Date: March 2006

Author: Finance Investment & Risk Management Board

The Profession's Practice Boards produce from time to time various briefing statements to enable officers, members of Council and senior members of staff to respond to questions from the Profession, the public and the media about important topical issues and developments.

These statements may be used as background for public pronouncements. They are not formal guidance, neither are they a definitive expression of the views of the profession as a whole on the subject.

There is a contact name for enquiries at the end of each statement. Please feel free to speak to this person if you would like more information.

Introduction

Yields on long-dated UK government bonds (gilts) have fallen sharply recently. The importance of these investments as a reference point in assessing the present value of pension liabilities means that most trustees will have seen a dramatic increase in the value of these liabilities. The solvency position may also have deteriorated, particularly if the assets held by the scheme have not risen in price by as much as these gilts.

In addition, trustees who were planning to move more of their assets into gilts to match their liabilities and reduce the volatility of the solvency position, now face the prospect of doing so on less favourable terms. They have an increasingly difficult decision to make: should they postpone the move until gilt yields are higher, or continue to bear this volatility? This briefing note outlines some of the general issues which trustees should discuss with their advisers before making this decision.

Background

When actuaries assess the value of defined benefit pension fund liabilities, they often use government bonds (gilts) as a reference point. Gilts either have a fixed coupon (commonly called 'conventional gilts') or are index-linked (referred to as 'ILG'). The yield on a gilt changes when its market price changes. When the price rises, the yield falls and the present value of pension liabilities will be higher. A one percent decrease in the yield used to value liabilities increases the value of liabilities by about 15% to 20%, although this will depend on the duration of the liabilities. Such a fall in yield will be caused by a price rise, the amount of which will similarly depend on the duration to maturity of the bonds. So in the case of a fully funded scheme where the liabilities are valued with reference to ILG yields, and the scheme's assets are ILGs of an appropriate duration , changes in the yield have little or no effect on the scheme’s solvency. We describe this situation as “matching” the assets to the liabilities.

Long-dated ILG yields in the UK have fallen from around 4% (real, in excess of inflation) in the mid 1990s to below 1% today. Although there has been a steady decline in yields for some time now, the fall has accelerated recently. The 50-year index-linked gilt was issued in September 2005 at a real yield of 1.1%. Recently it fell to a low of less than 0.4%, but at the time of writing has increased somewhat.

ILG yields are indisputably very low in an historical context. It is highly unusual for a British government to be able to borrow at real interest rates which are so far below the trend growth rate in the economy. However yields can remain low for long periods of time.

ILG yields are also low relative to other government index-linked bond markets. In the US the equivalent index-linked yield is currently around 2%.

The government borrows by issuing gilts maturing in different years. Traditionally, longer-dated issues have commanded a higher yield than shorter-dated issues. This is because the longer investors tie up their funds or expose themselves to market risk in the event of earlier sale, the greater the compensation that they require. From the issuer's point of view, the government is prepared to pay a premium to secure funding over a longer period without having to take the market risk of earlier refinancing. For several years now, this tradition has been confounded as long-dated yields have been lower than medium or short-term yields. This so called ‘inverted yield curve’ has been even steeper recently. This may mean that investors expect yields to fall or reflects an increase in demand for very long-dated bonds.

Switching assets into gilts may be attractive to some pension trustees who have a desire to match the assets to the liabilities. The perceived benefits are to reduce the risk that the assets will not be sufficient to meet the liabilities as they fall due, or to help make the solvency of the scheme or the cost of pensions to the employer more predictable. The cost is likely to be reduction in the investment return. If so then the contributions required to support the scheme would be higher. Some employers are prepared to pay higher contributions, particularly if they are already faced with significant costs in the short term to improve the solvency of the scheme.

Questions for trustees to consider

Under the terms of the 2004 Pensions Act, trustees are responsible for a pension scheme's investment strategy. The choice of strategy will influence the cost of the scheme, most of which is normally borne by the sponsoring employer, and it is a legal requirement for the trustees to consult the employer in making their decision. It is therefore important for trustees to fully understand the consequences of selecting a particular strategy. In assessing the significance of the current ILG yield, in relation to a change in investment strategy, trustees need to consider its impact on ultimate cost of the scheme as well as on the current solvency position.

Trustees also have a responsibility to take advice on the various approaches they can adopt by using investments to reduce the risks in their pension scheme. Noted below are examples of the questions that need to be considered when taking that advice. In helping to design and implement strategies which manage investment and liability risks, members of the actuarial profession are well placed to help.

In order to act in the best interests of the scheme’s beneficiaries, pension fund trustees wishing to reduce the risk of their investment strategy need to consider the following questions:

1.	What is the current solvency position and what are the implications of changing strategy now? How much potential investment return should be sacrificed in order to achieve a lower risk portfolio of assets.
2.	What are the implications of staying with a higher risk strategy? For example, if the scheme is invested in equities, are they now likely to outperform gilts by a greater or lesser margin than previously expected? This may change the outlook for the scheme's solvency in the longer term.
3.	How urgently does any change in strategy need to be implemented? Has the employer set a timescale over which the changes should be implemented? Is there a way of phasing the change to reduce the likelihood that gilts are bought at the "wrong" time? Making the change in steps will help reduce the risk of bad timing, although there is no guarantee that gilt prices will fall, and they may continue to rise.
4.	What is the financial strength of the employer? Is this likely to change in the near future? Trustees should consider the financial backing or strength of the employer's covenant when agreeing the appropriate level of risk which can be taken in the pension scheme, and deciding how relaxed they can be about the timing of any risk reduction measures.
5.	Are there other investments which can be used as an alternative to gilts which help to reduce the risk at a lower cost to a long-term investment performance, perhaps as an intermediate step? Corporate or overseas government bonds may be useful alternatives, even if trustees need to take extra action to reduce currency risks. It may also be possible to use synthetic products such as swaps to effect a change to the investment strategy without having as much impact on the potential investment return.

Contact for enquiries:

Mark Symons
Tel: 020 7632 2133
Fax: 020 7632 2131
E-mail: mark.symons@actuaries.org.uk