By Mark Davies
The evolving situation with the steel industry has interested me greatly; not only because I got married in Port Talbot, but also because the pension scheme is at the forefront of discussion.
This has been most true in the last day or so where the discussion has been around reducing member benefits in order to make the pension scheme less of a problem for a potential buyer. The change being discussed is to change pension increases from being linked to RPI to being linked to CPI. The rationale being that CPI is usually lower than RPI and therefore the “cost” of the pension scheme will be cheaper.
The issues being discussed in this story actually highlight the challenges DB pension schemes are facing at the moment.
The first of those is around the size of the deficit and the optics of it. If you accept that CPI is going to be lower than RPI then, evidently, future pension payments will be lower. This is clearly a set of future cashflow payments, whereas the liability value and deficit are both single number estimates of these cashflows in today’s terms. Therefore to put that in today’s terms, the size of the deficit is driven by expectations of this difference between RPI and CPI, as assumed by the Trustees and Actuary. I have read that the change is expected to shave off £2.5bn from the liabilities. From my back of the envelope calculations, this looks like the assumed difference between RPI and CPI is between 0.75% and 1%. If the realised difference is higher or lower than this, then it is obvious the actual benefit of this change could be wildly different. For the sake of argument, if assuming 0.75% difference eliminates the deficit then that will clearly be very attractive to a buyer, but that is just optics – the reality for the cost of the pension scheme is not driven by the assumption, but by the reality of how much lower CPI is compared to RPI.
This leads to the second challenge of how the deficit changes over time. A buyer may be attracted to a smaller deficit from an initial transaction cost perspective, but on an ongoing basis they are exposed to how that deficit moves. So let’s take the CPI/RPI change being discussed, if the gap between RPI and CPI turns out to be half that assumed, then the cost of the pension scheme to that buyer will be £1.25bn more expensive because of how reality turns out compared to expectations.
So, for me, what’s important is not only looking at the size of the deficit but also at what can make that deficit change over time. Generally speaking these factors are the following:
- Investment Returns – the steel pension scheme has a proportion of its assets invested in equities and the current deficit assumes a certain investment return from those equities. Therefore if that investment return isn’t achieved, in reality the cost will be higher than we currently think.
- Inflation – as discussed above, if inflation is different to what we assume then the pension scheme will be more or less costly than we currently think.
- Longevity – quite simply, if people live longer than we expect then clearly we have more pensions to pay and so it will be more expensive than we think.
Now, it is not all doom and gloom. There are things Trustees can do to manage all of these risks, whether it is diversifying the investment strategy or hedging tools such as Structured Equity (to manage the risk of equities underperforming) or LDI (to manage the risk of interest rates and inflation being different to what we expect).
The steel pension scheme has some LDI in the form of a large allocation to gilts, and also derivatives to manage the interest rate (read assumed investment return) and inflation risk which is clearly a positive for the prospective volatility of the deficit. However, the irony of the CPI/RPI change being discussed is that it may make the deficit look smaller, but it makes managing the inflation exposure more difficult – index-linked gilts are RPI linked not CPI linked.
So the interesting question following on from this is, if the government is looking into this more, will they stumble upon the issues discussed here and as a result consider more strongly issuing CPI linked gilts?
Mark Davies is managing director, Derivatives, River and Mercantile Group.