Pension Deficits

by George Hatjoullis

The question of pension deficits keeps coming up. To recap, it refers to the discounted present value of pension fund liabilities compared to the assets available in the pension plan. It can be calculated by actuaries directly or by getting a buy-out quote from an insurance company. Basically it is the amount that you would have to pay an insurance company to take the problem off your hands. The insurance company uses actuarial calculations in getting to the price so the result is much the same. It is a concern for corporate defined benefit (aka final salary) schemes. State schemes are underwritten by the taxpayer. Regulations exist because failed schemes can end up needing to be bailed out. The debate arises because valuing future liabilities is not as simple as it may seem.

Discounted present value has been explained several times across this blog but it is, oddly, not easy to grasp. To recap, ask yourself, if someone offered you a pound today or a pound tomorrow, which would you choose. A few years ago the automatic answer would be, a pound today of course. You could always put the money in a risk free deposit and get more than a pound tomorrow. With the advent of negative interest rates a pound tomorrow might be preferable. The value of a pound tomorrow depends on the size and sign of the interest rate. High positive interest rates mean a pound tomorrow is worth less than a pound today. Moreover, because of the compounding effect, the further into the future is tomorrow, the less the value of that pound today. So, discounted present value merely means using some interest rate to calculate the present value of each future liability and adding it all up. It is more complicated because the future set of liabilities is contingent but let us just focus on this discount factor; the rate at which we discount future pounds to get a present value.

It should be clear that if interest rates are zero then the present value of each pound is the same whenever it is to be paid out. If interest rates are negative the present value of future pounds is greater than one, so your liabilities are increasing, other things being equal. The period of low to negative interest rates has boosted the PV of future liabilities in ways that was not seriously thought possible a few years ago. Hence we have a pension deficit crisis (longevity is another reason). The sensitivity of deficits to interest rates is evident from the reports of variations. According to the FT yesterday, the aggregate pension deficit fell to £194.7 billion last month from £275.9 billion, entirely because of a rise in gilt yields (the main determinant of the discount factor). The funding ratio is now up to 88.1% up from 84.1%. These are huge moves. If bond yields keep rising very soon we will be talking about pension surpluses and corporations taking money out of the plans.

To recap, the plans are the liabilities of the corporations that offer them to staff. The assets in the funds actually belong to the corporations not the pensioners. The regulator needs to ensure that assets allocated to the funds are sufficient to meet the liabilities, or the corporation has other plans in place to meet the pension liabilities, and that is why this valuation process takes place. The question is, is it correct?

My own view is that it is not a correct way to calculate deficits. It in fact flies in the face of all financial advice. If you are 30 years old and about to start saving for a pension then you are saving to meet a liability in 35-to 40 years time. No IFA would advise you to stick it all in bonds and cash. They would probably advise you to hold most in property and equity funds. As you get closer to retirement they would advise shifting increasing amounts into cash and bonds. Why should the same logic not apply to corporate pension plans? The implication is that while the discount factor for near term liabilities (5-10 year) should be closely linked the gilt yield, the discount factor for longer term liabilities should more closely reflect long run returns from equities and property (and other assets classes that can be held). This would reduce the variability of deficits and make them much less sensitive to gilt yields. It would also encourage plans to hold less bonds at unprecedentedly low yields.

The debate is not a technical one only of interest to the regulator and plan sponsors. It has very real implications for pensioners and for corporate valuations. One of the reasons that defined benefit schemes are dying out is because of this valuation method and the impact it has on share values. Some companies are constantly under scrutiny because of their pension deficits, so calculated, and having to make large payments into the schemes out of profits. The incentive to wind down defined benefit schemes is thus huge and nobody is starting new schemes. The pension planning problem is thus being shifted to the individual through defined contribution schemes. The deficits do not go away but merely sit in millions of individual hands rather than a few corporate hands. Ironically, the individuals are better advised (if they pay for it and heed it), and have greater flexibility, in how to manage these deficits.

The corollary is that corporations that have seen their share price depressed by the pension deficit are partly hedged against rising bond yields. Their deficits will shrink and they could quickly move into surplus. This would enable them to take assets out and into the profit line. No doubt the populist press will present this as raiding the pension pot, stealing from pensioners etc but it is simply the implication of deficit valuation methods. A correct valuation method would result in less variability in deficits and less sensitivity to interest rates. It would relieve corporations of this uncertainty and allow them to concentrate on what they do best. It would also make them less inclined to run down schemes (longevity is another issue encouraging wind down of course). Most important of all it will deprive the populist press from yet another source of tawdry and misleading headlines.