TO SMOOTH OR NOT TO SMOOTH

Executive Summary

– On 5th December 2012 the government announced within the Autumn Statement its intention to consult on the introduction of smoothing for pension scheme valuations
– The DWP launched this consultation on 25th January 2013, which is set to close on 7th March 2013
– The DWP acknowledges the lack of consensus on how smoothing would operate and hence there is very little in the way of detail, rather the consultation poses  the question to the readers on how they would suggest incorporating smoothing into the current scheme specific regime
– The consultation is set out in a very balanced way, the DWP is very much in information gathering stage and doesn’t give any indication on its currently preferred approach
– The DWP does indicate that averaging over a 2 to 5 year period may be optimal, although it leaves open the possibility of a longer period
– The DWP strongly suggests that assets and liabilities would be treated in a consistent way, thereby insuring the effectiveness of any liability matching which pension schemes have undertaken

 
Why change?

The principal reason for this consultation is due to the concern that pension scheme funding requirements are exacerbating pressures on companies which are already under pressure from the ongoing financial crisis.   In particular, the current low interest rate environment has caused pension fund liabilities to increase dramatically in recent years.

Therefore, if the DWP is to recommend introduction of smoothing, it is likely that it will need to be convinced that the adoption of a smoothing approach will go some way towards relieving this pressure.  Indeed the first question asked is perhaps the most interesting:

“What would be the effect of smoothing assets and liabilities in schemes undertaking valuations in 2013 and going forward? Would it materially improve the sponsoring employers’ ability to attract investment or to invest in short term? If so, what evidence is there of this?”

It is likely then that in order for the DWP to recommend a change, first they will need to be convinced that valuations would improve under a smoothing approach, secondly that this improvement would lead to a material reduction in contributions, and then lastly that it could be done in a way that doesn’t impact the flexibility and credibility of the current funding regime.

Effectiveness of Smoothing

 
Real yield:
Equities:

Pension scheme funding:

The charts above show the 20 year history of the FTSE All Share TR, the 20y Index-linked gilt yield and then a proxy for a simplified pension scheme deficit.  For the pension scheme we have assumed 50% allocation to equity and a 50% liability hedge ratio.  We have considered 2 year, 3 year and 5 year averaging periods.  We have done this on a daily basis, while in reality it is likely to be a quarterly or annual basis.

On the liability side the introduction of smoothing would indeed increase the discount rate used.  We estimate  currently that it would increase real yields by 44bps using the 2 year average, by 67bps using the 3 year average and 94bps using the 5 year average.  Clearly this benefit will steadily fall if we remain in a low interest rate environment.

However it is important to note that smoothing is likely to apply to the assets as well as the liabilities.  In the consultation the DWP note:

“Consistency would require that assets should be smoothed over the same period as the gilt rate in order to preserve the integrity of relevant funding calculations. The composition of the asset portfolio will affect the net effect of any smoothing on the scheme’s assets to liabilities. The Government believes that any form of smoothing would have to involve smoothing of assets as well as liabilities.”
 
 As you can see from the second chart, equities are currently at all time highs on a total return basis.  Moving to averaging approach would lead to equity assets being marked down by 12% for 2 year averaging, 15% for 3 year averaging and 22% for 5 year averaging.  This would offset much of the benefit the pension scheme would get from using a higher average discount rate. 

In order to estimate the overall effect on the deficit, the third chart shows a crude proxy for a pension scheme deficit, ignoring contributions and accrual of future liabilities (it is unclear how either of these will be treated in a smoothing regime).  As you can see while the smoothing approach would have reduced volatility in the funding position, the benefit in terms of deficit reduction for valuations done currently would be modest at best and in fact a 2 year averaging period could actually lead to a higher deficit level.

Therefore in order to be effective at reducing deficits for 2013 valuations careful consideration of the averaging period is required.  This leads to the risk that, even if an averaging period is found which benefits most schemes, in future years smoothing may be unfavourable.  Resulting in a risk that pension funds  “pick and choose” between smoothing and unsmoothed depending on which suits then best each time.  The DWP appears considered at this inconsistent approach:

“Effectively allowing schemes to ‘pick and choose’ the method they use depending on the prevailing market conditions could undermine confidence in the entire scheme funding regime. “
 

Reduction in contributions

So, careful choice of the averaging period will be required in order to achieve the goal of reducing pension scheme deficits.  On the assumption that this is achieved, will this necessarily lead to a reduction in contributions and hence alleviate pressure on the sponsoring companies?  The DWP highlighted in the consultation:
 
“The Pensions Regulator and others have noted that as the actual amount paid annually in recovery contributions should be based primarily on affordability rather than the level of the deficit, the impact on short term cash flows may therefore be limited. It is worth noting that other factors taken into account in determining the level of deficit repair contributions, such as the strength of the sponsoring employer’s covenant will not be affected by smoothing.”
 
Indeed a lower deficit level may only lead to the trustees asking for a shorter recovery plan, because in many cases the limiting factor on contributions is not the size of the deficit but simply what is affordable to the sponsor.  So if affordability, and not the calculated size of the deficit, is in fact the main factor in setting contribution rates then there could be only modest benefit from changing the funding regime so that it reports lower deficits.
 
From the tone of the question the DWP will need to be convinced that there would be a tangible benefit for companies from the lower deficit levels.

Credibility and Flexibility of Funding Regime

It could be argued that there is already a substantial element of smoothing in the current funding regime, while deficits are calculated based on market conditions on a single day, companies are given relatively long periods to make good on the deficit.  As most recovery plans are longer than the 3 year gap to the next valuation, if conditions improved at the next valuation then the company is able to amend its funding programme and thereby only having to fund a portion of the deficit originally calculated.

Having valuations based on market conditions on a single date does lead to an effective valuation date lottery.  You could have two identical companies with identical pension schemes, except for the triennial valuation dates, finding that they are paying contributions at a markedly different rate.  While in the long run this should even out, this could lead to acute short term pressure on certain unfortunate companies.  An averaging approach would reduce this effect.

It should be noted that any change in the funding basis would not lead to changes in accounting valuation.  Under IAS19 the smoothing mechanism, known as the “corridor approach”, was removed from 1st January 2013.  On the face of it, it would seem strange for the UK’s funding standard to be moving in the opposite direction to international accounting standards.

Conclusion

The consultation is presented in a very balanced way, with the DWP laying out both advantages and disadvantages of moving to a smoothed approach.  It is clear that the DWP is aware of the disadvantages of smoothing and will need to be convinced that there would be a tangible benefit of changing the current funding regime.
 
In our view there is a good chance that the DWP will decide not to make any change, pointing to the flexibility already inherent in the current regime.
 
In either cases, the fact that the DWP gives a strong indication that it expects assets and liabilities to be treated consistently, and any changes to the funding regime will not impact the accounting or economic valuation of the scheme, we expect this to have a limited impact on pension scheme hedging.


Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer
 

Author: Guy Whitby-Smith

Guy is part of the RBS Pension & Insurance Solutions Group and focuses on providing risk management solutions to UK pension funds. He joined RBS in 2005 and is responsible for risk analysis and structuring solutions for pension schemes. Prior to RBS, Guy worked at Lane Clark & Peacock, where was as investment consultant providing investment advice to pension schemes and researching liability driven investment solutions. He is a Fellow of the Institute of Actuaries and holds a first class Masters degree in Physics from Oxford University.