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An actuarial research report on UK pensions
The discount rate quandary
The impact of different approaches to
discounting pension scheme liabilities
Richard Jones FIA, Chris Parlour FIA and Helen Skinner FIA
February 2017
The discount rate quandary
Executive summary
 UK pension scheme funding has dramatically worsened in recent years. Total scheme funding, as
measured by the PPF 7800 Index, has not seen an aggregate surplus since March 2011 and fell to its
lowest ever level, an overall deficit of £413 billion, in August 2016.
 The key driver of this collapse in the funding position of schemes is the fall in government bond yields,
with real returns falling from +0.6% per annum in March 2011 to -1.8% per annum in August 2016 (i.e.
investors are expected to lose money every year in real terms from investment in government bonds).
 Whilst legislation allows schemes to utilise bond yields in their valuations directly, the majority of
schemes do not choose to do so. Instead they set their discount rate based on the expected return on
their assets, taking advantage of some of the flexibility in the funding regime.
 Data from the Pensions Regulator shows that despite schemes taking advantage of this flexibility, the
average scheme has effectively just added 1% per annum to the gilt yield at the point of their valuation
whatever the market conditions.
 In effect, schemes are setting their expected returns for assets such as equities as being fixed relative to
gilt yields such that their discount rate effectively flows entirely from the gilt yield even though it is not set
directly by reference to the gilt yield. This “gilts plus” approach is used by the overwhelming majority of
schemes but it is not the only credible method for setting expected returns and thus discount rates.
 One alternative is the “inflation plus” approach which sets the equity return relative to expected future
inflation and thus is less correlated with bond markets. A further alternative is the “intrinsic value”
approach which seeks to derive the return on assets from market information within those markets rather
than data from the bond market.
 Considering the simplest models available and focusing solely on UK equities we can see that
historically these methodologies all aligned but they have diverged dramatically since 2011 when real
bond yields turned sharply negative.
 Adopting an alternative approach to setting the discount rate would have a dramatic impact on funding
levels and employer contributions. Even a 10% reduction in liabilities (through using a higher discount
rate) would result in a significantly improved funding position for all schemes. Indeed, around 25% of
schemes in the country would move from deficit to surplus with another 25% of schemes having their
deficit reduced by more than half.
 Adopting a higher discount rate means that the scheme is taking more risk and thus in order to be
comfortable with the additional risk a full Integrated Risk Management Plan would be required for
schemes changing their approach.
The discount rate quandary
Contents
1. Introduction ..........................................................................................1
2. Funding a pension scheme ..................................................................3
3. The “gilts plus” approach ......................................................................5
4. Alternative approaches to expected returns .........................................9
5. Illustrating the differences .....................................................................11
6. What is causing the differences between the approaches? ..................16
7. Use of different approaches for actuarial valuations .............................22
8. Options for sponsoring employers ........................................................27
9. Summary and conclusions ...................................................................28
The discount rate quandary
1. Introduction
In August 2016 the combined deficit of the UK defined benefit pension schemes covered by the Pension
1
Protection Fund (“PPF”) was estimated to be a record £413.1 billion by the PPF 7800 Index , representing a
remarkable turnaround from a modest surplus just over five years earlier in March 2011.
The outside observer might consider that the increase in these deficits was due to pension schemes losing
money on their investments. However, the PPF 7800 Index shows that the assets of the schemes covered
by the PPF have increased by some 53% since March 2011 from £974 billion to a record amount of £1.5
trillion through a combination of deficit contributions by employers and investment returns.
The liabilities as measured by the PPF 7800 Index have exploded over the past five years, more than
doubling from the £937 billion recorded in March 2011 to £1.9 trillion as at August 2016. Whilst some of this
extraordinary growth is due to the maturation of the schemes, leading to the PPF covering more of their
benefits, the overwhelming majority of the increase is due to changing market conditions and in particular
falling real and nominal bond yields.
On the liability side of the funding equation, the PPF 7800 Index is an approximation of the cost of securing
PPF benefits through insurance company annuity contracts and thus is driven by the yield on government,
and to a lesser extent, corporate bonds. The graph below illustrates this point with the aggregate surplus or
deficit on the PPF 7800 Index plotted against the real yield on government bonds, demonstrating that the
funding position on the PPF 7800 Index is highly correlated to the yield on government bonds.
200
2.0%
100
1.5%
£ billions
0.5%
-100
0.0%
-200
-0.5%
-300
-1.0%
-400
-1.5%
-500
-2.0%
PPF 7800 Index (Aggregate deficit)
1
% per annum
1.0%
0
Real yield on index linked bonds
The PPF 7800 Index is a measure of the funding position of the UK defined benefit schemes calculated by
the PPF on a monthly basis with further details available at:
http://www.pensionprotectionfund.org.uk/Pages/PPF7800.aspx
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The discount rate quandary
The falling yield on government bonds since April 2006 as illustrated in the previous chart is part of a very
long trend in the UK, as shown by the full twenty five year history of the yield on index-linked government
bonds in the graph below.
Yield on index-linked UK Government bonds
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
Following the Brexit vote in June 2016 and the subsequent extension of quantitative easing by the Bank of
England the yield on index linked bonds has fallen to a historic low of around -1.5% per annum. Rather than
making an annual return above inflation, as inventors would have expected prior to 2011, investors in
government bonds in 2016 expect to lock-in a return of around 1.5% per annum below inflation.
The PPF 7800 Index is only a broad indication of the funding of UK pension schemes and only reflects the
PPF level of benefits using a particular calculation approach. The legislation surrounding scheme funding
does not prescribe a particular set of assumptions, only a set of broad principles to be followed by schemes.
The purpose of this report is to explore:
 the impact of falling government bond yields on pension
scheme funding;
 different approaches to setting the discount rate in a
scheme funding context that are available; and,
 how these approaches could be implemented.
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The discount rate quandary
2. Funding a pension scheme
Defined benefit pension schemes in the UK are required to produce triennial actuarial valuation reports which
show, among other things, the funding level of the scheme. The legislation governing the current approach
to the calculation of the discount rates used in these valuations was introduced by the Pensions Act 2004.
Part 3, Section 222(3)(b) of the Pensions Act 2004 states:
“…the liabilities to be taken into account shall be determined in a prescribed manner and the
scheme’s technical provisions shall be calculated in accordance with any prescribed methods
and assumptions.”
The details of the prescribed methods and assumptions are found in the Occupational Pension Schemes
(Scheme Funding) Regulations 2005. The regulations covering the derivation of the discount rate are found
in Section 5, paragraph 4(b) and state:
“…the rates of interest used to discount future payments of benefits must be chosen prudently,
taking into account either or both –
(i) the yield on assets held by the scheme to fund future benefits and the anticipated
future investment returns, and
(ii) the market redemption yields on government or other high-quality bonds…”
It should be noted that the legislation, therefore, provides for two potential methods of deriving the discount
rate – (i) and (ii) above.
Legislation does not require that the yield on government bonds is
used for pension scheme funding and specifically states that
schemes are free to take into account the expected return on their
assets in setting their discount rate assumption.
Despite what some commentators have been led to believe, nearly all schemes set their discount rate based
on their expected return on assets (utilising approach (i)) and not by direct reference to the yields on
government bonds (utilising approach (ii)). Despite schemes taking this approach we find that the discount
rates used across the industry have historically been such that it might appear that approach (ii) has been in
use rather than approach (i).
This impact can be seen in data from the Pensions Regulator on discount rates used in the UK pension
2
industry as a whole as shown in the “Scheme funding statistics” document published in June 2016 which
shows the spread of discount rates above nominal gilt yields each year (from September 2005 to September
2006 in tranche 1 to September 2013 to September 2014 in tranche 9):
Single equivalent
discount rate
above nominal
gilt yields
Tranche
1
2
3
4
5
6
7
8
9
th
1.83%
1.76%
1.84%
1.86%
1.50%
1.64%
1.87%
1.90%
1.85%
th
75 percentile
1.41%
1.38%
1.40%
1.31%
1.09%
1.15%
1.40%
1.37%
1.24%
Median
1.08%
1.03%
1.12%
0.99%
0.84%
0.88%
1.05%
1.05%
0.94%
0.84%
0.81%
0.83%
0.61%
0.51%
0.57%
0.65%
0.65%
0.58%
0.24%
0.23%
0.22%
-0.10%
-0.23%
-0.13%
-0.07%
-0.18%
-0.12%
95 percentile
th
25 percentile
th
5 percentile
2
Available at http://www.thepensionsregulator.gov.uk/docs/scheme-funding-appendix-2016.pdf
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The discount rate quandary
Across the nine tranches of data (from September 2005 to September 2014) it can be seen that the median
discount rate is around 1% per annum above the nominal gilt yield.
However, measured relative to inflation, the discount rate in use has become significantly more prudent as
can be seen from the table below:
Real single
equivalent
discount rate
Tranche
1
2
3
4
5
6
7
8
9
th
3.07%
3.05%
2.92%
3.16%
2.58%
2.61%
2.03%
1.89%
1.98%
th
75 percentile
2.59%
2.62%
2.46%
2.57%
2.10%
2.04%
1.49%
1.28%
1.39%
Median
2.26%
2.29%
2.16%
2.22%
1.79%
1.74%
1.13%
0.88%
1.05%
1.94%
2.03%
1.84%
1.84%
1.46%
1.42%
0.76%
0.48%
0.68%
1.27%
1.36%
1.17%
1.07%
0.77%
0.68%
0.08%
-0.29%
0.00%
95 percentile
th
25 percentile
th
5 percentile
The 1.2% per annum reduction in the median real discount rate from tranche 1 to tranche 9 will have
increased the recorded liabilities of a typical scheme by around 25% in isolation over this period.
Whilst tranche 10 data (covering September 2014 to September 2015) will only become available later
during 2017 with tranche 11 data (covering September 2015 to September 2016) not available not until 2018,
our experience is that valuations agreed in both these tranches are following the existing trend; discount
rates are averaging around 1% per annum above gilt yields despite a further fall in the average real yield
to -0.7% per annum in tranche 10 and -1.0% per annum in tranche 11.
Despite the fact that most schemes choose to set their discount
rate “taking into account … the yield on assets held by the scheme
to fund future benefits and the anticipated future investment
returns” the data shows that the discount rates derived in this way
are correlated with bond yields. Why?
To explain why discount rates continue to be correlated with bond yield requires consideration of how
schemes set their discount rates.
The general approach is fairly simple; firstly, the return that is expected to be generated from the assets in
which the scheme invests is determined and secondly, a suitable margin for prudence is deducted from this
return reflecting the strength of the employer covenant supporting the scheme.
The overwhelming majority of schemes take this approach and calculate the expected return on non-bond
assets (such as equities, property and alternatives) by taking the government bond yield at the date of the
valuation and adding a fixed risk premium to this yield to calculate the expected return. This fixed risk
premium is utilised for all valuations, whatever the market conditions in the specific equity, property or
alternatives markets at the valuation date.
It is worth exploring the origins of this “gilts plus” approach before considering alternative approaches.
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The discount rate quandary
3. The “gilts plus” approach
The “gilts plus” approach assumes that the return on any asset is correlated to the return on gilts. Deriving a
discount rate under this approach simply requires taking the gilt yield at the relevant date and adding an
adjustment (or “risk premium”) to this yield to allow for the riskiness of other assets held by the scheme.
3.1 The Capital Asset Pricing Model
This methodology is rooted in the Capital Asset Pricing Model (“CAPM”), which was developed from Modern
Portfolio Theory by William F Sharpe in 1964. It is an economic theory which assumes that the risk-reward
profiles of all assets are linked, such that the return on investments can be broken down into a “risk free” rate
of return plus a premium allowing for the expected additional return on riskier assets reflecting the systematic
risk of that investment relative to the risk free return.
In other words, the CAPM assumes that investors require compensation for:
(a) the time value of their money; and,
(b) the systematic risk of the investment.
The consequence of (a) is that investors require a return on their investment even where they anticipate no
risk. This can be thought of as the opportunity cost of investing, and in financial economics this return is
known as the “risk free rate”. In pensions this is the yield on long dated government bonds of a suitable
term.
Investors require additional return in proportion to the risk taken on, as per (b) above. It should be noted that
the CAPM assumes that only systematic risk is rewarded. Unsystematic risks, or specific risks, can be
diversified away by holding a large number of different investments. Investors, therefore, are not rewarded
for taking on this unnecessary risk. By contrast, systematic risk is risk inherent to the market – it cannot be
diversified away within that market and thus investors require a return for taking it on. In pensions this is the
fixed risk premium.
Expected return (R)
The CAPM assumes that the compensation investors require under (b) is positive and linear. In other words,
investors are assumed to require a greater expected investment return as the risk of the investment
increases. In financial economics this is known as the “risk premium” and is shown in the graph below.
0
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Risk (β)
The discount rate quandary
The line shown on the graph is known as the security market line (“SML”) and is calculated according to the
following equation:
𝑅𝐴 = 𝑅𝑓 + 𝛽𝐴 (𝑅𝑀 − 𝑅𝑓 )
where:
𝑅𝐴 is the expected return of asset 𝐴
𝑅𝑓 is the risk free rate of return
𝛽𝐴 is the sensitivity of 𝐴 to market returns
𝑅𝑀 is the expected return of the market
The expected return of asset 𝐴 is therefore calculated as the risk free rate of return “𝑅𝑓 ”, plus the risk
premium of 𝐴 “𝛽𝐴 (𝑅𝑀 − 𝑅𝑓 )”.
The risk premium of 𝐴 is made up of two parts. 𝛽𝐴 is a measure of the riskiness of 𝐴 compared to the
riskiness of the market as a whole. Riskiness, in this model, is indicated by volatility of returns. The market
has a 𝛽 equal to 1; assets with a 𝛽 greater than 1 are riskier (or more volatile) compared to the market, and
assets with a 𝛽 of less than 1 are less risky (or less volatile) compared to the market. (𝑅𝑀 − 𝑅𝑓 ) is the
expected market return above the risk free rate. This is the premium that the investor expects for investing in
the market instead of in risk free assets. Multiplying these two elements together gives the risk premium that
the investor expects for investing in 𝐴 given the riskiness of 𝐴 and the expected market returns.
The risk free rate of return can be found where the SML crosses the vertical axis in the graph above. This is
because the risk free rate has a 𝛽 of zero; 𝛽 is measurement of riskiness, or volatility, and the return on the
risk free asset is assumed to be certain, meaning the level of risk is zero.
This analysis is used for single assets, but can be extended for use with a portfolio of assets. For this,
Modern Portfolio Theory (“MPT”) is used.
3.2 Modern Portfolio Theory
MPT states that the risk and return characteristics of all investments must be considered in terms of their
effect on the portfolio as a whole. The reason for this is that investments that are not perfectly correlated
reduce the overall risk of the portfolio, thus all investments must be considered in relation to one another, not
independently.
According to MPT, when deciding upon an investment portfolio there are three areas to be considered by the
investor:
 the expected returns of each investment;
 the variance (riskiness) of each investment; and,
 the covariance (correlation) of each investment with each of the other investments.
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The discount rate quandary
Return
Given enough data, all these areas can be calculated and the best investment portfolios can be found.
Under MPT, the best portfolios are those which maximise the investment return for a given level of risk, or
equivalently minimise the level of risk for a given investment return. Portfolios which meet these
requirements are said to lie along the “efficient frontier” which is shown in blue the following graph.
Risk
Efficient portfolios
Individual investments
As can be seen from the graph, individually the investments (shown in light purple) are found in various
places on the graph. However, when considered in combination, it is possible to derive many portfolios
which have a more desirable risk-return profile than any investment alone.
Return
This graph only represents the efficient frontier in the absence of a risk free asset. If a risk free asset is
available then more efficient portfolios exist, as shown by the dark purple line in the graph below. This line is
referred to as the capital allocation line (“CAL”), and it represents the efficient frontier in this situation.
Risk
Efficient portfolios
CAL
Individual investments
The point at which the CAL touches the original hyperbolic efficient frontier represents what is known as the
“market portfolio”. At this exact point on the graph, this level of return can be obtained for this level of risk by
investing entirely in market assets in certain proportions; no risk free asset is held. Other portfolios along the
CAL require the investor to hold the market assets in the same proportions as they are found in the market
portfolio, but also to hold some amount of the risk free asset. In some situations one of these holdings may
be negative.
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The discount rate quandary
When all investors behave rationally, all investors will hold the risky market assets in the same proportions,
which will be the same proportions that are found in the market portfolio. Each investor will, however, hold a
different amount of the risk free asset depending on the investor’s risk appetite.
The equation of the CAL is approximately:
𝑅𝑃 = 𝑅𝑓 +
𝑅𝑀 − 𝑅𝑓
𝜎𝑃
𝜎𝑀
where:
𝑅𝑃 is the expected return of portfolio 𝑃
𝜎𝑀 is the volatility of the return on the market
𝜎𝑃 is the volatility of the return on portfolio 𝑃
This equation is similar to the SML seen earlier for a single asset; the return of the portfolio is made up of the
return on the risk free asset plus a risk premium. The risk premium element of both equations is made up of
two parts – the expected return of the market above the return on the risk free asset, and another factor
representing the riskiness (or volatility) of the asset or portfolio compared to the market in general. In the
𝜎
SML this factor is 𝛽𝐴 whereas in the CAL this factor is 𝑃 .
𝜎𝑀
It is the theoretical existence of this straight line which forms the basis of the “gilts plus” approach to setting
discount rates in actuarial valuations. It is assumed that the expected return on a portfolio of assets can be
summarised as:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
The yield on UK government bonds is generally used as the risk of default for these assets is so low as to be
essentially zero. The return on these assets can therefore be considered to be certain, or risk free. The risk
free return can be split into two elements for clarity and comparison with other approaches; the expected rate
of future inflation and the risk free real return (as measured by the yield on index-linked gilts).
The “plus” element of “gilts plus” allows for the additional amount of return expected as reward for taking on
additional risk (i.e. holding some risky assets), referred to in the equation above as the risk premium. It is
assumed that the size of the risk premium is proportional to the riskiness, or volatility, of the assets held.
3.3 Issues with this approach
The CAPM and MPT make a number of simplifying assumptions. This report will not consider these in detail,
although some are highlighted below.
The equations outlined earlier involve the use of expected values, such as the expected return on the market
and the volatility of those returns. In practice, historic values are often used for these measures. These
historic values may fail to take account of changing circumstances or future situations that have not arisen
before and may cause future outcomes to be significantly different to the past.
Similarly, the models are probabilistic, meaning that no attempt is made to understand the reasons why
certain risks, returns or losses may occur. The model simply takes as read that these things are likely to
occur to various degrees.
The models also make a number of assumptions, including that all investors have the same time horizon,
that everyone has access to perfect information, and that there are no taxes or transaction costs. The fact
that these assumptions are not true in reality means that pension schemes may judge risks significantly
differently to other investors. For example, pension schemes tend to invest with longer time horizons than
other investors, meaning that the day-to-day volatility of a particular investment should not be a concern to a
pension scheme.
The “gilts plus” model therefore has a sound theoretical background but is driven entirely by the base
assumption that all the markets are intertwined and that investors measure their returns and risk relative to
the return on risk free assets. What other approaches might be available?
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The discount rate quandary
4. Alternative approaches to expected returns
Whilst there are an infinite number of approaches that could be utilised for setting the discount rate we will
just consider the two most common approaches used in pensions (albeit in a very limited set of examples
where schemes have diverged from the “gilts plus” approach); an “inflation plus” approach and an “intrinsic
value” approach.
4.1 The “inflation plus” approach
The theory behind the “inflation plus” model is based on the “Fisher equation”, developed by Irving Fisher.
Fisher hypothesised that the total interest, or return, on assets was made up of an element allowing for the
level of inflation plus an element representing the “real” return (i.e. the return in excess of inflation). The
Fisher equation is:
1 + 𝑖 = (1 + 𝜋)(1 + 𝑟)
where:
𝑖 is the nominal rate of interest
𝜋 is the rate of inflation
𝑟 is the real rate of interest
It is often approximated to:
𝑖 = 𝜋+𝑟
It can be seen that this is analogous to the “gilts plus” approach, in that the model adds a premium to an
underlying rate to allow for additional risk and corresponding additional return. In the “inflation plus” model
the underlying rate is the expected rate of future inflation, typically measured from the gilt market, whereas in
the “gilts plus” model this is the risk free rate.
The reasoning behind the “inflation plus” model is that investors in assets are assumed to consider expected
returns in real terms after allowing for the effect of expected inflation; that is to say investors do not suffer
from money illusion. The real equity returns required by investors are in real terms to compensate for the
capital risk taken on by the investor. It is a function of the Fisher equation that if the expected rate of inflation
increases, investors will require the investments to continue to provide a real return, thus the nominal
expected return on the assets increases. The overall return can therefore be summarised as:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑟𝑒𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛
4.2 The “intrinsic value” approach
The “intrinsic value” model derives the expected rate of return of an investment, and thus the applicable
discount rate, from an entirely different basis to the “gilts plus” and the “inflation plus” approaches. The
intrinsic approach focuses on information relevant to the investment being considered, rather than wider
economic assumptions such as risk free rates. For example, the key input into the expected return on a
property portfolio would be the current rental yield which would be combined with a rental growth and cost
assumptions to project an expected return.
This approach is widely used in relation to equities by investment analysts using measures such as earnings
(basing projections on earnings yields or price earnings ratios), smoothed earnings (such as the cyclically
adjusted price earnings ratio), assets, revenues or dividends. There are a wide range of intrinsic models that
can be used but the essential feature is that they take actual measurements from the market in question and
then combine these with assumptions rather than the “gilts plus” approach of taking a measurement from the
bond market and combining this with risk premium assumptions.
For illustrative purposes in this document we will focus solely on equities and the “dividend discount model”.
This model values the shares of a company by assuming that its correct stock price is equal to all future
dividend payments, discounted at an appropriate rate. The most popular dividend discount model is the
Gordon Growth Model (“GGM”) which was developed by Myron J. Gordon in 1956.
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The discount rate quandary
The GGM derives the following equation which is used to price equities:
𝑆=
𝐷
𝑘−𝑔
where:
𝑆 is the share price
𝐷 is the expected dividend per share in one year’s time
𝑘 is the required rate of return
𝑔 is the expected growth rate of dividends
This equation can be rearranged:
𝑘=
𝐷
+𝑔
𝑆
The equation now provides a formula for calculating the expected return of an equity, which can be
incorporated into the calculation of a suitable discount rate. The expected return is equal to the expected
dividend per share divided by the share price (together, the expected dividend yield) plus the expected
growth rate of dividends.
This equation can be generalised to estimate the returns on a portfolio if each element is assumed to be the
appropriate value for the entire portfolio instead of a particular investment. In words, the equation becomes:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ
The formula is particularly sensitive to the assumption for expected dividend growth which is highly likely to
vary in different inflation environments. However, this element of the equation can be broken down in order
to build an assumption from perhaps more reliable estimates.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ
4.3 Overview
Both alternative approaches to the “gilts plus” approach have a similar level of theoretical backing to the “gilts
plus” approach itself, and all three approaches are somewhat supported by historic data. The purpose of this
paper is not to argue for one approach over any other but, given that alternative models exist, consider the
implications of adopting these alternative models.
In our view schemes could adopt any of the three models described
so far to set their actuarial valuation discount rate assumption subject
to them understanding the full implications of doing so.
Page | 10
The discount rate quandary
5. Illustrating the differences
In order to demonstrate the impact of adopting either the “gilts plus”, “inflation plus” or “intrinsic value”
approaches, this section will look at an example for a scheme with a simplified investment strategy investing
50% of its assets in UK equities. Whilst the example below is based purely on UK equities, similar principles
can be applied to any other asset class that a pension scheme can be invested in.
Firstly the three models need to be calibrated for UK equities and for each model this means:
 setting the fixed risk premium to add to the long dated government bond yield for the “gilts plus”
approach;
 setting the real equity return to add to the expected future inflation rate derived from bond markets
for the “inflation plus” approach; and
 setting the expected real growth in equity dividends assumption to add to the dividend yield and the
expected future inflation rate derived from the bond markets for the “intrinsic value” approach.
From this explanation we can see that all three approaches are similar in that there is one assumption made
that is then combined with other current observable market variables to generate the expected return. All
three approaches and the differences between them are essentially driven by the one assumption of each
model.
5.1 Calibrating the “gilts plus” approach
It was seen earlier that the “gilts plus” approach is derived according to the following equation:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
According to the theory underlying the “gilts plus” approach, assuming that an investor’s portfolio is
sufficiently diversified so as to approximate the market portfolio, the equity risk premium is a fixed amount
representing the risk of the market over and above that of the risk free rate.
The risk free rate is taken to be the yield available on long dated UK government bonds at the valuation date.
The fixed addition, called the “equity risk premium”, is typically arrived at by consideration of the historical
data. Analysis of the returns on UK equities and bonds from 1900 to 2015 shows that equities outperformed
3
bonds by 3.7% per annum with a volatility of 17% per annum. These findings are broadly similar to those in
4
other countries reported in studies such as that by Dimson et al which analysed the outperformance of
equities over bonds in several countries over the period 1900 to 2010. A selection of the results is shown in
the table below:
3
1900 – 2010
Equity risk premium
Volatility
United States
4.4%
20.5%
Canada
3.7%
18.2%
Japan
5.0%
32.8%
Australia
5.9%
19.8%
Europe
3.9%
16.6%
World
3.8%
15.5%
PSTS analysis using data from Barclays Equity Study and Credit Suisse Global Investment Returns
Sourcebook
4
http://www.cfapubs.org/doi/pdf/10.2470/rf.v2011.n4.5
Page | 11
The discount rate quandary
It would be possible to consider equity risk premiums over different periods of time. This can lead to quite
different results, even within one country, as shown for the United Kingdom in the table below:
UK
Equity risk premium
Volatility
1900 – 2015 (115 years)
3.7%
17.1%
1900 – 1950 (50 years)
2.2%
11.3%
1950 – 2015 (65 years)
4.9%
20.3%
1965 – 2015 (50 years)
2.9%
21.3%
1990 – 2015 (25 years)
0.0%
17.1%
2005 – 2015 (10 years)
-0.1%
21.4%
From the data analysis an assumption must be chosen. Most typically the approach is to consider the
longest and widest data set, perhaps focusing on the 110 year returns from global equities (3.8% per annum)
or the 115 year equity risk premium on UK equities (3.7% per annum). There are a number of different
approaches to setting the equity risk premium that could be considered appropriate; the level of the equity
risk premium is only an assumption and not a measurable fact.
Typically pension schemes are utilising an assumption of between
3% and 4% per annum for the “equity risk premium” and for
simplicity we will adopt an assumption of 3.7% per annum for this
variable being equal to the achieved rate on UK equities from 1900
to 2015.
5.2 Calibrating the “inflation plus” approach
It was seen in previous section that the “inflation plus” approach assumes that the return on equities can be
derived according to the following equation:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑟𝑒𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛
Expected inflation is derived according to the current market implied inflation at the valuation date.
Setting the real equity return in this context is once again considered in relation to historic data. Here a
simple approach is taken, similarly to the “gilts plus” approach, of choosing the achieved value over the
longest period of study available. Analysis of historic UK data has found that the return on equities has
exceeded inflation by an average of 5.3% per annum since 1900.
Page | 12
The discount rate quandary
As with the equity risk premium for the “gilts plus” approach this is an assumption and is not a measurable
fact. The historic data shows a wide variety of rates on an annual basis and only converges over very long
time periods. The following chart shows the annual real return on equities since 1900.
120%
100%
Return per annum
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
In the relatively rare cases where pension schemes are using the
“inflation plus” approach they are utilising an assumption of
between 5% and 6% per annum and for simplicity we will adopt an
assumption of 5.3% per annum for this variable being equal to the
achieved rate on UK equities from 1900 to 2015.
5.3 Calibrating the “intrinsic value” approach
It was seen in previous section that the “intrinsic value” approach assumes that the return on equities can be
derived according to the following equation:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ
The dividend yield is directly measurable from the equity market and the future rate of expected inflation from
the bond market leaving the expected rate of real dividend growth to be estimated.
Setting this assumption is somewhat more subjective given that patterns of dividend payments and taxation
changes make the historic data difficult to consider without significant adjustment. There are a number of
ways to consider historic dividend growth data but for simplicity we will describe one approach to managing
the issues in the historic data below.
5
Analysis of historic UK data shows a real dividend growth rate of 0.4% per annum between 1900 and 2000.
th
However, it is important to note that significant changes in the financial markets over the 20 century means
that this period is effectively split into two distinct periods.
Prior to around 1950, the information provided to investors and the freedom given to management meant
that equities were perceived as income assets. In effect investors would subscribe equity for the
establishment of an asset (such as a railway line) and expected all the returns to be paid out in dividends
without any reinvestment to grow the business. Dividend yields were high with pay-out ratios around 100%
and the rate of dividend growth struggled to keep up with inflation due to the lack of reinvestment.
5
Triumph of the Optimists p. 154
Page | 13
The discount rate quandary
After around 1950, the information provided to investors increased and managerial freedom was constrained,
which allowed investors to become more comfortable with companies reinvesting some of the annual profits
such that for most of this period pay-out ratios have been around 50%. Dividend yields have been lower but
dividends have grown sustainably faster than inflation. Real growth in dividends should therefore be
analysed from around 1950 onwards, which results in real growth of approximately 2.3% per annum between
6
1950 and 2000.
A further more detailed study of the underlying data, excluding periods where dividends were subject to
government controls and different tax regimes and allowing for cyclical adjustments, gives a real dividend
growth rate of 2.0% per annum.
Theoretical approaches of deriving the real dividend growth assumption lend support to its existence. An
alternative and common approach is to assume that dividends grow in line with Gross Domestic Product
(“GDP”). GDP is the total market value of all goods and services produced and there are several methods of
calculating GDP, one of which is to calculate Gross Domestic Income (“GDI”) which in theory is equal to
GDP. This involves adding up the incomes that households receive from firms in exchange for providing the
factors of production such as wages, interest on capital (dividends) and rent. If it is assumed that the
proportion each factor of production contributes to GDP remains constant, then the future rate of growth in
GDP can be considered a proxy for growth in corporate earnings and dividends.
UK GDP is fairly stable compared to other financial measures. During the equivalent period to the real
dividend yield data above, 1950 – 2000, UK GDP was an average of 2.8% per annum. Over the entire
7
period released by the ONS, 1948 – 2015, it averaged 2.6% per annum.
These (limited) figures suggest that GDP growth may outstrip real dividend growth slightly over long periods
8
of time. Such an assumption is supported by the academic work of Bernstein and Arnott who argue that this
is to be expected because dividend growth will be slower than the economy as a whole due to a dilution
effect, caused by the creation of and the raising of capital for new companies. We therefore should expect
real dividend growth to be similar to the level of GDP growth but slightly lower than this level reflecting the
dilution effect.
It must be remembered that the expected future rate of real dividend growth cannot actually be measured
and this can only ever be an assumption.
In the relatively rare cases where pension schemes are using the
“intrinsic value” approach they are utilising an assumption for “real
dividend growth” of between 1% and 2.5% per annum. For
simplicity we will adopt an assumption of 2.0% per annum for this
variable being a pragmatic choice from the range of options.
6
Triumph of the Optimists p.154
ONS data: https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/abmi/pn2
8
Earnings Growth: The Two Percent Dilution, 2003
7
Page | 14
The discount rate quandary
5.4 Resulting expected return assumptions
st
Based on market conditions as at 31 December 2016 the results from the “gilts plus”, “inflation plus” and
“intrinsic value” approaches as summarised in the table below for comparison:
% per annum
Gilts plus
Inflation plus
Intrinsic value
3.4%
3.4%
3.4%
(1.6%)
-
-
-
-
3.5%
3.7%
-
-
Real equity return
-
5.3%
-
Real dividend growth
-
-
2.0%
5.5%
8.7%
8.9%
Expected inflation
Real yield
Dividend yield
Equity risk premium
Equity return
It can be seen that, whilst all the approaches start with the expected rate of future inflation, the “gilts plus”
model gives a considerably lower expected return than the “inflation plus” and “intrinsic value” approaches
that give similar results at this date. However, this has not always been the case as the relative position of
the three approaches varies across time with changes in the bond and equity markets, with sometimes the
“gilts plus” approach producing the highest answer and sometimes either the “inflation plus” or “intrinsic
value”. The following chart shows the results of the three different approaches over the fourteen year period
from January 2003 to December 2016:
Implied equity returns per annum
11%
10%
9%
8%
7%
6%
5%
4%
Gilts plus
Inflation plus
Intrinsic value
The chart shows that until 2011 the three approaches were extremely well aligned with only marginally
different answers for the most part. The “gilts plus” approach gave the highest rate (2003 – 2005) and then
the “inflation plus” approach (2005 – 2008) and then the “intrinsic value” approach (2008 – 2011).
Whilst the “intrinsic value” and “inflation plus” approaches continued to give very similar answers, the “gilts
plus” approach diverged from these significantly as the real yield fell, until reaching the current point where
the gap is a circa 3% per annum, which is highly significant.
Page | 15
The discount rate quandary
6. What is causing the differences between the approaches?
st
The key driver of the difference between the approaches as at 31 December 2016 is the current negative
real gilt yield. The assumptions have all been calibrated from historic data and the realised real return on
government bonds between 1900 and 2014 was 1.6% per annum rather than the -1.6% per annum that is
currently being observed in the government bond market.
Were the historic average real yield of 1.6% per annum to be substituted into the “gilts plus” model, the
st
results under the three different approaches as at 31 December 2016 would be much more comparable:
% per annum
Gilts plus
Inflation plus
Intrinsic value
Expected inflation
3.4%
3.4%
3.4%
Real yield
1.6%
-
-
-
-
3.5%
3.7%
-
-
Real equity return
-
5.3%
-
Real dividend growth
-
-
2.0%
8.7%
8.7%
8.9%
Dividend yield
Equity risk premium
Equity return
The historic average real yield is actually observable and thus whilst substituting in the historic figure for the
current real yield provides an explanation for the differences between the output from the three models, it
does not provide any indication as to which approach is most likely to be correct.
A way of considering the question of which is likely to be more indicative of future returns is to consider what
changes need to be made to the assumptions to make the “inflation plus” and “intrinsic value” methods align
with the “gilts plus” approach and consider whether these assumptions could be justified.
6.1 If the “gilts plus” approach is correct
If the “gilts plus” approach were correct then the real equity return and real dividend growth assumptions
would have to be altered to produce an equity return of 5.5% per annum as follows:
% per annum
Gilts plus
Inflation plus
Intrinsic value
3.4%
3.4%
3.4%
(1.6%)
-
-
-
-
3.5%
3.7%
-
-
Real equity return
-
2.1%
-
Real dividend growth
-
-
(1.5%)
5.5%
5.5%
5.5%
Expected inflation
Real yield
Dividend yield
Equity risk premium
Equity return
In this event a real equity return of only 2.1% per annum would be required compared to the historic average
of 5.3% per annum, and real dividend growth of -1.4% per annum required rather than +2.0% per annum.
If investors expect to receive a real return on equities of 2.1% per annum in the future compared to a rate of
5.3% per annum achieved over long time periods in the past, either the “inflation plus” model is completely
invalidated (i.e. investors do not consider the return they will make after inflation when deciding to invest).
If investors expect real dividend growth of -1.4% per annum in the future compared to a rate of 2.0% per
annum achieved in the UK since around 1950, either the “intrinsic value” model is completely invalidated or
the outlook for the economy is radically different than in the past.
Page | 16
The discount rate quandary
There are a variety of potential explanations for such a low level of expected real dividend growth including,
but in no way exclusive to, those in the following list:
Description
Detailed consideration
Overinvestment
in capital
Whilst pay-out ratios remain around 50%, the profits reinvested turn out to be
insufficient to grow profits in advance of inflation and thus dividends cannot be
grown faster than inflation. A possible explanation would be the relative lack of
new investment even at record low levels of interest rates. In effect the global
economy is saturated with cheap capital such that all good opportunities have
already been taken up meaning that returns on capital are too low to support
significant profit growth from reinvestment.
This scenario implies that the situation is so bad that whilst China has record
amounts of capital investment most will turn out to provide very low returns.
Whilst superficially attractive this seems a somewhat implausible scenario given
that were it widely accepted as true then investors would just demand that
companies cease to reinvest profits and raise their pay-out ratios to pre-1950
levels. Certainly dividend growth would then be expected to be below inflation
but not before dividends doubled due to the increase in the pay-out ratio.
Dividends are
about to be cut
dramatically
Negative expected real dividend growth could be justified if it seemed highly likely
that companies could not afford their current dividends and across the market
large cuts would be required to rebase their dividends to an affordable level. The
scenario assumes that while dividend yield might currently be 3.6% per annum, it
would be expected to fall significantly in the very near term. A similar position did
arise in the financial crisis where a significantly higher historic dividend yield
existed than was actually priced into the market because it was known that large
dividend payers such as banks would not be able to pay the same dividends as
were implicit in the historic dividend yield.
Given a complete lack of market commentary on the issue, this seems
extraordinarily unlikely to happen and thus equally unlikely that the market is
pricing this expectation into market prices and pushing dividend yields up before
the cuts come through.
It should be noted that the levels of dividend cuts required across the market to
offset the negative dividend growth assumption would be greater than 75%;
dividend paying as a concept for UK equities would effectively be gone.
GDP growth is
expected to be
approximately
zero, meaning
that real
dividend
growth will be
negative
Page | 17
As discussed earlier, over the periods of positive real dividend growth studied
GDP grew faster than real dividends as would be expected due to dilution. Were
GDP to stagnate then the income of corporations would stagnate in real terms
making increasing dividends faster than inflation practically impossible. A
negative real dividend growth rate of around -1.5% would be consistent with flat
lining GDP over the projection period.
This is not a mainstream expectation although some economics commentators
believe that future GDP growth will fall to around zero, or is already doing so.
Larry Summers, previously Secretary of the US Treasury, is of the view that much
of the developed world is suffering from “secular stagnation”. This is the idea that
there has been or will be a fundamental change in the nature of the economy
such that negligible or zero economic growth is the new norm, as a result of
excessive saving and under-investment.
The discount rate quandary
GDP growth is
expected to be
approximately
zero, meaning
that real
dividend
growth will be
negative
(continued)
Although possible, this is by no means widely accepted. The majority of
mainstream economic projections tend to show that future GDP growth is
expected to continue at similar levels for the foreseeable future.
Secular stagnation is almost impossible to prove for or against in advance; in the
end only time will tell whether GDP growth will continue. That said, secular
stagnation was originally promoted as a theory in the 1930s, only to fall out of
fashion once the post-war economic boom began in the late 1940s. Historic data
suggests that the majority of economies have continued to grow over time
despite a multitude of obstacles, and there is little reason to suppose this is likely
to change now.
The following charts show UK real GDP from 1830 to 2009 from the Bank of
England 2010 Q4 Quarterly Bulletin article "The UK recession in context — what
do three centuries of data tell us?" on both a linear and lognormal scale.
As can be seen real growth has been remarkably consistent for more than 175
years with a simple geometric growth rate of 1.86% per annum explaining 99% of
all the historic variation in UK GDP.
Accepting secular stagnation is something of a grand leap for a scheme to take
(given the implications implied for UK GDP growth) but it would have the benefit
of being entirely consistent with a negative real gilt yield which would be
expected in an economy with such a gloomy outlook.
It could be that markets expect a combination of these factors to be at play to a greater or lesser extent.
Even so, it seems a stretch to explain a swing in observed real dividend growth of 1.6% per annum achieved
in the past to -1.6% per annum in the future.
Given that most schemes use the “gilts plus” method and that the results of this model differ so radically from
the other available methods, schemes should review the appropriateness of their methodology and form a
view on the types of issues considered in this section.
Page | 18
The discount rate quandary
6.2 If the “inflation plus” or “intrinsic value” approaches are correct
If one, or both, of the “inflation plus” or “intrinsic value” approaches were correct then the equity risk premium
would have to be altered to produce an equity return of between 8.7% per annum and 8.9% per annum as at
st
31 December 2016 as per the following table.
% per annum
Gilts plus
Inflation plus
Intrinsic value
3.4%
3.4%
3.4%
(1.6%)
-
-
-
-
3.5%
6.9% - 7.1%
-
-
Real equity return
-
5.3%
-
Real dividend growth
-
-
2.0%
8.7% - 8.9%
8.7%
8.9%
Expected inflation
Real yield
Dividend yield
Equity risk premium
Equity return
In this event we would be expecting an equity risk premium of between 6.9% per annum and 7.1% per
annum compared to the historic average of 3.7% per annum. Whilst such an explicit equity risk premium
assumption seems high it is an entirely plausible future outcome given that 21% of historic fifteen year
periods between 1900 and 2015 have seen an achieved equity risk premium of 7.0% per annum or higher.
There are a variety of potential explanations for such a high level of expected equity risk premium including,
but in no way exclusive to, those in the following list:
Description
Detailed consideration
Increased
equity
volatility
A significant increase in the expected future volatility of equities would be
consistent with an increase in the equity risk premium. The more volatile
equities are, the more risky they are and under the CAPM theory this higher risk
should come with a higher expected return.
However, there is no evidence from the market for traded options (from which
short term volatility expectations can be derived) that such a change has
occurred and indeed the level of volatility increase required to generate the
required return under CAPM is somewhat ridiculous. On a straight-line basis if
equities had a historic equity risk premium of 3.8% per annum at a volatility of
17% then volatility would have to rise to over 30% to justify a premium of 7.0%
per annum.
Increase in
global risk
aversion
The theory of an equity risk premium is based upon the idea that the market is
willing to trade a certain level of risk in exchange for a certain level of additional
return. It is possible that the risk aversion of the market in general, being the rate
at which investors are prepared to trade risk for return, has increased
dramatically. This would have the effect of steepening the slope of the capital
allocation line shown in the second graph in section 3.2, and therefore increasing
the amount of return required to take on a given amount of risk.
There is no objective measure of risk aversion in the market meaning it is hard to
rule out this possibility. However, there are indications that some investors in the
global economy are significantly risk averse.
Page | 19
The discount rate quandary
Increase in
global risk
aversion
(continued)
The negative nominal yields seen on government bonds in countries across the
globe (including Switzerland, Denmark and Sweden) mean that investors are
paying to invest their money with these governments at the expense of a
potential real return elsewhere. It is possible that the monetary policies of
countries across the globe (including ultra-low interest rates and quantitative
easing) are a reflection of the low level of confidence of investors requiring
significant stimulus to get them to invest. This would imply that investors are
considerably more risk averse than has been the case historically, such that the
risk premium is now significantly higher than historic data shows.
This is the view of Scott A. Mather, CIO of U.S. Core Strategies, who believes
that as the global risk free assets (i.e. government bonds) begin to return
negative rates, investors see this phenomenon as risk free assets being removed
from the financial system, and only riskier, loss-making assets appearing in their
place. This may encourage some investors to take on additional risk (as indeed
is the intention of the policy to stimulate investment and promote growth) but he
notes that other investors may be forced to reduce the level of risk they take on
as the risk free assets no longer provide a “guaranteed” income.
This view is likely to strike a chord with pension schemes because they often find
themselves in similar positions. As a pension scheme’s funding level falls, the
trustees often reduce the level of risk in the investment strategy in order to
protect the current level of funding and reduce the risk of further falls. This
generally takes the form of increasing the holdings of bonds and reducing
holdings in equities – in other words the pension scheme considers there to be a
greater risk in holding equities than previously. This switch in investment strategy
to holding a greater amount of bonds means that if yields on bonds fall further the
problem is exacerbated.
However, the risk premium required is almost double the rate of that observed in
the past such that the rate at which risk and reward is traded (risk aversion)
would also have to double. This seems somewhat unlikely.
The link
between
equity and
bond
markets is
broken due
to abnormal
monetary
policy
Page | 20
It may well be the case that the CAPM does not apply in current market
conditions because of distortions in the bond market that stop the market
operating efficiently (efficient markets being an axiom of CAPM). In this instance
one could expect that the normal equity risk premium would have to be adjusted
upwards for the distortion in the bond market.
There are a huge number of plausible distortions in the bond market, not least
pension fund behaviour and that of other regulated institutions such as banks and
insurance companies. But the major player in the bond markets is now the Bank
of England who intervened through reducing base rates to record low levels and
holding them there, and by spending £435 billion on government bonds through
quantitative easing, which accounts for around 25% of the UK gilt market.
The discount rate quandary
Historically this is unprecedented; prior to 2009, quantitative easing had never
been tried in the UK and interest rates have never been below 2% per annum,
as shown by the following chart of Bank of England base rates since 1694.
18%
16%
Bank of England base rate
The link
between
equity and
bond
markets is
broken due
to abnormal
monetary
policy
(continued)
14%
12%
10%
8%
6%
4%
2%
0%
The CAPM requires that investors trade between equities and bonds to ensure
that the market prices are aligned such that the risk premium on equities remains
stable. The extraordinary monetary policy (as well as other distortions in the
bond market) may well be preventing this rebalancing such that bond yields and
equity returns are no longer aligned.
Any scheme switching from a “gilts plus” approach at previous valuations to either an “inflation plus” or
“intrinsic value” approach would need to determine an explanation for why the “gilts plus” approach is broken
and needs to be replaced. We would expect that most schemes choosing to do so would focus on the
extraordinary monetary policies adopted by central banks in recent years.
There are a wide variety of plausible explanations for the major
divergence between the “gilts plus” approach and the two other
approaches discussed in this report. It seems clear that all
schemes should consider these issues at their next actuarial
valuation whatever approach they eventually settle upon.
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The discount rate quandary
7. Use of different approaches for actuarial valuations
Whether trustees and employers fully understand the position or not, the choice of approach for setting the
expected future return on UK equities (and other asset classes) as part of the discount rate derivation is in
essence making some very strong statements about the future path of the UK economy and markets. In
high level terms these statements can be summarised as follows:
 By adopting the “gilts plus” approach trustees and employers are effectively saying that the bond
market is not distorted, that investors price other assets against this bond market (rather than by
reference to inflation) and that GDP is going to stagnate (or something equally gloomy is going to
happen to risky assets such as equities).
 Conversely by adopting either the “inflation plus” or the “intrinsic value” approach trustees would be
assuming that the bond market has been distorted by the Bank of England’s monetary policy (or
some other equally plausible explanation) such that the link between bond markets and equity
markets is broken and GDP will continue to grow in line with historic trends.
This is not to imply one or the other is more likely to be correct, but that whatever method chosen comes with
it some very strong opinions on the future of the UK economy and markets.
7.1 Implied discount rates as at 31st December 2016
In the relatively rare cases where a scientific approach is used to determine the appropriate margin for
prudence to adopt in setting the discount rate assumption, the most common method is to create a model of
the return distribution expected over a suitably long period. From the return distribution, one can select the
equity return assumption that provides the required level of confidence that the actual return will be at least
as great as the assumption. In effect a confidence interval is drawn from the distribution created.
The simplest approach would be to utilise a lognormal model compounded over a number of years which
requires assumptions for the mean return and the volatility of return only. For illustrative purposes, a volatility
of equity returns of 20% per annum and a 15 year period is used for the projections set out in the table
below, where the mean is assumed to be the derived future equity return assumption under each of the
models:
% per annum
Gilts plus
Inflation plus
Intrinsic value
Equity return
5.5%
8.7%
8.9%
55% confidence
5.1%
8.5%
8.7%
60% confidence
4.4%
7.8%
8.0%
65% confidence
3.7%
7.0%
7.2%
70% confidence
2.9%
6.3%
6.5%
75% confidence
2.1%
5.4%
5.6%
Gilt return
1.8%
1.8%
1.8%
If the “gilts plus” approach were being used, to be 60% confident that the actual equity return will exceed the
assumed equity return, the return should be set at 4.3% per annum. This means that it is expected that in
60% of future scenarios the achieved equity return would be greater than 4.3% per annum and that in 40%
of future scenarios the return achieved would be below this rate. Under the “gilts plus” model the probability
of equities out-performing gilts over 15 years is around 76%. This is broadly in line with historical averages
which show a positive equity risk premium in 79% of historic fifteen year periods between 1900 and 2014.
The “inflation plus” and “intrinsic value” calculations have such a high equity return compared to the return on
gilts that the probability of outperforming gilts is around 91% over 15 years; there is still some risk embedded
in the equity return but the level of risk, compared to gilts, is mitigated by the very high level of return
expected from equities.
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The discount rate quandary
If the investment strategy of the scheme was expected to be 50% in UK equities and 50% in gilts for the long
term then half of the discount rate would be based on the gilt yield directly (reflecting the actual yield on the
assets actually held) and half of the discount rate on the equity return adjusted for the level of confidence (or
prudence) required to reflect the covenant. In broad terms:
 A scheme supported by a “Strong” covenant might utilise a confidence interval of around 60%.
 A “Tending to Strong” covenant might utilise a confidence interval of around 65%.
 A “Tending to Weak” covenant might utilise a confidence interval of around 70%.
 A scheme supported by a “Weak” covenant might utilise a confidence interval of around 75%.
Under all these covenant ratings, using the “gilts plus” approach leads to an equity return assumption of
around 3.5% per annum lower than under the “inflation plus” and “intrinsic value” approaches. For a scheme
investing 50% of its assets in equities, that translates to a discount rate which is lower by around 1.75% per
annum. That is a hugely significant differential over the average term of a pension scheme. For a typical
scheme, adopting a discount rate that is 1.75% per annum lower might increase the value placed on its
liabilities by around 35%.
Whilst this is an oversimplification, given that most schemes do not intend to remain invested in 50% equities
and 50% gilts and trustees may wish to model a greater level of risk in setting their discount rate under the
“inflation plus” or “intrinsic value” approaches, any widespread diversion from the “gilts plus” approach would
clearly make a dramatic difference to the landscape for UK pensions.
Assets as a percentage of technical
provisions
The following chart shows the distribution of scheme funding levels in the latest scheme funding survey from
the Pensions Regulator:
120
110
100
90
80
70
60
50
40
1
2
3
4
5
Tranche
6
7
8
9
The data shows that in Tranche 9 almost 25% of schemes were fully funded or in surplus. For those
schemes, reducing the liabilities by adopting a higher discount rate would not have any significant short term
implications. However, for the circa 25% of schemes that are between 90% and 100% funded, a reduction in
liabilities of even 10% would move them from being in deficit to being fully funded or in surplus, eliminating
the need for their sponsoring employers to agree recovery plans with their trustees and to pay deficit
contributions. A further circa 25%, with funding levels between 80% and 90% would see their deficits
reduced by at least 50% if their liabilities were reduced by 10%. This too would have a huge impact on the
amount of money flowing into schemes in the short to medium term. Even those circa 25% of schemes with
funding levels below 80% would see a significant improvement in their funding position and a reduction in the
amount of money they needed their employers to contribute from a 10% reduction in liabilities.
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The discount rate quandary
7.2 Impact of adopting lower technical provisions
Essentially, in current market conditions, adopting either of the “inflation plus” or an “intrinsic value”
approaches means setting a lower level of technical provisions and thus, on average, this would mean that in
all future scenarios the scheme will be holding fewer assets at any one point in time.
Setting aside any covenant issues, this is inconsequential; the valuation process is a budgeting exercise that
is refreshed every three years and whatever the level of technical provisions is set at members’ benefits will
be paid. Either the returns will come through as expected or the company will make deficit contributions in
the future to ensure there are sufficient assets are available to meet benefits as they fall due.
There are some second order impacts, still ignoring covenant. For example by setting the technical
provisions higher the probability that the scheme will have positive experience and become fully funded on a
buy-out basis is increased. But covenant issues are foremost and there are two distinct issues to consider:
 Firstly, all employers are susceptible to insolvency and, should this occur, having lower assets leads
to members receiving lower benefits than they would have otherwise (or the PPF taking a greater
loss).
 Secondly, by setting the technical provisions lower now, there is a risk that the reduction in the
technical provisions needs to be reversed in the future. This could lead to a deficit arising in the
future (due to adverse experience) that is subsequently unaffordable to the employer (similar to the
position that Uniq plc found itself in where it could not afford to fund its pension obligations).
In essence, by choosing to adopt a valuation methodology that leads to a higher discount rate, the scheme is
taking additional risks (over and above those present when adopting the “gilts plus” approach).
7.2.1 Risk of employer insolvency
Whatever the strength of the covenant, there is a probability of insolvency of the employer, leading to a windup of the scheme with fewer assets than would otherwise be the case, resulting in members receiving lower
benefits (or the PPF taking a greater hit).
Pension schemes are very long term obligations and however strong the sponsoring employer may be at the
point of the valuation there is a chance that the employer will become insolvent. Using data provided by
Moody’s on defaults since 1920 it can be seen that the probability of default accumulates to significant
values over long time periods even for the strongest credits.
Defaults
5 years
10 years
15 years
20 years
AAA
0.2%
0.9%
1.4%
1.7%
AA
0.7%
2.2%
4.2%
5.4%
A
1.2%
3.2%
5.4%
7.1%
BBB
3.1%
6.9%
10.5%
13.3%
BB
9.7%
18.7%
26.0%
31.3%
B
22.0%
35.5%
44.0%
48.8%
C – CCC
41.3%
52.9%
62.3%
69.9%
The scheme funding analysis data from the Pensions Regulator shows that the average scheme is setting its
technical provisions at around 75% of the cost of securing benefits with an insurance company which
becomes relevant on insolvency. In the absence of a full recovery of the Section 75 debt triggered on
insolvency (which is extremely rare) benefits will have to be reduced on insolvency of the sponsoring
employer.
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The discount rate quandary
Setting the technical provisions at a lower level, due to a higher discount rate being used, would generally
mean that the assets held by the scheme will be at a lower level at all future points in time than if a lower
discount rate was used. Broadly, over the long term, we might expect the difference in asset values to be
close to the difference in technical provisions (before considering complexities about the timing of
contributions to get to full funding and any variation in the recovery of the Section 75 debt).
Simplistically, if the higher discount rate leads to assets being 10% lower on average on insolvency and the
risk of insolvency is around 10%, then the expected value loss to members is around 1% of their benefits.
This may not seem overly significant but in practice the situation is that 90% of outcomes will see full benefits
paid (ignoring any affordability issues which we discuss further below) and 10% of scenarios will see
members receive 10% less benefits (ignoring the underpin provided by the PPF which schemes are required
to ignore in making their decisions).
For a scheme supported by an employer with a weak covenant, the risk would be much more marked. The
accumulated probability of default for a BB rated entity over a 20 year period is 31.3%, hence there would be
almost a one-in-three chance of members of such a scheme losing an extra 10% of their benefits as a result
of adopting a 10% lower funding target. Conversely, schemes supported by employers with strong
covenants would be far less likely to suffer the additional 10% reduction in benefits – the chance of
insolvency over 20 years being a fraction over one-in-twenty for a AA rated entity.
This analysis is somewhat speculative. To consider the implications of setting lower technical provisions on
the security of member benefits more sophisticated analysis would be required.
7.2.2 Risk of future employer affordability constraints
Setting the technical provisions at a lower level immediately improves affordability of the deficit payments
given that the deficit will be substantially reduced and thus much more affordable to the employer. After this
initial gain for the employer then affordability should not be impacted by the setting of technical provisions at
a lower level; adverse deviation that needs to be funded in the future should not be greatly affected by the
change in technical provisions. For example, the impact of unexpected improvements in mortality will require
broadly similar additional contributions from the employer whatever discount rate approach is used.
The major issue arises where a scheme adopts lower technical provisions (because, for example, it was felt
that the “intrinsic value” approach was appropriate), requiring lower contributions from the employer and thus
a lower level of future assets, but at a subsequent valuation it becomes apparent that the lower technical
provisions are no longer supportable and a switch back to the “gilts plus” approach is required. Suddenly
there is a large additional deficit to be dealt with, and this could coincide with weakness in the sponsoring
employer and other significant adverse experience such that the resulting deficit to be recovered becomes
completely unaffordable.
In such scenarios where a sponsoring employer is solvent but has no hope of meeting the deficit with any
degree of confidence even over an extraordinary length of time (the maximum period considered realistic is
generally 20 – 25 years), a solvent compromise is required. This means the pension scheme is separated
from the employer along with the majority of the value of the employer, and most famously occurred with
Uniq plc where the scheme received 90% of the value of the employer. Such cases are fortunately quite rare
given the flexibilities in the funding regime allowing employers to be given breathing space to allow their
fortunes to turn around.
Considering these risks is somewhat difficult but simplistic scenarios can be considered. For example, if the
scheme was 80% funded on a technical provisions basis prior to the change in technical provisions (which
raises the funding level to 90%) it would be worth considering any stress tests based on the higher, not
lower, technical provisions. Thus, if the 80% funding level fell due to adverse deviation to some severe but
realistic level such as 60%, would the employer be able to afford the contributions required to restore the
funding level to 100% over a reasonable period? And would they still be able to do so if their profits had
fallen by 50% or even 75%?
Generally, where sponsoring employers are relatively small compared to their schemes, the risk of
affordability issues arising is higher and very careful consideration needs to be given by schemes in
changing the technical provisions in case these affordability risks are compounded.
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The discount rate quandary
7.2.3 Modelling the risks
Considering the issues arising if one chooses to set the technical provisions at a lower level is extremely
complex given the multiple interactions and the long term time horizons. Schemes must consider these
issues in detail if they are to alter their discount rate approaches and be confident they are not putting the
security of member benefits at risk. This would require quantifiable analysis on the range of possible
outcomes and the likelihood of those outcomes arising.
This is why, in 2017, we will be publicly launching our integrated risk
management model, the “Risk of Ruin”, which we have used to
consider these types of complex issues on special projects since 2006.
7.3 Incorporating new approach into an integrated risk management plan
The difficulty for trustees is that while all three of the approaches outlined in this report are credible they
generate very different answers. Furthermore, no theory is irrefutably better than the other two as all contain
various assumptions within them. Deciding which approach to take is therefore a matter of judgement.
It should be noted that schemes are required to review the method and assumptions used for each valuation.
Regulation 5, paragraph 4(d) of the Occupational Pension Schemes (Scheme Funding) Regulations 2005
states:
“any change from the method or assumptions used on the last occasion on which the scheme's
technical provisions were calculated must be justified by a change of legal, demographic or
economic circumstances.”
Therefore, any scheme looking to modify the methodology used to set the return on equity assumption would
need to be able to justify this with reference to changes in the economic environment. However, in our view
it would not be going too far to say that all schemes using the “gilts plus” methodology should review the
continued appropriateness of that approach in the current economic climate.
There are many reasons why schemes might conclude that the “gilts plus” method should be
retained. Firstly, the scheme funding regulations require the discount rate to be chosen prudently and in the
current economic environment, the “gilts plus” method gives by far the lowest equity return assumption and
hence trustees can always argue that they are being prudent by choosing that method. Furthermore, some
schemes will be tied to a “gilts plus” method because they are seeking a measure of liabilities that is either
consistent with an investment strategy where their interest rate and inflation risks are (or will be) significantly
hedged or an objective to buyout their benefits with an insurance company. Those schemes with weaker
covenants are also, quite rightly, more closely aligned with the cost of buying out their liabilities with an
insurance company.
The fact that the Pensions Regulator has historically benchmarked the discount rate adopted by schemes
against the yield on gilts has no doubt also been a significant driver of behaviour. Anecdotal evidence that
suggests some schemes derive significant comfort from the fact that they are doing broadly the same as
everybody else, not wishing to stand out from the crowd. This may well be the case both for the trustees
responsible for setting the method and assumptions (subject to the agreement of the employer in most
cases) as well as for the Scheme Actuaries advising them. Often trustees will consider the data published by
the Pensions Regulator and their advisers to see what other schemes are doing as part of the process of
setting their assumptions.
As discussed in the previous sub-section, adopting a higher discount rate leads to greater risks. To mitigate
these risks, the Pensions Regulator would expect the trustees to ensure that this risk can be tolerated and to
incorporate actions into their Integrated Risk Management Plan (“IRMP”) to specifically address both the fact
that the assets of the scheme are expected to be lower in future and the possibility that the economic model
underlying the valuation basis proves to be incorrect and subsequently needs revision.
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The discount rate quandary
8. Options for sponsoring employers
There will be many FTSE 100 finance directors paying a hefty progressive dividend, with plans for
substantial real dividend growth, who will be astonished that their pension scheme believes that investors in
companies like theirs will generate a return (from a combination of dividend payments and capital growth) of
just 5.5% per annum for their investors.
They will also no doubt be surprised to know that their pension scheme is funded so conservatively that there
is just a one in three chance that the assets will not deliver the level of return implied by the discount rate, or
that the prudent long-term equity return assumption is lower than the current dividend yield.
It seems to us that most people in the business world have not changed their expectations of the type of
returns that equity investment will generate in the future. If you are a sponsor of a defined benefit pension
scheme and you cannot fathom the meagre equity return assumption being made by your trustees, whilst
being somewhat concerned about the unconventional monetary experiment being undertaken in the UK, the
question is, how do you persuade the trustees to move away from a “gilts plus” approach?
The first thing to note is that it will only be possible to move away from the “gilts plus” methodology and
accept more risk if the employer covenant afforded to the scheme is sufficiently strong to support this. In
other words, if the scheme is funded to a lower level and suffers from experience being worse than assumed,
including but not limited to the new model for setting the discount rate turning out to be wrong, can the
employer afford to correct the higher deficit? The employer will need to consider this and be confident that it
affords the scheme a sufficiently strong covenant before attempting to persuade the trustees that this course
of action is appropriate.
In terms of the process that would need to be followed, the first stage would be for the employer to construct
and document its investment beliefs. It would then use this as the basis for developing a set of rational
arguments to present to the trustees in support of any proposed change in funding methodology. The
trustees would need to take advice and to commission detailed analysis of the company’s proposal and the
potential impacts that accepting it could have on the scheme and in particular the range of possible
outcomes for members. The trustees would also need to consider the range of mitigating actions that could
be taken in the event that they were to adopt the company’s proposal, only for subsequent experience to
suggest they were wrong to do so. The trustees would only be willing to accept the company’s proposals if
they were comfortable with the theory put forward and confident that the company would be willing and able
to correct any underfunding that resulted from the decision to adopt an alternative methodology.
Once agreed, the change to the funding methodology would need to be incorporated into the scheme’s
statement of funding principles. The trustees would also need to amend their IRMP to reflect the mitigating
actions that would be taken were experience to suggest that the new methodology was incorrect.
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The discount rate quandary
9. Summary and conclusions
We have seen that whilst schemes are attempting to set their discount rate based on the expected return on
their assets (rather than directly from bond yields), the investment return model generally used (the “gilts
plus” approach) leads to a perfect correlation between the discount rate and gilt yields as demonstrated by
the data on scheme funding from the Pensions Regulator.
There are other credible techniques that could be used instead, including the “inflation plus” and “intrinsic
value” approaches, that historically provided similar answers to the “gilts plus” approach but no longer do so.
Such approaches are as justifiable as the “gilts plus” approach and are specifically allowed to be adopted
under the legislation on scheme funding. Changing technique could dramatically improve scheme funding
levels and substantially reduce required employer contributions.
The key driver of the differential between the results of the different approaches is the extraordinary levels of
low interest rates in the UK and globally. The question that schemes need to answer is whether the bond
market is distorted or whether the bond market is telling us something dire about the likely future path of the
UK and global economy. There is no definitive answer and all the techniques considered in this report are
driven by one simple assumption (the equity risk premium, the real equity return or the rate of real dividend
growth) that cannot be calculated but only estimated.
Were a scheme to wish to change from the “gilts plus” approach then, as well as deriving a reasoned
explanation for the change, it would have to consider the complex additional risks created by doing so and
put in place an “Integrated Risk Management Plan”. This would detail what additional risks the scheme is
taking, the size of such risks, why the scheme thinks it is appropriate to take these additional risks and, most
importantly of all, what actions the scheme will take in mitigation in the event that such risks arise.
Richard Jones FIA
Principal
Tel: 020 3327 5290
Email: [email protected]
Address: 11 Strand, London WC2N 5HR
Chris Parlour FIA
Senior Consultant
020 3327 5293
[email protected]
11 Strand, London WC2N 5HR
Helen Skinner FIA
Consultant
020 3327 5292
[email protected]
11 Strand, London WC2N 5HR
January 2017
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