Many in the pensions industry fear that proposals set out in the Government's pensions Green Paper may encourage pension funds to favour equities over gilts but actuarial consultants do not think this is likely to happen
In its proposals for the reform of UK occupational pensions issued on 11 June, the Department for Work and Pensions aims to simplify occupational pensions in the UK and protect the benefits of both existing pensioners and those who are still accruing benefits.
However, changes to pensions legislation can often have a significant impact on investment returns over the medium term if pension funds respond by changing their investment policies. Various claims were made relating to the impact of the proposals on investments following the Government's announcement. Perhaps the main one was that the proposals would reduce demand for government bonds, particularly index-linked gilts (ILGs or linkers), and simultaneously improve the demand for equities.
At Legal & General, we have looked closely at these proposed rule changes and discussed them with the country's leading actuarial consultants in an effort to determine the extent of their potential impact on UK investment returns.
Let us begin with the pension rules relating to the Minimum Funding Requirement. The Government's Green Paper confirmed the UK will shortly get to wave goodbye to these rules, which effectively compel pension funds to increase their weightings in long-dated government securities.
This is because the rules require that a higher proportion of pension fund liabilities is discounted using gilt yields than was the case prior to their introduction in May 1997. This means any fall in gilt yields will automatically lead to a rise in the value of pension scheme liabilities. And if gilt yields do fall, any scheme that has low gilt weightings might not see a rise in the value of its pension fund assets to compensate for the increase in the value of its liabilities. Therefore by holding more longer-dated gilts, and index-linked gilts, pension funds can reduce the possibility of a mismatch arising between the value of their liabilities and assets.
In the left-hand chart, we present long gilt and index-linked gilt yields since 1990. The shaded area represents the period when the MFR rules really started to bite. As we can see, the demand for long-dated government bonds as these rules came into force was one of the key factors that drove yields down so sharply.
Now the MFR is passing into history, will there be a wholesale collapse in the demand for UK government bonds as some have claimed? The answer is almost certainly not. We spoke to a number of actuarial consultants about this possibility. They emphasised that for the majority of their clients, the MFR is not really a binding constraint any more. In other words, more than six years after the introduction of the rules, pension funds no longer feel compelled to increase gilt and ILG weightings because of this rule. MFR or no MFR, it seems likely this proposal will not precipitate a wholesale sell-off of gilts and index-linked bonds.
The Government's Green Paper also outlines proposals to reduce the inflation cap on pension benefits from 5% to 2.5%. This move means pension fund assets will require less inflation protection than in the past. This proposed change has led to claims pension fund demand for ILGs will fall as, under the proposal, their inflation-related liabilities would also fall. This seems at first to be the obvious conclusion. However, we believe it to be wrong for two reasons
First, pension funds still have substantial inflation-linked liabilities, accrued since 1997, that are capped at 5%. Should the change to 2.5% be implemented, it will not be applied retrospectively. Instead, it will be applied to benefits accruing after 2005, which means a substantial proportion of liabilities will still have an associated inflation cap of 5%.
Second, while it is true an increasing proportion of liabilities would have an associated cap of 2.5%, this is unlikely to influence linker demand significantly. Our discussions with actuaries reveal that 40%-75% of pension fund liabilities are RPI-linked in some way. A significant proportion. According to the Russell Mellon CAPS and WM surveys of pension fund holdings, shown in the left-hand chart, the average pension fund weighting in index-linked gilts is around 10%, well below the proportion of RPI-related liabilities.
From a purely matching perspective then, UK pension funds are significantly underweight in this asset class. Given the current trend among trustees to hold assets that more closely match their liabilities, there will be plenty of demand for index-linked gilts for some time, despite this change to the indexation cap. Indeed, because of this trend, the demand for ILGs is more likely to increase than fall over the next few years.
The Government has also announced its intention to set up a Pensions Protection Fund (PPF). Under this proposal, pension schemes would all make a small contribution to this fund. The purpose of the fund would be to guarantee existing pensioners receive 100% of their pension benefits and current workers receive 90% of their accrued benefits, in the event of any sponsoring employer becoming insolvent.
Some commentators have suggested the PPF would give pension trustees the confidence to increase the proportion of equities held in their funds. This way, the deficits in their schemes would fall more rapidly if equities recover significantly. If equities collapse in the future causing the scheme to become hopelessly insolvent, the PPF would pick up the tab. However, in our view, scheme consultants will be advising trustees not to read the proposal in this way.
Secondly, the Government is proposing that scheme donations to this fund be related to the assets held in the scheme. That is, a scheme with riskier assets, like equities, should make a higher contribution to the fund than an equivalent scheme holding a higher proportion of lower risk assets, like gilts.
In our view, the PPF as currently proposed will not be seen by trustees or their advisers as a green light to pile back into equities when it comes into force.
On the surface, the abolition of the MFR rules, the scrapping of the 5% pensions indexation cap and the creation of the PPF look to be government bond negative and equity positive. However, in practice, we feel the pension fund preference for fixed income over equities is likely to continue and, if anything, is likely to be reinforced by another of the Green Paper's proposals. This is the proposal relating to the voluntary wind-ups of Defined Benefit (DB) schemes for solvent firms.
Under the proposals, any solvent sponsoring company wishing to wind up its DB scheme will have to do so based on the full buy-out cost, a cost sufficient to guarantee all the benefits accrued in the scheme to pensioners and non-pensioners.
Although not yet announced, the basis of the buy-out calculation is likely to be similar to the liability valuation rules used in FRS17. These require liabilities to be valued using yields on AA-rated sterling corporate bonds and, as such, the massive pension fund demand for higher quality corporate bond assets over the past two years has been at least partially driven by FRS17.
Even though most companies could not afford to wind up their schemes on the basis required, some may be able to. The best way to prepare for this wind-up is to increase corporate bond weightings. For those who will not be able to afford the wind-up under these conditions, a line in the sand has been drawn.
If their intention is to engineer a situation whereby they can afford to wind up their schemes, their investment preference will be for high quality sterling corporate bonds, which will act as a long-term support for this market.
While the Green Paper may not necessarily be as government bond negative and equity positive as some have claimed, if we dig deep into the proposals, they will continue to support, and probably increase, pension fund demand for corporate bonds when they come into effect.
The MFR is being scrapped but this will not lead to a collapse in demand for government bonds.
Pension funds will require less inflation protection than in the past but demand for index-linked gilts should hold up.
The proposed Pension Protection Fund will not lead to a shift to equities.
The proposed rules on the voluntary wind-up of pension funds could lead to an increase in support for government bonds.
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