Volatility is seen as the great evil of pension schemes. Be they defined benefit (DB) or defined contribution (DC), it is volatility that is the greatest cause of concerns. But should it be?
To answer this we need to look at the causes of volatility and the impact of it.
There are two types of volatility people worry about, the first of which is the volatility of asset values. It is easy for trustees and companies to overly focus on this volatility as asset values are very visible and stock market swings are publicised in the news. But is this volatility important? Not really.
If I have 500 euros it would be easy to get concerned about their value going up and down with the exchange rate. But if I’d agreed to pay 500 euros for my hotel when I go on holiday next month then it really doesn’t matter to me how much they are currently worth in sterling. My transaction has no volatility at all.
The key focus of pension scheme volatility therefore needs to consider both assets and liabilities and hence, for DB schemes, the deficit or funding level. And this can be very volatile!
I did some analysis for a recent conference talk looking at history and put together the chart below. This shows how the funding level of a scheme would change over time assuming market based (gilts+) type valuations and 10 year spreading of surpluses/deficits. The funding level routinely changes by about 10% each year.
This chart also shows the recent crisis in pensions caused by a perfect storm of:
- Not great investment returns
- Increased mortality expectations
- Falls in bond yields
The current ultra-low bond yields actually being the second wave of large falls in bond yields/interest rates. The first starting at the end of the 90s.
This perhaps also brings into focus what we really mean when we say we dislike volatility, and that is falls in the funding level. Upside volatility is fine. For example some people talk about volatility from mortality but actually this has generally been pretty smooth (albeit with some step changes to reflect late application) upward only (in terms of liabilities) adjustments. So, not volatile, just more costly! The fact that it is relatively smooth reflects the fact that data only arrives each year and 1 year’s data is not used to determine the future expectations. It is accepted that 1 year mortality figures can be volatile and not necessarily the best guide of the future. A useful concept to bear in mind when we look at the causes of volatility.
So what are the causes of funding volatility?
There are many specific causes but fundamentally it’s because liability values and asset values don’t change in the same way.
The biggest specific cause of volatility in UK pensions? Long dated bond yields. And this is primarily because liabilities are generally pegged in some way to these yields via the discount rate used. For some measures, such as accounting bases like FRS17 or IAS19, this is prescribed. For others, such as buy-out costs, it reflects reality in how insurers are required to reserve for the benefits. But, for pension scheme funding, it is often a modelling choice made by the actuary, led on in no small way by the Pensions Regulator and a bunch of “economists” that don’t really understand what pension scheme funding is all about (and who struggle so much with 2 definitions of the word valuation that actuarial standards now require us to attempt to explain it to them in every report we do!). You can perhaps see what side of this debate I sit on.
Essentially the biggest cause of volatility in UK DB pensions is our choice of tape measure.
When it comes down to it, the fact that pensions are funded at all is a choice, and it would actually be more efficient not to fund them. A pension scheme itself is merely a series of future cashflows. We fund the scheme by investing in assets to enable us to pay those cashflows. So what really matters is the volatility of cashflows that can be obtained from our assets.
Bonds are therefore of course a great asset for this as you can build a cashflow stream in line with that expected for your liability payments. Investing in bonds can therefore remove a large amount of volatility through matching – and in this case there is no debate that the yield on those bonds should be the discount rate used.
These days things are even easier as synthetic bonds can be used to provide better and/or more cost effective matches for liability payment streams.
The downside of bonds though is their return – or lack thereof – particularly gilts in the current climate.
So what about growth assets or, in particular, equities. Equities prices are extremely volatile. They also have almost no correlation to gilt yields so if your liability valuation is pegged to gilt yields your volatility goes up further still. But in the long-term (and let’s face it pension scheme are long term) the vast majority of the return you get from holding equities comes from the dividend payments, not the change in capital value. And dividend payments aren’t that volatile. So, if we look at things from a cashflow matching perspective, a low volatility dividend payment combined with greater expected long term returns looks very attractive. If you make allowance for dividends when determining your discount rate this reduced volatility can effectively filter through to your funding position.
Current equity prices, rather like last year’s mortality experience as I mentioned above, are not a great guide to their long-term future worth in many cases.
Other growth vehicles
The growth vehicle of choice at the moment is the Diversified Growth Fund (DGF) of some form or other. These are all very different in strategy but have similar aims of long-term equity like returns but with lower volatility. In actual fact their “target” is often stated as cash plus.
The reduced volatility of assets that these bring is attractive. However, they offer no form of cashflow matching at all so in some ways could be viewed as more risky than holding equities over the long term. Just a thought…
Where cash plus does come into its own though is when using derivative products to generate long term cashflow matching in exchange for cash outgo. If your DGF gives you cash plus with vastly reduced capital volatility then maybe the biggest form of volatility in scheme funding is solved without losing out on the longer-term return benefits.
I’m more traditional and holistic in view point and favour long term equity biased growth strategies with more appropriate valuation techniques. However, in the current legislative environment, a DGF + swaps type strategy looks very attractive.