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