At the start of 2014 the view of most economists and fund managers was that the recovering global economy would result in increases in interest rates and this, in turn, would result in longer dated bond yields rising from their historical lows. A year later it is quite clear how wrong those predictions were: the best performing asset classes were gilts and index-linked gilts with long dated bonds delivering returns in excess of 25%. In contrast the UK equity market, despite positive economic sentiment, struggled to make any headway with the market flat over the year.
A time to consider how funding valuations are undertaken?
With falling gilt yields UK pension schemes will have, in the main, seen their deficits significantly increase, with gilt yields being a key factor in the calculation of the current value of pension liabilities. Given this backdrop of 20 year gilts offering yields of less than 2.2% pa, does it still remain right for pension scheme valuations to utilise gilts as the bedrock for the calculation of the value of a scheme's liabilities?
My view is that trustees and companies should look to alternative approaches to their pension scheme valuations in these low yield times. It is quite feasible to consider the valuation in terms of a 'haircut' on the expected return of the asset portfolio as opposed to a 'gilts-plus' approach. Simply put, why should a scheme that doesn't hold gilts have to base the valuation of its liabilities on what is happening in gilt markets? If buy-out was the goal in the short to medium term then logically this would be the case but if the scheme is relatively immature and wishes to meet the liabilities through the investment returns and cash flows of the asset portfolio why must a gilt yield form the basis of this calculation? There are a number of UK pension schemes that adopt this type of approach and, given market conditions, corporates and trustees may wish to explore alternative funding methods.
Pension Freedom!
It is not all bad news in the world of pensions, however. The long-awaited pension changes have arrived, providing greater choice at retirement. Gone are the days where the only option was the purchase of an annuity. For many, this will be a good thing given the cost of securing annuities in today's low yield environment. And yet the options pension scheme members will take is unknown – it's still early days, and too soon to make a call on whether or not the Chancellor's idea was a sound one. Will there really be the rush to convert to pensions to cash, and a 'spend today and worry tomorrow' attitude? Furthermore, will defined benefit pensions be transferred to defined contribution schemes to allow pensions to be converted to cash?
Time will tell if we'll be looking at a future of Lamborghinis which no one can afford to drive. The prospect of pensioners abandoning the secure income in favour of cash or drawdown is a definite possibility, and the attractiveness of these options increases in an age where the cost of providing an annuity is so high.
The silver lining for many pension scheme sponsors is that members exercising the option to take transfer values and move money to their own pots may help reduce deficits and the overall risk of the pension scheme.
Whichever way things pan out, one thing to be cautious of is the threat of another pensions mis-selling scandal should decisions made today look less attractive with the benefit of hindsight.
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