“2017 kicked off with an early win for U.K. pension schemes - the PPF 7800’s aggregate funding ratio improved to 88.2% from 86.8% in January. Trustees would do well to keep the champagne on ice for now, however. Sadly, this is not as good a news story as it first seems. Under more commonly used liability measures – such as a technical provisions basis, accounting basis or solvency basis, the funding level impact would have been materially less. Time will tell if January’s early win is the start of a comeback for UK pension funds, or a mere consolation in a relegation season.
“The difference in performance across liability measures stems from the fact that the PPF measure of liabilities assumes materially lesser inflation exposure than the other liability measures. As such, when nominal government bond yields rise materially over a month, as they did in January, PPF-measure liabilities to shrink relative to asset values, and funding levels measured on the PPF basis improve. For solvency or technical provisions liability measures, however, nominal yields rises alone are not sufficient, because such liabilities are predominantly inflation linked – it is real yields that need to rise for these liabilities to decrease. A nominal yield rise caused by higher inflation expectations – which is exactly what has happened as markets price in the impact of a “hard Brexit” by devaluing Sterling – has no impact on real yields. Indeed, whilst 10-year nominal yields have risen over 40bps since mid-2016, real yields of the same maturity are actually over 40bps lower. As such in that time period, PPF-liabilities would, all else equal, be lower, but solvency or technical provisions liability values would be higher. Pension fund managers should be careful not to take misplaced comfort from the wrong sort of yield rises.
“UK defined benefit pension schemes with funding gaps are juggling two seemingly conflicting objectives – reducing volatility in the funding position and improving asset returns to claw back deficits. Thankfully, the two objectives need not be mutually exclusive - a diversified, flexible cashflow matching framework can achieve both benefit security and capital growth. BlackRock recently surveyed 240 institutional clients globally, representing c$8trillion of assets, on their asset allocation intentions in 2017 – and some 61% of them plan to increase holdings of real assets. The appeal is clear - such assets, combined with corporate bonds, allow pension funds to meet near-term cashflow needs at materially higher yields than government bonds. Leveraged gilt exposure can complete the cashflow picture by focusing on longer-dated liabilities, allowing pension funds to free up capital to spend on other return seeking assets. Most importantly, matching strategies should be flexible not rigid – consider a wide range of instruments and strategies, take advantage of market pricing, and don’t try to be overly accurate in matching liabilities. Ultimately, actuarial estimates of liabilities are just that – estimates.
They rest on assumptions around member longevity, decisions on commuting their benefits and other unknowns, such as regulatory change. Pension schemes have only limited visibility of the future so should manage risks while allowing themselves flexibility to react.”
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