Schemes should make the discount rate a function of the investment strategy rather than vice versa, says JP Morgan Asset Management’s Sorca Kelly-Scholte.
At the heart of this debate is the collision of two contrasting philosophies as to the purpose of assets held by pension funds.
These are: a finance-led philosophy assuming assets are intended to generate long-term return to part-finance the liabilities; and a collateral-led philosophy assuming assets are intended to secure pension liabilities with high-quality, low-risk assets.
It is clear that for maturing pension funds that are gradually turning into annuity books, collateralisation – or securing the cash flows at a reasonable price – is the ultimate goal
Much of our DB system was built on a finance-led philosophy. Pension funds, as long-term investors, were deemed able to ride out shorter-term volatility in order to capture long-term returns and finance member benefits.
This philosophy dictated that investment returns were the primary objective, with occasional checks and balances to ensure the plan was on track to finance the liabilities.
Funding levels were measured by discounting the benefits at the expected long-term rate of return, often smoothed through time.
But the hardening of the guarantees attached to pension promises, the increased maturity and size of pension liabilities, and increasing regulatory and accounting pressure has brought a collateral-led philosophy to the fore.
Under this belief system, benefit promises are considered a form of insurance and should be fully funded and collateralised, much as insurers collateralise their guarantees.
Liabilities should be priced by reference to the cost of collateralising them, or equivalently by discounting the benefits at the yield available on matching bond assets.
The two philosophies coexisted reasonably happily for a time, with pension funds allocating a portion of their assets to collateralise the liabilities via liability-driven investment programmes, retaining a portion in long-term growth portfolios to finance the liabilities that have not yet been secured, and laying down plans to progressively collateralise the liabilities as target investment returns were achieved.
All of this was framed by the ‘gilts plus’ approach to valuing the liabilities – a sort of half-way house between the two philosophies which allowed for the journey from finance-led to collateral-led by gradually reducing the ‘plus’ part of ‘gilts plus’.
Divergence in beliefs
The extraordinary financial conditions of recent years have driven a wedge between finance-led and collateral-led approaches, and destabilised the strategies that sought to balance the two perspectives.
The cost of collateralising assets – principally sovereign debt and related derivatives – has increased rapidly, with interest rates in precipitous decline across the globe.
Returns from growth assets have been unable to keep pace with the rises in the prices of bonds that pension funds seek to match the liabilities.
This has taken the affordability of implementing a collateral-led philosophy beyond the reach of most pension funds for the foreseeable future, and progress along glidepaths to full collateralisation has been achingly slow.
Pension funds are being timed out of finance-led approaches, but cannot yet afford to fully collateralise.
It is clear that for maturing pension funds that are gradually turning into annuity books, collateralisation – or securing the cash flows at a reasonable price – is the ultimate goal. Obvious candidates are assets that deliver a cash flow throughout their life in a stable way.
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Certainly high credit quality government debt is one of those, but it extends through to credit and then to spread sectors like emerging market debt, a lot of which is actually investment grade-rated, and goes through to high quality loans and private credit.
It further extends to real assets which are defensive in nature, such as core real estate and infrastructure, ground lease rent, and other forms of secure income streams.
This discount rate can then be explicitly linked to the investment strategy by looking at the default-adjusted yield available on the assets held. Under this system, the discount rate is a function of the investment strategy.
By contrast, under a ‘gilts plus’ approach, the investment strategy is often driven by the choice of discount rate, creating built-in incentives to maximise the allocation to gilts and related instruments, no matter what the price.
The question we must answer in determining how to measure funding is whether we are managing to the measure, or measuring our management.
Sorca Kelly-Scholte is head of EMEA pension solutions at JP Morgan Asset Management
