By Laura Brown
The Pensions Regulator recently published its annual funding statement and the new advice takes into account the provisions of the March Budget, which provided the regulator with a new objective to support “scheme funding arrangements that are compatible with sustainable growth”.
The current funding statement tries to relieve to some extent the immediate burden on parent company contributions to pension schemes. This is achieved by (i) reminding schemes that funding improvements should not simply be reliant on parent company contribution but also investment returns and (ii) allowing greater flexibility in the setting of recovery periods. The new funding advice relates to those schemes with valuation dates between September 2012 and September 2013, which accounts for approximately one third of all pension funds.
The move follows an international trend to relieve pressure on defined benefit (DB) pension funds and insurance companies from the impact of historically low real and nominal interest rates. Regulations have been changed in the Netherlands, Sweden, Finland and the US to help companies ignore the impact of these low discount rates. Quantitative easing purchases of government bonds by central banks and the provision of excess liquidity are designed to drive down real risk free rates to bring forward deferred consumption and help economies escape liquidity traps. This poses problems for insurance companies and pension funds which have already made (often fixed) promises about future consumption. The regulatory solution has been to seek ways of allowing pension funds and insurance companies to ignore current interest rates in the hope that they will eventually rise back to more acceptable valuations as their respective economies normalise from the prolonged period of post-crisis weakness.
We call this ‘post-it note accounting’ based on the old fund manager advice to put a post-it note over the screen to avoid having to take account of adverse pricing movement in the hope that in time the trend will reverse, without the manager having to acknowledge the unrealised loss. The UK shift is more subtle and much less of a game-changer than the international rules because it does not change any of the underlying regulations. The government and the regulator’s intention is to reduce the impact of current funding issues on parent companies and ensure that funding levels reflect expected future asset returns above and beyond the negative real rates on which valuations are ultimately based.
The key phrases from the regulator have been to urge trustees to take into account what is “reasonably affordable” for company sponsors when setting contribution rates and to “agree long-term strategies with employees that protect the interests of retirement savers, whilst also enabling viable businesses to thrive and grow. We expect them to mitigate the risks to the scheme, but we do not expect them to be overly prudent”.
The most concrete outcome of this policy change is to effectively eliminate the previous provision that pension funds should try to eliminate their deficits within 10 years. The inevitable conclusion from the investment banking consensus is that the changes are relatively minor and have been largely discounted since the government signalled its intentions in the Budget, but at the margin they imply less demand for long-dated gilts because at the margin it reduces the pressure to hedge liabilities.
We view this conclusion as too facile and the reality to be more nuanced. The request for compassionate forbearance does not alter the underlying position for the DB pension funds nor the legal imperative of their fixed promise. The need for liability driven investment (LDI) hedging strategies to reduce funding level volatility remains. The need to do this on a leveraged basis and hence retain growth assets is perhaps the most obvious conclusion to be drawn from the regulator’s advice.
Laura Brown is head of Ignis Solutions at Ignis Asset Management
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