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The Actuary The magazine of the Institute & Faculty of Actuaries
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Pensions risk open forum

The next Actuarial Profession open forum, ‘The influence of pensions risk on equity and bond prices’, takes place at Staple Inn on Monday 5 July 2010. This forum is open to actuaries interested in developing practical knowledge from cutting-edge research projects by Imperial College Business School alumni.

It will be of interest to practising pension actuaries and finance investment practitioners. The informal style should result in some good discussion while showcasing the calibre of actuaries who pursue the Imperial pathway to qualifying.

As an actuary and the programme director for the MSc Finance at Imperial College Business School, I am proud of the research contribution the programme affords the profession. The open forums provide a perfect opportunity for this practical and commercially valuable research to be disseminated in a way that is accessible and relevant to practising actuaries.

The speakers at this event reflect a programme that develops actuaries who have the capacity and skills to tackle the big questions. Ruth Loseby, research manager for the Profession, says: “We are looking at finding new ways of getting the important research done at universities back to the Profession’s members as CPD. It is great that the Finance and Investment practice areas have worked with Imperial to pull together this open forum. I hope it will be the first of more such collaborative events.”

The forum will be chaired by Paul Sweeting, the current chairman of the Finance and Investment Practice Executive Committee, and the speakers will include Louise McCarthy of Towers Watson, Adam Gregory of Mercer and Paul Nicholas of Hewitt Associates who conducted the research strands shown opposite.

Corporate bond spreads, equity volatility and pension schemes
Louise McCarthy investigated the impact that a number of relevant variables had upon the difference between the rates of return on corporate bonds and gilts, explaining the existence and components of this corporate bond spread in the UK. Her results were drawn from panel data regressions run over a five-year period, 2003-2007, using UK FTSE350 information. Louise investigated 394 corporate bonds (around 15,000 monthly observations).

The results indicated that the investigated variables explain about 30- 40% of the spread seen in corporate bonds, suggesting that other factors such as market conditions and illiquidity premiums must play an important role in determining corporate bond spreads.

The majority of factors included in the regression returned results in line with expectations under the Merton model in terms of significance and direction of their impact on the spread. Interestingly, over the period of study, the effect of pension scheme funding was shown to be inconclusive, suggesting that pension fund deficits were valued differently in the market (for example, on another economic basis, ignoring the implicit salary assumption) or had not been valued at all, which could suggest default risk is higher than the bond pricing implies.

Pension liabilities, credit spreads and corporate bond returns
Paul Nicholas looked at the now-familiar problems of large pension funding shortfalls in the UK’s biggest companies, which are draining cash in already difficult times. During Paul’s time advising trustees and sponsors of defined benefit (DB) schemes, he had become interested in questions such as ‘do pension liabilities pose a real threat to the survival of these companies?’ And, if so, ‘do market prices of equity and debt anticipate this? How do analysts adjust their views to reflect pension liabilities?’

He investigated how funding shortfalls were seemingly largely ignored by analysts until the arrival of FRS17 in the early part of last decade. He noted that the US was somewhat ahead of the UK in this regard, which was possibly due to the earlier implementation of FAS 87. In 2004, Franzoni and Marin published research that suggested analysts systematically overvalued companies with pension shortfalls and were ‘surprised’ by the negative implications.

Cardinale found that, by 2007, corporate bond spreads in the US reflected the size of pension deficits. However, replicating his analysis for UK bonds led to surprising results to be shared at the forum.

Do equity returns reflect pension risk?
Adam Gregory found that, despite having worked within a pension consultancy for more than two years, he had never stopped to consider at a micro level when and why private DB pension schemes were introduced and why they made sense at the time. From a macro level, he had not appreciated the scale of the pension promises accrued and the impact they were having on many UK companies.

He discovered that the opaque nature of pension accounting laws had led some to conclude that the level of pension deficit was not fully accounted for within the value of firms. This meant that, in effect, the magnitude of pension deficits was being hidden from shareholders. If the size of the deficit was not fully understood, then what chance was there that the risks associated with the schemes were being valued?

He then examined the relationship between overall firm risk and the risks within a company’s pension scheme. In particular, he wanted to help to shed light on whether or not shareholders really do understand what they are buying when they purchase shares in a company with significant risk attached to the pension scheme.

He took as his dataset North American company data from 2002-2007 and removed any companies with insignificant liabilities when compared to company size. The approach was to consider the overall beta of companies. All else being equal, if pension risk was being properly incorporated within company valuations, then share prices would be more volatile (higher beta) if the pension scheme had a significant allocation to risky assets.

The results show that there is a positive relationship between pension risk and overall firm risk, but the relationship is not as strong as it should be.

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Tony Hewitt is the programme director of the MSc Actuarial Finance at the Imperial College Business School and, having practised as a consulting actuary for over 35 years, is passionate about the education of actuaries