The increasing use of liability-driven investment has led to a greater use of bonds and gilts as a means to balance pension deficits. Peter Maher warns this could be a misguided strategy.
In its interpretation of The Pensions Act 2004, the Pensions Regulator has suggested that employers and trustees of pension schemes in deficit should organise a ten-year recovery programme. Not only is this a short timeframe for pension schemes, but the drive to match assets with liabilities means mitigation is almost impossible without significant cash injections.
Bonds and gilts typically yield a lower return than equities over the longer term. As a result, liability-matching investment is fuelling the deficit. Whilst bonds and gilts tend to be less volatile than equities, UK pension schemes are paying the price of this short-termism.
Take the long view
The UK has benefited from successful pensions practice for more than a century, which has been largely founded on the gradual long-term rise in equities and the consequent mismatch between assets and liabilities. Any fund manager will tell you that equities outperform bonds over the long-term. Whilst there have been periods when the performance of pension scheme assets has not matched liabilities, imbalances tend to right themselves over time.
Pensions are essentially long-term investments. People are living longer, and this means that pension schemes are having to fund beneficiaries over a longer period.
The Pensions Regulator estimates that British companies would have to pay an extra £130 billion into their pension schemes to eradicate their deficits. According to the Office of National Statistics, a total of £13.2 billion was paid in by employers during the second quarter of 2006.
Alternative strategies
Rather than a company pouring money into a pension scheme – which reduces the amount that it can invest in the business – trustees might consider employing an independent auditor to assess the financial covenant of the sponsoring employer. If an employer can ultimately ‘underwrite’ the pension scheme, why spend money matching assets with liabilities?
The cost of running a pension scheme is based on underlying assumptions. For gilt or bond returns this might be 4.25% pa, whereas for equity returns it might be 6.25% pa, giving an immediate reduction in the funding requirement. Pension funds need reliable cashflows, so a sensible strategy would be to cover off likely cashflow requirements for the next five to ten years using gilts and bonds, assuming a more aggressive equity-driven approach with the balance of funds.
More sophisticated routes
Other strategies that pension scheme trustees may consider include leveraged buy-out bonds. These enable employers to crystallise the full buy-out liability of the scheme by transferring all of its assets to an insurance company that will secure deferred annuities for scheme members, whilst granting a loan to the employer for the full buy-out deficit.
Additionally, the funding deficit can be insured (either full buy-out or FRS 17), so that an insurance company extinguishes the debt upon the principal employer going into liquidation or other notifiable events. This approach is finding great favour in the mergers and aquisitions market.
Structured investment products can also be used. For example, trustees could invest 80% of the scheme assets in AA-rated bonds, with the remaining 20% used to buy call options on, say, the FTSE-100 total return index for ten years. This time horizon enables long-term exposure to equities whilst protecting the downside.
In summary
Trustees need to use some common sense for the benefit of the longevity of pension schemes. In this way, employers may not see schemes as a millstone around the company’s neck and may instead start to view them as a means of attracting and retaining staff – by any standards a novel and worthy ideal! Any financially sound employer should be able to manage its pension deficit. A measured approach combining a number of strategies should help.
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