Estimated reading time: 5 minutes
In a couple of months’ time we will be nearer the next English and Welsh Local Government Pension Scheme (LGPS) valuations due in 2022 than the last one in 2019. As ever, time flies but the events of the first half of 2020 and the resulting investment market volatility will be remembered for a very long time. I doubt anyone reading this will ever forget it!
Funding ongoing defined benefit pension promises is a long-term business and actuarial models need to be long term to produce sensible valuations. With so many reasons to carry out valuations these days and the move over the last 20 years to shorter term market related models, it’s times like these that will test actuarial models to see if they are delivering sensible, long-term valuations amidst all the short-term volatility.
Changes in asset values
Firstly, let’s looks at what’s happened to assets since 31 March 2019.
In the chart above we have compared projected assets (based on our 2019 valuation assumptions) against estimated actual assets (based on market returns). So, not unexpectedly, equity returns and total asset returns were negative for the year to 31 March 2020. This was perhaps not as bad as expected though, thanks to some strong returns in the first three quarters before losing around 20% in the first three months of 2020, when the pandemic hit the western world. However, since March, equities and total assets have bounced back to above where the 2019 valuation would have projected them to be.
Examining the effect on LGPS funds
We know, however, that that the range of returns for LGPS funds varied considerably in the twelve months to 31 March 2020 - and most funds were probably in the zero to minus 10% return range with the average around minus 5%.
The following chart shows the change in asset values for a sample of our LGPS funds.
Source: Barnett Waddingham
Of course, it’s not just all about the assets. We also have some liabilities to consider to understand how we might value them. The discount rates underlying most actuarial models in the LGPS are based on underlying yields of various asset classes; usually gilts, bonds, equities or a combination, or some margin above assumed future CPI inflation.
Changes in yields and forward inflation
In the accounting world of course it’s all about corporate bond yields on one particular day of the year. Having churned out hundreds of accounting reports as at end March, more often than not it was a case of “you’ve managed to lose some assets but don’t worry, your accounting deficit has reduced.” This apparent paradox was primarily due to a reduction in future inflation expectations compared to twelve months earlier and a big hike in bond yields in the second half of March 2020 back to where they were twelve months earlier.
The following chart shows how yields changed between March 2019 and March 2020.
What about the funding level?
So accounting numbers had a bit of a story. But it’s also important to look at the numbers that matter; the ongoing funding position.
Below we show how a typical fund faired under three ongoing models. We assume the fund was 90% funded under all three models as at 31 March 2019 and look at the change in funding position since then.
As we see, the CPI Plus and Gilts Plus models exhibited large falls and massive volatility in funding levels in March 2020 before bouncing back; gilts more so than CPI as gilt yields fell to earth as the pandemic unfolded. The Barnett Waddingham best estimate minus model, where asset values are smoothed and the discount rate reflects the underlying investment strategy and smoothed changes in underlying yields rides out the storm, keeping funding levels much more stable.
In terms of total employer contributions then, we had the following.
Again, we see massive volatility in March 2020; within the space of only a few days, the total contribution rate under the Gilts Plus model was showing fluctuations of up to 7% of payroll. This makes for some exciting charts!
English and Welsh funds who use the Gilt Plus or CPI Plus models will be glad they had their valuations in March 2019 and not March 2020. However Scottish and Northern Irish LGPS fund valuations are as at 31 March 2020. The combination of market uncertainty and volatility will result in this being a challenging time for CPI Plus and Gilt Plus models. They will also need to consider whether to allow for the positive post valuation changes in market conditions and, if so, how much. One minute you have a reasonably significant deficit requiring extra funding and the next minute you don’t. Where do you draw the line?
The perils of predicting too far ahead
None of this is easy. Making long-term decisions amidst short-term volatility can be challenging unless you just ignore the model output! Whilst our model managed to ride out the storm (as expected) there are still challenges ahead.
One challenge we have with our model is that one of the inputs is the dividend yield from equities. This market statistic is essentially dividends received in the previous twelve months divided by current market prices. As we know, many UK companies have either reduced or suspended dividends or are planning to. Dividends are normally paid twice a year so the market yield will not reflect a full year’s worth of reductions or suspensions.
So the current published yields are not a great indicator of future dividend yields, at least in the short term, and we expect them to fall as the full impact of suspensions or reductions works its way through the numbers. These days, however, our model is based on global rather than UK equities. But we still anticipate a reduction in global dividends, albeit less than we expect to see in the UK. Therefore, we could see a fall in discount rates which would result in an increase in the value of the liabilities.
In my next blog I will look at this in a bit more detail and what impact this could have on assumed future equity returns, funding positions and employer contribution rates.
If you would like to talk about this topic, please get in touch with your usual Barnett Waddingham contact to find out how we can support you. Alternatively, please contact me below.
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