Don’t overreact to vast pension scheme deficits: We need a new normal for how they’re measured

Pension schemes are faced with serious challenges following the EU referendum result and the Bank of England’s recent stimulus package.

Both events have driven down long-term gilt yields. As a result, for defined benefit pension schemes valuing their liabilities using gilt discount rates, deficits continue to grow. Our Skyval Index shows that deficits have increased by £100bn over the last month alone, with the total defined benefit deficit standing at £700bn, on a measure used by pension fund trustees to assess the cash contributions required from their company sponsors to cover liabilities.

That cash funding measure is typically calculated with reference to gilt yields. In reality, however, pension liabilities are mainly affected by inflation and longevity. Given the current unprecedented expectation of lower yields for longer, pension trustees and sponsors should revise their approach to valuing their scheme liabilities.

The fundamental question all pension schemes should ask is whether gilt yields are still a relevant reference for them when it comes to measuring deficits. In many situations, this won’t be the case. Unless a pension scheme’s asset strategy is directly or indirectly mainly exposed to gilts, or there is the prospect of a transaction where a third party will use gilts or similar financial instruments, there may be more appropriate valuation measures for the scheme. There need not be a one-size-fits-all approach.

As such, pension trustees and company sponsors should not over-react to the large deficit numbers they see in the headlines, whether for their own funds or for the industry generally. Figures showing deficits being in excess of £1 trillion assume that the majority of pension funds look to buy out their liabilities with insurers. This is a hypothetical scenario which does not reflect the reality of how most pension schemes will be managed over the next few years.

Pension decision-makers should understand the assumptions which sit behind any analysis presented to them around pension risk or deficits. Having a tailored valuation measure in place will give a more realistic assessment of the pension deficit situation. Transparency is critical to avoid inappropriate decisions and reactions.

So what is the alternative to gilt yields? Pension trustees and company sponsors must first define the strategy for managing the pension assets and liabilities. Then, they can choose the most appropriate method for both measuring and repairing the deficit. There are diverse strategies available, including asset portfolios which are not primarily dependent on gilts, but where the income generated from the assets held broadly matches the liability cashflow to be paid out by the pension scheme, at least over the medium term.

Of course, the source of the problem could be redefined too. There are plenty of options to reshape liabilities. This can be done in ways which pension fund members choose and find valuable, while at the same time reducing risk for the pension fund itself. Examples include swapping some future pension, or pension increases, for higher up-front payments.

Just as markets are now in a “new normal”, we need a new normal for how we deal with pension deficits.

Pension funds are complex and solutions don’t happen instantly. But as the pensions challenge is likely to be with us for at least another decade, there is time to act – although early movers will benefit the most from their actions.