Bond yields: unwelcome news for defined benefit pension scheme sponsors

Bond yields are at all-time lows. Notably, long-date corporate bond yields ended the year as low as they’ve been for at least a decade. My handy source of data doesn’t really go back much further, but I wouldn’t be surprised if they’ve never been this low – ever.

 (Source: FT-SE Actuaries indices, Markit iBoxx indices)

This may be great news if you are invested in bonds, but for many defined benefit pension scheme sponsors it is unwelcome news. Unfortunately, pension liabilities on corporate balance sheets should be calculated using a discount rate equal to corporate bond yields. Thus, as yields have fallen, balance sheet liabilities have risen – our friends at Mercer have estimated that overall balance sheet deficits could have doubled over 2014.

Some sponsors may be ambivalent about such balance sheet volatility – taking the longer-term view that what goes up, must come down. But others may be more sensitive, worried about how an apparent weak balance sheet might be perceived by customers, lenders, and possibly even shareholders.

Low corporate bond yields could have other effects. I have a client who pegs commutation factors (the conversion rates used to determine how much pension is reduce by when a member opts for a lump sum on retirement) to corporate bond yields. As yields have fallen, those rates have become steadily more generous – great news for scheme members at retirement, but potentially very expensive for the scheme sponsor. Transfer values are usually linked to bond yields as well, so they too will have become more generous.

Balance sheet volatility may encourage sponsors to try and do a better job of matching assets and liabilities. But trying to match when yields are low means locking in at what feels like precisely the wrong time – unless of course you take the view that in 6 months’ time I’ll still be saying that bond yields are at an all-time low.

John Broome Saunders
Actuarial Director
Telephone: +44 (0)20 7893 3456
Email: contactus [@] broadstone.co.uk

Will Collective Defined Contribution plans get out of first gear?

The new Collective Defined Contribution (CDC) plans, which were announced in the Queen’s speech today, may offer cost savings for pension savers.  We are sceptical whether they will ever get off the ground in the UK.

We live in a post-Defined Benefit (DB) world, where many FDs continue to rue the day their predecessors agreed to the open ended pension commitment of such schemes, and, where behind the scenes they continue to place considerable financial strain on many of the country’s employers. Most private sector employers closed their DB schemes over the last ten to fifteen years replacing them with DC arrangements, with comparatively lower levels of contributions.

While the industry discusses the merits of the system the elements that smell of with-profits, the cross generational subsidy, whether pensioners will be 30% or 50% better off, the real issue is: will employers want to adopt these systems? For three major reasons we think they won’t:

 

1.  It isn’t DB but it is a bit like DB.

 

A feature of Collective DC is an “aspiration” of a benefit at retirement which could be perceived as a defined benefit by members. With those expectations could come moral imperatives for some employers. It is unlikely that employers that bear the scars of DB would embrace these new risks with open arms.

 

2.  What about the flexibilities to be introduced from April 2015?

 

Which employer wants to explain to their employees that they are entering into an arrangement that removes all the new flexibilities that have been trumpeted by the press and have just come into force for an ‘aspiration’ they will be better off in retirement.

 

3.  Auto enrolment has already made DC the pension scheme of choice.

 

Many employers have been forced to review their provision and put something into place to meet their auto enrolment requirements. Will they want to undo that work and adopt a CDC approach? It is unlikely.

 

I am not against CDC and believe that we will come full circle and reappraise defined benefit provision in the future (perhaps long into the future) but fear that CDC has come too late. The Government should ensure their focus remains on repairing the active membership phase of DC provision to keep charges competitive, improving governance and ensuring knowledge and financial education is as good as possible to give individuals the skills to make informed choices.

David Brooks

Pensions Consultant

Telephone: +44 (0)20 7893 3456

Email:  contactus [@] broadstoneltd.co.uk

Our poll of trustees and sponsoring employers on the changes from the Budget

We recently ran a high level breakfast seminar to discuss the pensions revolution kick-started by George Osborne in March.

During the sessions we surveyed the attendees to gauge their views on some of the pertinent issues.

Our poll found that:

100% support the government’s decision to expand pension flexibility.

This is perhaps no surprise. Increased freedom and choice is nearly always universally welcomed, despite the short period of flux that we have to go through to get there.

68% expect defined benefit (DB) members to be tempted to take their transfer value and convert to defined contribution (DC) to access flexibilities.

This is surprisingly high and only time will tell if this view is borne out. If the government decides to ban transfers from DB to DC from April 2015 (and we have received strong indications from HM Treasury that if they do bring in a ban it will be from that date) this could create a “buy it now while stocks last” style firesale. However, if the government does not ban the transfers it will be interesting to see the steady state numbers. It is hard to think that many members will transfer as they will risk losing the guaranteed income, which surely remains very valuable.

90% of attendees think that individuals will act prudently in retirement.

This has certainly changed from my early conversations with employers who were very worried that their members could make more decisions in retirement. It is here that the guidance guarantee will be crucial in ensuring members consider their own needs and don’t underestimate their longevity – otherwise there could be a lengthy wait for a Lamborghini (or Aston Martin...).

73% expect annuities to remain a key part of retirement planning.

This certainly echoes our view that the need for a guaranteed income during retirement will be highly valued by individuals. There is no doubt that the frequency or size of annuity purchases will decrease and it is likely that many individuals will use some of their DC savings to purchase an annuity at some point.

14% support a government ban on transfer from defined benefit to defined contribution.

This is interesting as restricting freedom to just DC only members seems to go against the government’s ideology and is perhaps driven by the fear of the impact on the economy by the possible exodus from long-dated gilts.

What should employers and trustees be doing?

The wide-ranging changes in the budget mean that trustees and sponsoring employers need to move from ‘wait and see’ to taking action. Top of their list should be the need to review their default investment strategies to ensure that they remain relevant for the majority of their members. This is especially so when typically the vast majority of the members make use of default strategies.

Sponsoring employers should also review the benefit structures in their DB schemes to ensure they remain fit for purpose in the changing world. Members use of trivial commutation and additional voluntary contributions are going to change with the Budget’s changes to the way members will structure their retirement income. By reviewing the schemes’ benefits employers could realise long-term cost savings as members have access to the fullest range of options as possible. In many cases rules will need to be changed and this work should begin sooner rather than later.

David Brooks
Technical Consultant

Telephone: +44 (0)20 7893 3456

Email:  contactus [@] broadstoneltd.co.uk