BAE actuarial switch sidesteps funding slump

The defence and aerospace giant recently declared a £2.1bn actuarial deficit across its nine schemes, as of March 31 2017, leaving its funding level broadly unchanged since the last triennial valuation.

The results contrast with the wider DB universe, where funding positions have worsened significantly over the past three years. By its own funding measure, the Pension Protection Fund found that the aggregate deficit increased from £39.3bn to £226.5bn over the same period.

The value of pension liabilities doesn’t depend on the expected returns of the assets a fund happens to hold... just like my mortgage doesn’t shrink if I buy equities

John Ralfe

BAE’s own accounting deficit has increased by 24.5 per cent over a similar period, standing at £5.61bn at June 30 2017. In January the scheme held about 21.4bn in assets.

BAE is currently contributing around £205m annually to its UK schemes. The valuation change is at least partly responsible for a reduction in scheme liabilities. Contributions will rise to around £220m in future, matching any increase in dividends paid.

Expected returns behind new measure

Actuaries working for the nine BAE defined benefit schemes have now adopted an “asset-led” valuation system, where liabilities are discounted based on the expected returns of the assets held by the schemes.

In contrast, the ‘gilts-plus’ methodology, which is common practice in the industry, discounts liabilities based on the yields available on gilts, often referred to as the risk-free rate of return. In recent years, deficits have ballooned as gilt yields have fallen.

Both methodologies aim to produce an estimate for the returns that the scheme will be able to achieve over the period until liabilities fall due, with a margin for prudence, and can often produce similar results.

However, experts said a growing number of schemes are seeking to mirror BAE’s shift, in recognition of the fact that a large proportion have no desire to transfer liabilities to insurers, and therefore no fundamental need to hold gilts in their portfolios.

Explaining the change, a spokesperson for BAE said: “More than 50 per cent of our assets are invested in equities and property… we’ve come to the conclusion that linking to gilts doesn’t make much sense for us.”

The spokesperson said that for each of the changes to its nine UK DB schemes, the company confirmed and agreed its approach with the Pensions Regulator. BAE declined to disclose the discount rate it had used or the change in rate from the previous valuation. The group said a slowdown in longevity improvements had also helped to reduce its overall pension liability.

BAE’s schemes still have active members, which along with an uptick in inflation would put upward pressure on their liabilities.

An end to scheme bond-buying

Breaking the link to gilts has been viewed as a crucial step by some in the pensions industry. Henry Tapper, business development director at First Actuarial, welcomed the regulator’s approval of the decision, adding that the move will benefit both members and shareholders.

“Provided BAE Systems has no intention of closing, in which case the gilts-type approach is sensible, valuing the scheme’s liabilities in relation to the assets as they have chosen to do is entirely appropriate,” he said.

If DB schemes are aiming to buy out their liabilities in the near future, they are likely to reduce volatility in their funding level by investing in the fixed income assets used by insurers.

Schemes that do move to an asset-led approach are likely to see a significant improvement in their funding level if they are invested in growth assets.

First Actuarial’s best estimate index, which reflects the actual investments held by schemes, found that schemes have an aggregate surplus of £316bn and funding level of 126 per cent at the end of October.

The company recommends that trustees set funding assumptions at a point between the best estimate level and the buyout level, dependent on the covenant of the sponsor.

More schemes could invest for growth

A move into positive funding levels will not bring back the UK’s open pension schemes, Tapper said, but will allow them to invest for growth, and retain the link between employer, trustee and members. In its latest Purple Book, the Pension Protection Fund found that bond-buying has hit another record high.

If pension schemes adopt a liability measure that is not sensitive to gilt yields, they will not have to invest in gilts or other liability-driven investments, and should be able to access a wider range of assets, including real assets.

Tapper said several schemes were seeking to up their investment in illiquid ‘patient capital’ assets.

“It’s encouraging to see a large number of schemes saying roughly the same thing,” he said. “It would suggest that we may have reached a turning point.”

Is it just an actuarial trick?

For all the deficit reduction brought about by BAE’s new funding methodology, the underlying nature of its pension promises and the assets held to meet them has not changed, leading some to question the merits of such a move.

“Has BAE pulled off the trick of shrinking its pension liabilities simply by ignoring the economics of pensions?” asked John Ralfe, an independent pensions expert.

AA bond yields with the same cash flows as the scheme should be used to value a scheme’s liabilities, because liabilities “have the same value as the market value of a bond portfolio with the same cash payments, the same timing and the same certainty as the pension promises”, Ralfe said.

“The value of pension liabilities doesn’t depend on the expected returns of the assets a fund happens to hold – the liabilities don’t go up if it moves to bonds or go down if it moves to equities,” he added. “Just like my mortgage doesn’t shrink if I buy equities.”

Ralfe argued that a gilts-plus approach often diverges from these underlying pension economics in exactly the same way, because the “plus” feature often brings the discount rate above what could be achieved using AA-rated corporate bonds.

Self-sufficiency driving shift

Nonetheless, an increasing number of schemes are queuing up to make the switch to asset-led valuations, with the blessing of the Pensions Regulator, according to Paul McGlone, a partner in Aon Hewitt’s retirement practice.

Where the regulator has previously been prescriptive on the funding methodologies used by schemes, it now gives schemes and actuaries greater freedom, as long as those measures are prudent, suited to the scheme’s long-term goals, and clearly documented.

“We are seeing a number of schemes looking at whether gilts plus a margin is still the right way to think about what return they might get in the future,” said McGlone.

McGlone said the decision to change valuation methodology should hinge not just on the assets currently held by the scheme, but also the assets the scheme intends to hold in the longer term.

For example, a scheme that intends to complete buy-ins and buyouts with insurers may get better pricing if it holds gilts and other bonds at the point of transaction, so a gilts-based valuation will be a suitable measure of progress towards that goal.

However, said McGlone, “if you’ve got no intention of holding gilts… then basing your expectations of future returns on an asset class that you don’t hold is somewhat flawed.”

He added that some schemes have been allowing changes in gilt yields to impact their discount rates but have retained the same ‘plus’ margin without assessing how their assets are performing relative to gilts, a practice he called “completely lazy”.

For those schemes that are able to reduce their sensitivity to gilt yields, the benefits could be significant. McGlone highlighted that while schemes would still have to hedge out inflation risks, traditional liability-driven investment would no longer become necessary.

“Suddenly the world opens up into what else you can do with [those assets],” he said.