DB PENSIONS Back to basics

Paul McGlone, Aon Hewitt, on why giving up the link between liabilities and gilts is not as simple as it sounds

In a nutshell: 
  • valuing liabilities using a “gilts plus” method has resulted in liability values that are both high and volatile
  • other methods can help to some extent, but we are in an environment of low expected returns, and if returns are low then more assets are needed
  • if changing methods means less volatile liabilities, then the question still exists as to how to make assets move like those new-style liabilities.

The ongoing debate about the “gilts plus” valuation method is something that we should all embrace. But it would be naïve to think that simply replacing one method with another will solve all the industry’s problems. As one issue is resolved, others emerge, as this fictional discussion between Dave (a trustee director and finance director) and his advisers illustrates.

Dave, the director Hi Akash, good to see you. As I mentioned before, I’m sick of this “gilts plus” method. Yields are all over the place, there are more “all-time lows” and we’re getting silly answers. Can we use something else?

Akash, the actuary Actually, a few of us put our heads together at the actuarial dining club the other night, and we thought you could set discount rates as a margin below best estimate rather than a margin above gilts. I’ve prepared some very valuable advice on the subject for you, and on page 33 of that advice I’ve shown the key insight on a graph. You can see that the blue dotted line is a lot smoother than the red dotted line (Figure).

Dave That’s really helpful, Akash, and thanks for this substantial piece of advice. Does the smoother blue discount rate line mean that I also have smoother liabilities?

Akash Yes, I thought you’d like that! The 3% fall in discount rate would have emerged much more smoothly using this method, so the huge increase in your liabilities would have been much steadier. It also means…

Dave Whoa! Hold on – you mean my liabilities still go up massively, even though they’re not linked to gilts?

Akash Oh yes. You see it’s not just gilt yields that have fallen, Dave. Expected returns on most assets have fallen, and if your assets are assumed to deliver 3% a year less then you need a lot more to pay the benefits.

Dave Crikey. So I need to find an asset that not only delivers good long-term rates of return, but also exhibits substantial capital appreciation when expected future long-term returns fall?

Akash I couldn’t have put it better myself, Dave. Perhaps you were an actuary in a previous life?

Dave So where do I find such an asset, Akash?

Akash Sorry, Dave, I don’t do investment advice. You need to ask Ivy, your investment consultant.

Dave Well it’s a good job I invited her to the meeting as well. Here she comes. Hi Ivy!

Ivy, the investment consultant Hi Dave, Hi Akash. How are things?

Dave Very good thanks, Ivy. Akash has a fantastic idea about funding the pension scheme, but he says that we need to find an asset that not only delivers good long-term rates of return, but also exhibits substantial capital appreciation when expected future long-term returns fall.

Ivy Yes, that sounds like something Akash would say. Actually, I have just the thing for you. It’s an asset that is pretty well correlated with falls in expected returns over long periods. It’s called a long-dated gilt, and as expected returns have fallen it has increased in value substantially.You can even buy artificial gilts that give you the same exposure without having to sell your other assets, so you can still generate the long-term rates of return that you need. I’ve even written up the details in this highly valuable advice that I anticipated you might need. The asset class is summarised on pages 22 to 26. How does that sound?

Dave Sounds ideal. Although I do have a feeling of déjà vu. But let’s run with it for now. If Akash measures my liabilities using a discount rate of Best Estimate less a margin, then these artificial gilts can hedge me against long-term falls in expected returns, correct?

Ivy Well yes. But it’s not exact – and there is quite a lot of short-term noise.

Dave I suppose it’s too much to ask you to get rid of that short-term noise as well?

Ivy I’m sorry, Dave. I’m afraid I can’t do that.

Akash Actually, Dave, I may have a solution for you. If you’re going to invest in Ivy’s artificial gilts, then I can measure your liabilities so that they move in exactly the same way by setting a discount rate based on the yield on the artificial gilts plus a margin. Reduced volatility in the short term and the long term.

Dave But isn’t that exactly where we started?

Paul McGlone is a partner at Aon Hewitt.