Pension schemes rethink the liabilities metric

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On a single day in August, UK pension liabilities rose by an estimated £40 billion after the 10-year gilt and corporate bond yields – which are used to measure pension liabilities – fell sharply on the back of the Bank of England’s stimulus package.

The pension liabilities of 5,945 defined benefit schemes soared by more than £100 billion to total £1.9 trillion at the end of August, according to the Pension Protection Fund 7800 index. Although this fell back marginally throughout September to £1.87 trillion – liabilities have risen 23.5% throughout 2016.

Richard Murphy, a partner at consulting firm Lane, Clark & Peacock, said: “We are definitely seeing in cases where affordability [of deficit contributions] is a challenge, more and more pension trustees and companies are looking at other ways to measure their liabilities.”

He believes the last two months have been the most challenging period facing pension schemes since the financial crisis of 2007-2008.

UK defined benefit pension funds typically use the “gilts-plus” measure to discount pension liabilities, while under IAS19 accounting rules corporates use long-term corporate bond yields to calculate their pension obligations.

Throughout August, pension liabilities increased by 6.1% as conventional 15-year gilt yields fell by 21 basis points, while index-linked 15-year gilt yields fell by 39 basis points.

Gareth Edwards, a senior partner at consulting firm Mercer, said: “It is certainly worth asking the question of whether the current method for measuring liabilities remains fit for purpose.”

Murphy added: “There is certainly a fierce debate going on as to whether this [gilts-plus] measure needs to be changed… it is likely the current approach will be retained in straightforward cases, but in some of these more difficult cases, we may see some change.”

Soaring liabilities have also pushed up pension fund deficits. Schemes in the PPF 7800 index witnessed their deficits rise to £459.4 billion at the end of August 2016, from £376.8 billion the previous month. Funding positions of UK schemes have also fallen dramatically. At the end of August 2016, the average funding ratio of schemes was 76.1% compared with 84.3% a year earlier, according to PPF.

Edwards said that rising deficits were forcing pension fund trustees to be more open to the idea of reassessing how they calculate their liabilities.

“Pension fund trustees are looking at the funding shortfalls – caused by the historic approach of measuring liabilities based on gilt yields – with a degree of disbelief,” he said.

Edwards added: “Projected pension payments are probably no greater than they were 12 months ago, yet the liability valuation put on those benefits is vastly increased.

“That does beg the question – how could those liabilities have increased so much? It can all be traced back to the use of the gilt discount rate to measure benefit payments.”

He added: “This is a turning point for pension schemes – yields have fallen to a level where it really challenges how funds have been measuring their liabilities. Given these market distortions, pension schemes should challenge the way they measure their liabilities. The world has changed – and perhaps it is now time to look at how they measure risk and how they invest.”

Edwards believes pension schemes would be better served by working out their discount rate through cashflow-matching strategies, such as credit strategies, rather than basing the discount rates on a gilts plus measure.

Richard Butcher, managing director of independent trustee firm PTL, noted that although trustees can set their own discount rate to measure liabilities, most have opted to stay with the gilts-plus approach favoured by the Pensions Regulator.

Butcher said: “I don’t see pension fund trustees making a wholesale change to the way they assess their liabilities – it will be too difficult for them to do anything different and so much outside their comfort zone.”

He added: “Trustees should value their liabilities on a prudent basis. And if you decide you need to change the assumptions to get a different result, that is actually manipulating the result. To play around with the assumptions is to mask the problem and not deal with the problem.”

Meanwhile, Joanne Segars, chief executive of the Pensions and Lifetime Savings Association, cautioned that accounting for pension liabilities through marked-to-market valuations had proved even more problematic for pension schemes through a period of quantitative easing, with yields plummeting and pushing up pension deficits.

“This has made an artificial number look even more artificially large, with all the consequences that this has had for employers funding the schemes and capital allocation within the company,” Segars said.

LCP’s Murphy pointed to an August 31 trading update from Carclo in which the engineering firm said it might be forced to cancel its final dividend payment in October because of plummeting bond yields increasing expected pension deficits under IAS19 and “extinguishing” available distributable reserves.

“It’s an early sign that companies are coming under pressure because of the way pension deficits are measured and we expect to see more companies struggle as yields continue to stay low,” Murphy said.

The PLSA is hopeful that the Pensions Regulator will take into account the long-term stability of the sponsor and apply a “proportionate and flexible” approach to scheme funding.

Murphy believes pension funds ought to rethink entire investment strategies.

“We have seen a long period of derisking. The question for trustees is whether they should try and hold on to those low yielding bonds or find other ways to invest to achieve higher returns, but with higher risk,” he said.

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