Pension schemes: bond discounting is not the problem

Deficit challenges facing defined benefit pension schemes have persisted in recent years. A new approach is required, but it relates to investment decision-making rather than measurement of liabilities, argues John Dewey.

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a man pushing a big rock up a hill (Sisyphus)

Despite strong investment returns, many defined benefit schemes in the UK continue to report material increases in deficits. You do not have to look far to find the culprit: a mismatch between assets and liabilities and falling bond yields.

This has once again raised the question of whether it is appropriate to discount pension liabilities using a government bond yield or similar high quality bond interest rate. Given the scale of the deficit problem, some are proposing that it is time for a rethink. But it is too simplistic to characterise bond discounting as the root of schemes’ problems; in fact it has much to commend it.

The benefits of bond discounting

-    It is objective. The market may not be fair, but it doesn’t rely on a subjective judgement of long-term expected returns. History tells us almost nobody is good at this. Estimates have not just been wrong; they have been consistently, wildly and catastrophically wrong. This has cost companies hundreds of billions of additional contributions; reduced the income and quality of life of hundreds of thousands of pensioners and threatened the financial future of DB pension scheme members.

-    It has real meaning. Theoretically you can invest in a portfolio of government bonds that will meet all the promised pensions, with a government- backed guarantee. This is about as good as it gets. Nobody is saying you should do this now, but it is a handy reference point to start from.

-    It is consistent: If everyone talks a common language, we have greater clarity. Clarity can only be good for financial decision-making and outcomes for pension scheme members.

-    Anything else is delusion: It is one thing to plan an investment strategy based on outperforming meagre government bond yields, but marking liabilities lower by discounting at this higher expected rate of return? This sleight of hand tells us that the more investment risk taken, the lower our liability. Taking advanced credit for what we expect to happen in the future is not only illogical; it has consistently burnt pension schemes.

The downsides of bond discounting

-    Low yields.  The uncomfortable economic reality facing DB schemes is that with government bond yields so low, liabilities are high. We can debate about whether fixed income markets are now more distorted than other markets that pension schemes may invest in (equities, real estate, infrastructure, hedge funds, etc.), but the only way we will know whether we were right is with hindsight.

-    Not enough supply. In the UK in particular, it is clear there is a significant imbalance of demand for government bonds by pension schemes over the current stock and modest issuance. This suggests the market is indeed distorted and is not a fair reflection of the future path of interest rates.   

Pension schemes should not be forced to hold more overpriced bonds than is appropriate. This has clearly not been the case, as many pension schemes have chosen to run significant interest rate mismatches - to their detriment.

-    Yields are increasing. Sometime in the future, yields will be higher than today; possibly a fair amount higher (although probably not anytime soon, according to central bankers). Will they rise faster than market expectations to make this a winning bet? The truth is this is anyone’s guess, and I would question how much emphasis should be put on this single view.

So what’s the answer?

Everyone hates to admit they are wrong. This simple observation has been given academic rigour in the behavioural theories of loss aversion, regret aversion and the sunk cost fallacy, among others.  If you have lived with a view that yields are too low and expressed that view by not hedging, it is awfully hard to change now. This has been prevalent since LDI really got going over a decade ago.

Any pension fund trustee who chooses to hedge liabilities today faces challenging questions: why now; why not before; won’t things get better?

If we are to really tackle the challenges facing DB pension schemes, we must first acknowledge that the real issue is not one of measurement or methodology. What we do need, however, is an amnesty on risk management.  The Pensions Regulator should draw a line and provide clear guidance that a single, poorly diversified view on how interest rates will perform versus market expectations is not appropriate for trustees to make. Regret risk should be taken out of the equation: you will not be judged on the financial outcome of a decision that was taken with the reasonable intent of risk management.

At the same time, it is right that investors should retain the flexibility they have today to invest in and exploit opportunities consistent with their long term time horizon and the individual circumstances of their scheme. The opportunity set is large, including other fixed income assets in both public and private markets and high quality real estate and infrastructure assets. All can provide secure, predictable income streams to meet pension liabilities.

The UK Pension Protection Fund and other large corporate pension schemes have clearly demonstrated what can be achieved with a simple, transparent investment philosophy, even at a very large scale. The solution is not science or new; it is common sense: mitigate poorly-rewarded risks, invest for the long term and seek out attractive investment opportunities to outperform liabilities.

A version of this article originally appeared on Pensions & Investments

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