BriefingNote
February 2017
In brief
}} Many schemes appear
to be using the
‘gilts plus’ approach
when setting
discount rates
}} Historically increasing
the ‘plus’ has been
deemed a reduction
in prudence
}} Hence falling gilt yields
have led to falling
discount rates, in
turn contributing
to rising deficits
}} Depending on
the objectives of
the sponsor and the
trustees it may be
appropriate to review
the methodology
and/or the margin
over gilts assumed
Next steps
}} Speak to your
Scheme Actuary
or PS contact for
further advice specific
to your scheme’s
circumstances
}} See further details
of our Funding Reality
Check to explore
the alignment of
your funding and
investment strategy
with your covenant
The discount rate debate
One of the key assumptions in a scheme’s triennial funding
valuation is the discount rate. For many schemes this has
been derived based on a fixed margin above gilt yields
(the ‘gilts plus’ approach). In this briefing note we consider
the current debate around the suitability of the ‘gilts plus’
approach and possible alternatives to it.
Background
The interest rate (or ‘discount’ rate) is used to adjust future payments expected to
be made from a pension scheme back to a present day value. It is one of the key
assumptions used in a scheme’s triennial funding valuation and can have a huge
impact on the scheme’s funding deficit (or surplus), its future contribution rate
(if it still has members accruing benefits) and any contributions required to
remedy a deficit.
When carrying out a pension scheme’s triennial valuation, the trustees must follow
the scheme funding legislation; in particular the legislation states that ‘the rates of
interest used to discount future payments of the benefits must be chosen prudently,
taking 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 bonds or other high-quality bonds.’
According to an analysis of data published by the Pensions Regulator (TPR) carried out
by Punter Southall Transaction Services (PSTS), since the introduction of the scheme
funding regime in September 2005, the average scheme has ‘effectively just added
1% p.a. to the gilt yield at the point of their valuation whatever the market conditions’.
However, the discount rate assumed has fallen over time compared to inflation from
an average of 2.26% p.a. above inflation for valuations carried out 10 years ago to
1.05% p.a. more recently. It therefore appears that many schemes have effectively
used a ‘gilts plus’ approach, under which the discount rate is the gilt yield adjusted to
reflect the expected return on other asset classes. It should be noted that the discount
rate is usually also adjusted to reflect the prudence required by the trustees (typically
based on the perceived strength of the employer’s covenant). Until relatively recently,
changing the level of assumed out-performance was viewed by TPR to be placing an
increasing reliance on the employer covenant.
The ‘gilts plus’ approach
The ‘gilts plus’ approach assumes that the expected return on assets can be derived
as the sum of the risk-free rate of return (typically assumed to be the return on gilts)
and the risk premium expected to be achieved as a reward for holding riskier assets.
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Briefing Note
February 2017
What about alternative approaches?
‘Inflation plus’ - this approach is analogous to the ‘gilts plus’
approach, but instead assumes that the expected return on
assets can be derived as the sum of the rate of expected
future inflation and the expected real return on the assets
held by the scheme.
Intrinsic value - this can mean different things. A commonly
used model for equities is the ‘Gordon Growth Model’ which
discounts the future stream of dividends. Under this model the
expected return on equities is the sum of the dividend yield and
the expected future dividend growth.
Source: PSTS
What assumptions are required?
Should the trustees consider an alternative method?
Under all the methodologies assumptions are required to calculate
the discount rate.
Since discontinuance measures of the liabilities are set relative to
risk-free assets, a ‘gilts plus’ method is relevant for schemes which
need to consider this market pricing, e.g. for those at risk of failure
through a weak covenant.
For the ‘gilts plus’ method, the main consideration is how to
derive the ‘plus’ i.e. the risk premium on non-gilt assets held
by the scheme e.g. if a scheme is invested in equities, the
equity risk premium (ERP) needs to be estimated. This cannot
be derived from stock market prices, and would also depend
on precisely what equities are invested in. Commonly historic
ERPs are used to estimate a future ERP, as this is the best
information available; however, future performance may differ
from that in the past. Historic data for the UK indicates that the
ERP for UK equities can be volatile. The ERP over both the last
10 and 25 years is around 0% p.a. (although it is higher over
longer periods e.g. 4.9% p.a. and 3.7% p.a over the last 65 and
115 years respectively). This volatility makes it difficult to
choose an assumption as well as to justify a change in the ERP
between subsequent triennial valuations.
Similar difficulties arise for the other two methodologies in
estimating future returns from different types of assets. The Gordon
Growth model requires an assumption about the future growth
of dividends and it is also commonly assumed that the equities in
question are held in perpetuity, which is not likely to be the case
once schemes mature.
Do the different methods give different discount rates?
It depends. In their recent paper, ‘The discount rate quandary’,
PSTS illustrated the difference between the three approaches for
calculating the return on UK equities using certain assumptions
(based on long-term data) for equity risk premium, real return
on assets and expected dividend growth, the results of which are
shown in the graph below. It can be seen that up to 2011 the
discount rates were similar, before the ‘gilts plus’ methodology
diverged significantly as gilt yields fell. This shows that the
different approaches have the potential to give both similar
and different answers depending on market/asset data and the
assumptions made.
For other types of schemes there may be more flexibility to
consider either increasing the ‘plus’ in ‘gilts plus’ or adopting other
funding methodologies. Changing the discount rate method is
likely to affect the level of deficit disclosed in the scheme funding
valuation and therefore the timings of any contributions due from
the sponsor. Therefore any change to the discount rate method
could change the level of risk the scheme is exposed to.
In our view, the choice of the discount rate depends on a number
of factors such as the long-term objectives and risk appetite of
the scheme sponsor and trustees. It is important that the funding
strategy is aligned to both the investment strategy and the
covenant anticipated in both the short and longer term.
If more flexibility is used with regard to scheme funding, the
scheme’s Integrated Risk Management Plan should be considered
and strengthened (if necessary) where a decision is taken to change
the method used to derive the discount rate.
The above analysis suggests that it is right that discount rate
methodologies should be debated, given the wide divergence.
But no one methodology is suitable for all schemes.
Where can I get further information?
Please get in touch with Joanne Livingstone.
020 3327 5000
[email protected]
company/punter-southall
@puntersouthall
Alternatively, please speak to your usual
Punter Southall contact.
Punter Southall has offices across the UK.
For further information, visit our website at www.puntersouthall.com
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This communication is based on our understanding of the position as at the date shown. It should not be relied upon for detailed advice or taken as an authoritative statement of the law.
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