As JLT senior actuarial consultant Murray Wright explains: “I have clients that do not use the gilts model but those companies tend to be very big and very strong with very good sponsoring covenant companies. They have more freedom because they are not worried about them going out of business so they are never going to need to buy out their liabilities with an insurer.”
A CORRUPTED YARDSTICK?
For Goldman Sachs Asset Management head of UK institutional David Curtis, gilts used to be seen as the “yardstick” to measure liabilities because of their low risk status, but he believes their use as a discounting tool has attracted controversy more recently because they have been driven to decade-long low yields by QE.
“Has the yardstick become corrupted?” queries Curtis. “Is the yardstick still what it was intended to be? Does it still represent a low-risk rate, or has it become a tool of macro-economic policy? That is where the debate starts.”
Curtis says the gilts-plus method is driving schemes to take action they might not otherwise have taken in the past. That is, they are allocating more to fixed income at a time when it is a very highly-valued asset.
“If you know your portfolio’s cashflows with certainty you would know you can pay those pensions, so why would you discount at gilts if the assets you are going to back them [with] has a higher yield?” he adds. “It is very logical thinking.”
In terms of matching cashflows, Curtis believes schemes should opt for high quality assets because they give a higher degree of return certainty. This includes, for example, investment grade corporate bonds and highly-rated issuers.
“If you are looking outside of investment grade corporate bonds either by credit quality or liquidity, I think it is less likely you would use an illiquid or private asset purely for cashflow matching, but there is still a place for it in the portfolio,” he adds.
THE RIGHT ASSETS
The flaws inherent in the gilts-plus model have driven some schemes to think about adjusting the discount rate based on the expected return of the assets held in the portfolio.
As TPR’s Warwick-Thompson noted when speaking with PI: “That might include some gilts, but it will almost certainly include equities, possibly some property, maybe some infrastructure, some alternatives.”
Indeed, when setting investment strategy schemes would do well to remember TPR’s flexibility over liability valuation which opens up a broad range of interpretation when it comes to asset allocation.
