These are huge numbers, but many believe they have been artificially inflated by the central bank’s suppression of gilt yields. As a result, there is consensus the gilts-plus model has become compromised as a prudent approach to valuing scheme obligations. But rules are rules and, as consultancy Punter Southall estimates, about 90% of schemes currently use the gilts-plus approach to valuing their liabilities.
The Pensions Regulator (TPR) actually allows both approaches to funding. The watchdog’s July 2014 Code of Practice on funding, states: “The rates of interest used to discount future payments of benefits must be chosen prudently, taking into account either or both: the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns; and the market redemption yields on government or other high-quality bonds.”
TPR unofficially favours the gilts-plus approach because the regulator plays a key role in protecting the pensions safety net, the PPF, from taking insolvent schemes under its wing. The gilts-plus model is therefore in place as a safety measure because the insurance companies that would ultimately insure the liabilities of struggling schemes price their buyouts on gilts.
Speaking to portfolio institutional last month, TPR executive director for regulatory policy Andrew Warwick-Thompson said it was important for schemes to distinguish between valuations on a buyout basis and those done on a scheme-specific basis, both of which are valid methods for discounting liabilities.
He said: “A valuation which is done on a buyout basis, which is the basis often quoted in the media, is calculated on a gilts basis because that’s how insurance companies price buyout contracts… This idea that a scheme-specific valuation has to use gilts only is just not true.”
COVENANT: A DECIDING FACTOR
Schemes might have the choice of how they value liabilities, but in many cases the approach to funding will be dictated by sponsor covenant strength.
Generally speaking, for those with weaker employer covenants, or trustees looking to secure a buy-in or buyout, a gilts-plus approach tends to be the norm because insurers’ annuity prices are based on gilts. The same can be said for schemes with liability driven investment strategies in which the assets move in line with gilt yields.
Schemes with stronger covenants meanwhile, tend to use the asset-based approach because they are better funded and less likely to want to buy out with an insurer.
