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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 Page | 1 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. Page | 2 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 Page | 3 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. Page | 4 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 Page | 5 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. Page | 6 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. Page | 7 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? Page | 8 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. Page | 9 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. Page | 21 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. Page | 22 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. Page | 23 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. Page | 24 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. Page | 25 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. Page | 26 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. Page | 27 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 Page | 28