By Craig Wootton
Discount rate methodologies are likely to be the main focus of many scheme funding advice papers this valuation season.
For a long time the dominant method to derive a funding discount rate has been to take the market yield on gilts and add a margin that balances asset outperformance, the need for prudence and sponsor strength (the “gilts plus” method). For many years the Regulator required that the margin should only reflect these factors and not market conditions and cycles.
But with gilt yields dribbling along at all-time low levels, and with new flexibilities in the Regulator’s code of practice on scheme funding, trustees are now likely to be advised on many alternative methods or at the very least to take another look at the size of their “plus” margin.
I have recently drafted advice to trustees on funding discount rates and have highlighted alternative asset-based models, such as an “Inflation plus” method (for a scheme that is 100% invested in Diversified Growth Funds for the foreseeable future), and a model for equity returns (based on dividend yields, inflation and real growth), in an attempt to better reflect the future outlook for growth assets. This advice is tailored for each employer (avoiding a “one size fits all” method) and helps the trustees make use of the flexibility available for setting the discount rate highlighted in funding guidance.
At the same time I have been following the main sporting news story of the fortnight (i.e. the corruption allegations within FIFA – world football’s governing body – and the highs and lows of Sepp Blatter as its president), and I couldn’t help but notice the similarities between the undisputed ‘Golden Boot’ of discount rate methodologies, “gilts plus” (with a non market related premium), and football’s (former) farcical frontman:
For many years both “gilts plus” and Mr Blatter have remained firmly in command. But throughout their time at the top, both have endured increased scrutiny and criticism. Critics of “gilts plus” will say that for many schemes (especially those which hold a small proportion of gilts) the method does not appropriately reflect the investment strategy of a scheme and is an inadequate proxy for estimating the returns on non-gilts assets. It therefore leads to volatile funding positions, phantom deficits and increased and potentially unnecessary calls for cash on scheme sponsors.
Also, “gilts plus” could mean double-trouble for funding levels in times when there is a crash in equities or a widespread collapse in the value of growth assets. Investors will generally run to safe bond-type investments, gilt yields will fall and liabilities will rise, exacerbating the fall in asset values. But if trustees adopt an asset return model based on dividend yields, this could act as a natural stabilizer; a dip in growth asset values will increase dividend yields (at least in the short-term), which would lead to a fall in liabilities, dampening the fall in asset values.
But despite the unfavourable comments from disapproving parties, both “gilts plus” and Blatter not only survived, but they thrived with a large crowd of fans in their respective arenas. Regardless of Mr Blatter’s recent resignation, throughout his career he fended off intense pressure and criticism and won five presidential elections.
Likewise “gilts plus” has survived, despite pressure from scheme sponsors, perhaps because there has not been enough exploration of the credible alternatives.
This could have been for a number of reasons; trustees may want to maintain consistency with their last valuation, or they may feel it suitably reflects their long-term investment de-risking plans. Also; if “gilts plus” remains the most popular discount rate method then many trustees will not wish to take a contrarian view, especially given the Regulator’s continued obsession with benchmarking everything to “gilts plus”.
But what does the future hold? The final whistle has blown for Mr Blatter and he has finally hung up his boots, but will we see a similar revolution in valuation discount rate methods? Trustees have certainly not shown “gilts plus” the red card just yet, but with increased requirements for integrated funding strategies and better informed trustees making more objective decisions, there are certainly more players in the squad to consider.
Craig Wootton is a principal and actuary at Punter Southall
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