It was recently widely reported that the pension schemes of FTSE 100 companies had achieved a collective surplus on an accounting basis for the first time since the Credit Crunch, following a £35bn reduction in the net deficit during 2017.
In this article, we look at the factors driving this and consider whether there are lessons for smaller pension schemes to learn, to ensure they are not outpaced by their larger cousins.
Recent Developments in context
Firstly it’s important to remember that the accounting valuations under IAS19 are very different to the measures used by trustees and employers when agreeing funding. Research by JLT Employee Benefits still places the total deficit of UK corporate pension schemes at over £900bn, despite contributions of £160bn across the last 10 years. On yet another measure the PPF 7800 Index shows an improvement of £120bn during 2017, yet even after this the deficit is still over £100bn. So whilst the trend has been positive, different perspectives can be taken on average funding levels and individual schemes also vary widely.
There are a number of factors driving the 2017 improvement in FTSE 100 schemes:
- Sponsor contributions totalled £13bn, although this is reportedly only 1/6 of what they paid out in dividends.
- Investments returns were strong for many schemes, as a result of strong returns in most equity markets and UK real estate, against an environment where interest rates (although volatile during the year) did not continue their downwards plummet of recent years.
- Accounting assumptions around discount rates and inflation differ widely between schemes, but there is a trend towards using more “sophisticated” approaches to quantify AA rated bond yields, in order to increase the discount rate and reduce the measured value of liabilities.
- The latest mortality tables (CMI 2016) show a fall in life expectancy of 4-6 months, confirming that the decade-long trend for increasing life expectancy appears to have stalled in the last few years. For a typical scheme updating to the latest assumptions might reduce liabilities by 2%, but it is not yet clear whether this change is temporary or permanent. Historically, most pension schemes were slowish to update their mortality assumptions, but three quarters of the FTSE 100 companies that disclose their tables in 2017 had already adopted the most recent set of assumptions.
Practical Steps to Consider:
- Find out how your liability value has changed in light of the latest mortality assumptions. As well as informing you to make better strategic decisions, this will ensure that transfer values and other liability management exercises are priced fairly.
- H. James Harrington said: “If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it.” In the current environment it is very useful to be able to monitor your funding position frequently and rapidly, so that any opportunities can be captured. A range of solutions are available for such monitoring.
- On a related note, it is good to have reliable estimates on your current cost of buy-in/out. The improvements in mortality have filtered through to insurer pricing and the bulk annuity market has been very busy and competitive in 2018. If your funding position is relatively strong and has recently improved buy-in/out may be an attractive route to lock in recent gains in case life expectancy rises again. JLT has recently launched an innovative buyout comparison service that makes this quicker and easier.
- For schemes that are not yet able to afford buy-in/out, we are hearing a lot of interest in Cashflow Driven Investing. This uses bond focussed strategies customised to match cashflow requirements as they fall due, which reduces the risk of running short of funds or being forced to make unplanned contributions. This is a strong self-sufficiency strategy to adopt while waiting for years to pass so that deferred members retire and buyout becomes more affordable. Unlike holding equities now in the hope of de-risking later, it allows investment risk to be spread more evenly through time, and avoids the operational complexities of a implementing a de-risking glidepath.
- Finally schemes that still need to earn substantial returns may see an improvement in their funding position as an opportunity to reduce the risk of their investment strategy slightly. We note that the equity allocation of the FTSE 100 schemes has fallen to below 25% in 2017 (It was around 60% a decade before), and if your scheme still has a high equity weighting and has not diversified this may be an opportunity to lock in recent beneficial investment returns before the end of the current economic cycle.
If any of these approaches sound of interest you can discuss them with your usual JLT Investment Consultant, or Michael Wray, COO and Director of Strategic Investment Solutions (Michael_wray@jltgroup.com).