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1 February 2013 Andrew Connell, Head of LDI, Schroders Introduction The Chancellor s autumn statement announced that the Department for Work and Pensions (DWP) will be consulting in the New Year: On whether the Pensions Regulator should have a new statutory objective to consider the long term affordability of deficit recovery plans to sponsoring employers; and Whether to allow companies undergoing valuations in 2013 or later to smooth asset and liability values, on the grounds that volatile measures of pension scheme deficits can make it hard for companies to manage their investment plans and attract external funding. Adoption of these proposals would represent a material departure from the Pensions Regulator s current position 1, which opposes the application of smoothing for two reasons: 1. The application of smoothing is inconsistent with the current legislation which requires the valuation of assets on a mark to market basis; 2. Asset and liabilities should be valued on a consistent basis. To understand the implications of these proposals (and perhaps assist in the consultations) this Thought Piece examines the potential implications of the use of smoothing, and how best the DWP might address the long term affordability of sponsors pension obligations. Smooth operator To understand the potential implications of the smoothing proposals we have modelled an example scheme. The assumptions behind our modelling are set out below: 1. The assets and liabilities are valued quarterly, starting in March 2001 with a funding level proxy of 85% 2. For the purpose of generating a funding level proxy, the liabilities are: 25% fixed and 75% index-linked (to RPI) Valued using the returns on the FTSE over 15 year gilt and index linked gilt indices with a 1% per annum premium 3. The assets are invested in: 50% growth assets and 50% liability matching assets The growth portfolio generates the returns of the FTSE 100 (total return index) The matching portfolio is invested 25% in over 15 year gilts and 75% over 15 year index linked gilts. 1

2 We have looked at the progression of the funding level of this example scheme, both on an unsmoothed market valuation and a smoothed valuation. We have interpreted smoothed to mean that values are averaged, in this case over a rolling 3 year period (i.e. consistent with the current actuarial valuation cycle). The results are set out below. Figure 1: Example Scheme, funding level progression 'Market' funding level proxy (RHS) 'Smoothed' funding level (RHS) Liability proxy (Market) Asset proxy (Market) 110% 100% 90% % % 50 60% 0 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Source: Schroders, Bloomberg. At 30 September For illustration only. The 3 year average funding level is the arithmetic mean of the funding level at annual points over 3 consecutive years. For example, the September 2012 observation is the average of September 2010, September 2011 and September 2012 s snapshot funding levels. Volatility and pin risk Whilst over the period June 2004 to September 2012 the average funding level is similar under the two measures (market 84%, smoothed 82%), the graph indicates that the application of smoothing does reduce the volatility of the funding level (market 12%, smoothed 10%). The high level volatility statistics partly disguise the benefit to smoothing in that it reduces the cohort effect which results in a scheme s funding level being highly dependent on the date at which the valuation occurs. Over the period the effect of smoothing on the range of valuations over any four consecutive quarterly valuation points is dramatic. Under the market method the widest range of funding levels in a 12 month period is 30% (from June 08 to March 09) whilst for the smoothed approach it is 13% (also June 08 to March 09). On the basis of this analysis it would appear that the move to a smoothed valuation does dampen the volatility of funding levels over time. In times of economic distress this might shield sponsors from the pin risk of having an unusually poor (or good) funding position as a result of the specific date used. Average at best The autumn statement also appeared to raise the possibility of the selective use of smoothing, i.e. that it could be applied to either assets or liabilities. The graph below illustrates how averaging can both help and hinder the process of funding level improvement. Given market moves over the period and the scheme s asset mix, smoothing the liability value would improve the latest funding level by reducing today s value whilst applying smoothing to assets would offset that gain by reducing their value. 50% 2

3 Figure 2: Asset and liability valuation Index level Liability proxy Liability proxy 3 year average Asset proxy Asset level 3 year average Mar-01 Sep-02 Mar-04 Sep-05 Mar-07 Sep-08 Mar-10 Sep-11 Source: Schroders, Bloomberg. At 30 September For illustration only. The average takes the arithmetic mean of the asset or liability value at annual points over 3 consecutive years. For example, the 3 year value as at September 2012 is the mean of September 2010, September 2011 and September 2012 s values. A momentary lapse of reason? However, before we are seduced by the ease with which today s funding problem can be solved through regulatory slight of hand, it is worth considering the one aim that most pension schemes share. The majority of schemes in the UK are focusing on an end game, which is either buyout or self managed runoff with minimum risk. In either case, the key is to achieve full or at least high funding level (when measured on an economic basis) with as little risk as is practicable. The graph above indicates that there were two separate opportunities (circled in red) for the scheme to de-risk at a market based funding level of ~100%. With the benefit of hindsight, if the scheme had used these opportunities to fully derisk it would have retained a much higher funding level over the period (or bought out its liabilities). Had the scheme been using a smoothed valuation metric it could either miss these opportunities or attempt to lock down risk (on the basis of its smoothed valuation) at a time when market levels do not offer the gains required. It is pretty clear that insurance companies are not going to offer buyout terms related to smoothed values just because pension schemes adopt this approach. We believe that this loss of focus on the true underlying economics is at least unhelpful and potentially dangerous. You can t handle the truth The first element of the consultation concerns affordability, and many observers have (perhaps unconsciously) linked the affordability and smoothing elements together; assuming that lower volatility improves affordability (and is therefore a good thing). However, this doesn t hold up to investigation, and in fact, when thinking about the longer term, the current market value tells us a lot about where the smoothed value is going, as illustrated in Figure 3 below. 3

4 Figure 3: Progression of projected future market and smoothed funding levels Funding level Past Future From current time, central expectation is for unchanged market funding level After 3 years, projected smoothed funding level aligns with market funding level Source: Schroders, Bloomberg. For illustration only. Smoothed funding level is averaged over 3 years. The chart illustrates a hypothetical progression of market and smoothed funding level. It highlights that if our best unbiased estimate of the future market funding level is today s level (i.e. we are ignoring any bias from contributions or outperformance over prudent assumptions), then the best estimate of the smoothed funding level also trends towards the current market funding level. In other words, if we are planning for the medium to long term (which should be the case for contribution discussions and corporate planning), our best estimate of the smoothed funding level is based on the current market funding level. To put it another way, if we see a large drop just before the valuation date, would we really expect Trustees to be comfortable agreeing a contribution schedule that ignores this shift in their circumstances? Interestingly, a scheme with less than full liability coverage must (implicitly or explicitly) believe that tomorrow s liability valuation will be lower than that assumed using today s market rates. If this weren t the case then the only logical asset allocation would be to hold assets that cover 100% of the scheme s sensitivity to changes in interest rates and inflation. However, if a scheme believes that yields will rise, logic also suggests it should also favour the market based valuation methodology because under this metric the benefit of lower liability values are felt immediately in the funding level and under this valuation metric the market opportunities and levels are available to close out this risk at an attractive level. Willing suspension of disbelief? One of the more worrying consequences of focusing on a smoothed funding level is that it dampens the apparent risk of any given investment strategy. If smoothing really does provide protection from the vagaries of the market, then what s to stop trustees ramping up the risk in portfolios? In practice, do we really expect that trustees would respond in this way? Probably not, but if that s the case, you have to ask yourself why it is that they don t have the confidence to base their decision making on the smoothed value they believe in for their funding discussions. Smoothing; to summarise Time So far in this piece we have argued that taking a smoothing approach: Does reduce the volatility of the reported funding level, and Does mitigate the pin risk of being unlucky with the date used for the valuation, but also Does distract schemes from the true economic picture and hides market opportunities to de-risk, Does encourage them to take greater risks, and Does not directly translate into improving affordability or ease of planning for the sponsor. Fortunately, despite appearances, the consultation does not directly link affordability with smoothing. So let s consider it separately. 4

5 Affordability We ve argued above that smoothing doesn t necessarily help with affordability, so what might? This strays into the heart of pension funding philosophy and policy, and away from areas more familiar to LDI. As a result, we certainly won t pretend to be experts, but at a very high level if we want to change the amount that sponsors are paying in to the pension scheme (and assuming we don t change the actual cost of benefits, investment strategy etc.) the options include: Smoothing valuations, which we ve already covered Adjusting valuations in some other way that departs from a true market valuation For example, the Minimum Funding Requirement (MFR) adopted this approach and dividend discount models have also been used in the past. Most of the arguments above about smoothing apply equally here and ultimately we end up looking at a distorted, subjective view of the world which does not reflect reality. Adjusting recovery periods We are now starting to move away from the valuation part of the exercise and into the crux of affordability; the contributions that are actually paid. Flexibility to extend recovery periods will lower the annual amounts paid. The downside of course is that the covenant risk will be there for longer and this is why this approach tends to meet some resistance. However, we feel there is a case that with greater thought applied to the structure of contribution schedules, and perhaps their flexibility, pension cost pain points could be avoided without unduly compromising the sponsor s commitment to stabilising the funding level. We would certainly advocate flexibility in contribution design above disguising the true picture of the economics of pension scheme funding. Conclusion By using the funding level progression over the last decade of an example scheme, we have illustrated that: Smoothing of asset and liability values will reduce the volatility of a scheme s funding level and mitigates against pin risk from the cohort effect whereby a scheme s funding level can change materially depending on the date of the actuarial valuation An artificially smoothed funding level progression does not necessarily mean that recovery plan obligations are more affordable. A smoothed funding level may be lower than an unsmoothed valuation, resulting in overpayment by the sponsor of deficit recovery contributions Focusing on a smoothed valuation metric could lead to a scheme either missing opportunities to de-risk or taking them at a time when a market valuation-based decision making framework would not support such action. Smoothed valuations will not encourage strategies that will bring schemes closer to full funding with the minimum level of risk and as a result are unlikely to promote affordability in the long term. Therefore the best strategy for all stakeholders is to retain market based valuations of assets and liabilities, establish a clear plan of action to lock down funding level risk as funding gains occur as this is the best way to ensure the scheme affordability over the medium term. We look forward to the detail of the consultation and encourage readers to make their views known. 5

6 Important Information The views and opinions contained herein are those of Andrew Connell, Head of LDI at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No England. Authorised and regulated by the Financial Services Authority. 6