Archive for August 2019

Brendan McLean

How low can rates go?

The recent decline in yields is a sign of how quickly market expectations can change.

While the UK base rate has remained at 0.75% since August 2018, longer dated rates have recently been falling fast. Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.52% and 20-year rates from 1.77% to 1.11%. This will have dramatically increased pension scheme liabilities unless they have been fully hedged.

Global decline

It is not just the UK where rates have seen dramatic declines – it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.69% in August 2019, with a 0.38% fall in the last few weeks alone. This huge decline can be explained by the US Federal Reserve reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule.

PIMCO estimates that $14 trillion in government bonds, or 25% of the global government bond market, has negative yields. In early August 2019, German 10-year yields were -0.58%, and the Japanese 10-year yield was -0.22%. Large bond managers say it would not be impossible for the US Federal Reserve to reduce rates to 0%; they are currently 2% to 2.25%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns in government debt.

Monetary policy driver

The driver of the recent declines is changing central bank monetary policy. Global central banks have started to reduce interest rates due to slowing economic growth and investors are pricing in more rate cuts. Recently, India, New Zealand and Thailand surprised investors with larger than expected rate cuts. Investors are becoming more concerned about global growth, particularly in light of the US/China trade war which is showing no sign of ending and is beginning to develop into a currency war. Investors are worried, which is leading to declines in equities, more flows into safe-haven fixed income assets and depressing yields even more.

A popular recession indicator is the yield spread between US 10-year and 3-month Treasuries. It has turned negative before every recession since the Second World War and has been negative since May – so investors could have good reason to believe a recession is likely.

A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for developed economies, they will not be able to pull this lever and will need to find alternative solutions to avoid a prolonged recession.

So – just how low can rates go?

No one knows. We are in a period of low but stable global economic growth (except for the UK) with high employment – central banks are beginning to reduce rates to prolong the business cycle. Therefore, when the next recession occurs, central banks will cut rates even more. We may not have seen the bottom yet.

The recent decline in yields poses a question for pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.

Matt Masters

“Oh no! Not another valuation basis?”


A not uncommon cry in light of The Pensions Regulator’s latest annual funding statement, where the need for a long-term funding target could well become the de facto secondary, or even primary, funding objective for many schemes. But what does this mean in practice?

The journey


It’s good to have a destination in mind when setting out on a journey. Aside from the sheer pleasure of driving, very few people will actually get in their car without knowing where they are going, or indeed having a good idea of the route they will take. 

In a similar vein, as the end comes slowly into view for most defined benefit pension schemes in the UK – or at least as the build-up of future benefits has ceased and the lifetime of the pension scheme is limited only by the expected future lifetimes of its members – it’s necessary to start thinking about the destination of the pension scheme and how it’s going to get there.

As such, it’s helpful to be reminded of the purpose of the various “valuations” undertaken for pension schemes. There are quite a few: Technical Provisions, Solvency, best-estimate, gilts-flat, IAS19, FRS102, s179, s143, long-term funding target, or other. In particular, it’s worth highlighting that the results of each type of valuation are useful only insofar as the valuation is undertaken for a particular purpose, to answer specific questions. 

An illustration


For example, a gilts-flat funding basis could be a (relatively prudent) long-term funding target for our scheme. Once the target is achieved, our scheme is unlikely to need to have recourse to the employer. However, the real questions are: What does the result of such a “valuation” tell us? And how might we get to this position.

The question that a gilts-flat funding valuation answers is this: what amount of money must be injected into the scheme on the valuation date to have assets sufficient to meet the scheme’s liabilities, on the premise that the money injected is invested in gilts, and that all the existing assets are sold and the proceeds reinvested in gilts.  

Of course, many schemes will be invested in assets where the overall expected return will be significantly higher and where it would make little sense to change the investment approach.

In answer to the second question, it is worth emphasising the importance of not putting the long-term funding target cart before the investment horse. Investment strategies affect how much is needed to fund a scheme, not the other way around. 

As eminent economist Professor Kay made clear some 40 years ago, the calculation of a contribution to meet a liability is quite different from determining the value of that liability. As true as it is to say that the value of a liability can be determined independently of the assets held, the contributions required to meet that liability should not be determined without knowing how or where those contributions (and the rest of the scheme’s assets) are going to be invested.

So what?


So what does this mean for our gilts-flat long-term funding target? Essentially, a scheme can reach its goal through a combination of three factors:

  1. Contributions. Ask the employer to pay the requisite contributions over an agreed period. The length of time contributions are required will, in particular, depend upon the level of investment return.
  2. Investment Return. The level of investment return will depend upon the assets in which the Scheme invests and how this mix changes over time. For a given liability, if the expected level of investment returns is not achieved in practice, contributions will need to increase commensurately (and vice versa).
  3. Liability Management. Potentially providing benefits in a way that is more attractive to members, at a lower cost to the scheme, while better protecting those members who choose not to avail themselves of these options.

In our experience, most schemes invest in assets expected to earn a higher return than gilts, with a plan to gradually increase exposure to gilts and other “matching” assets over time. A number of these schemes also plan to retain a minimum level of higher returning assets. 

Conclusion


The current funding regime is “scheme specific”. What’s right for one scheme won’t necessarily be right for another. In a recent survey, around 40% of schemes were aiming to run on a “self-sufficiency” basis, a further 40% of schemes were looking to buyout benefits when affordable to do so, with 20% pursuing other (or no) long-term targets. So, while it would be eminently sensible to discuss an appropriate long-term funding target (and over the course of time it is likely to become mandatory to have one anyway), the journey taken to get there should be the one that works for both the trustees and employer. 

If you have questions on any of the issues raised in this blog, or would like to speak with our investment team or know more about liability management, please do get in touch.

David Davison

A question in the recent policy consultation “Local Government Pension Scheme: Changes to the Local Valuation Cycle and the Management of Employer Risk” asking if schemes needed greater protections from admitted bodies, and some recent communication with a Fund, really highlighted a misconception held by Funds and those associated with them.

A constant frustration for me, and something which must be a huge irritation for charities participating in LGPS is to be accused by Funds of recklessly building up liabilities they can’t afford and then complaining about having to deal with them. This is a blatant distortion of the facts and admitted bodies would in my view have every right to feel aggrieved by the assertion. I’d just like to set out some facts so that if this assertion does rear its ugly head it can be swiftly returned to whence it came.

  • Most organisations participating in LGPS were encouraged to do so by Councils and Funds without being provided with any risk warnings about their participation. Charities therefore joined with the best of motives but often unaware of the future risks they’d be exposed to. Had these warnings been provided in a clear way I’m sure many Trustee Boards would have taken a decision not to participate.
  • Even today warnings are far from transparent and the key driver for organisations not participating is that they are not permitted to join without Government or Council protection.  Most Funding Strategy Statements outline the process for achieving this for potential participants however Funds have taken no steps to rectify the legacy position.
  • In a similar vein Funds have been happy to transfer liabilities built up by these public bodies to organisations without their knowledge, without any choice and on a basis which leaves the charity with a liability many times that of the public body. The inequity is enshrined in Regulation and Councils in my experience use it as an excuse to avoid dealing with liabilities accrued on their watch.  Should Funds not be looking to protect members interests to the maximum extent possible. Surely a public sector guarantee over historic liabilities does this?  Yet Funds have been reluctant to pursue this with conflicts of interest to the fore. Indeed from what I’ve seen Funds and government bodies have looked instead to seek every route possible to avoid their obligations.
  • Crucially then Regulation limits organisations ability to deal with the issue. While other UK DB schemes will allow employers to close to future accrual and continue to fund on an ‘on-going’ funding basis to manage down risk in LGPS Funds unilaterally trigger a cessation debt on a gilts basis. There is the constant insistence that this is the correct basis to value these liabilities even though that is not the way Fund themselves invest their assets or indeed usually the way assets are invested post a cessation. Councils are effectively using exiting charitable bodies to cross subsidise their funding. Even where professional advice has been provided to the Scheme Advisory Board recommending change this has been strategically ignored.
  • Even where some flexibility is offered this is on the repayment term, not on the closure basis. In addition Funds are using the negotiation around an exit to leverage additional security or extort higher contributions.
  • Funds usually have a one dimensional view of risk driven by what happens when an admitted body looks to exit the Fund. They are not however balancing this with the risk they are exposing participants to by allowing further accrual, particularly for those with weaker covenants. Funds are not assessing this risk to properly identify the overall position and better manage it.

Based on the above I think charities would have every right to question who needs protection from who?

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