is a long term trend of companies increasing dividends to reflect growth in profits from increasing economic activity – however, let’s be ultra cautious and assume no dividend growth over the next 30 years. Turning to capital value – once again history suggests share prices will rise over long periods of time – however, let’s be ultra cautious again and assume the UK equity market falls 40% over the next 30 years. On that basis, the sale yield for the FTSE 100 Index would be 3.18%. Note that figure is in the same ‘ball-park’ as the projected inflation rate over that 30 year period.

How can it be prudent for Trustees to invest the majority of a scheme’s assets on the basis of a negative real investment return? With index-linked gilts (‘ILGs’) that negative return is guaranteed and with fixed interest gilts it is highly likely at current yields. You might just be persuaded to pay the current premium for ILGs if you thought the inflation rate was going to rise sharply in the medium/long term but in that scenario you wouldn’t want to touch fixed interest gilts with a bargepole! Except for the most mature schemes, it would be prudent to retain/increase equity exposure and adopt a discount rate that reflects a highly cautious assessment of the returns from a balanced portfolio of assets.

The discount rate used for UK pension funding should reflect market reality and not be based on a distorted benchmark that lacks credibility. Pension scheme sponsors have already paid tens of billions of pounds of ‘deficit reduction contributions’ for what are effectively notional shortfalls between ‘liabilities’ and the market value of assets. There needs to be a fundamental reassessment of funding levels and whether current contribution requirements are really necessary!!