Phil Hardingham and Keith McInally discuss linking scheme funding valuations to the cost of CDI assets, and what prudence looks like in this context
For a defined benefit pension scheme following a cashflow-driven investment (CDI) strategy, selecting the discount rate to value the liabilities for funding purposes requires special considerations.
If the scheme chooses a generic fixed expected return assumption for the discount rate, fluctuations in the credit spread (the difference in yield between the risk-free rate and the assets actually held) will cause the funding level to be unstable. However, while an increase in the credit spread may increase the deficit, this can be an unhelpful signal if the underlying cashflows are still expected to be sufficient to pay all benefit payments as they fall due.
Forming an explicit link between the cost of CDI assets and funding benefits provides more clarity to the trustees and sponsors. This may codify a more informal arrangement where the scheme actuary considers the prevailing credit spread on assets held when proposing a funding basis at an actuarial valuation.
Cashflows or spreads?
Credit-based buy-and-maintain strategies provide a set of promised cashflows that can be broadly tailored to match a liability profile at a lower cost than an equivalent set of government bonds (gilts). The credit spread is a handy way of reflecting this benefit and enables comparison of ‘value’ for fixed-income assets of different durations.
There are two main options for explicitly linking these investment approaches to the funding basis. We can carve out a set of liabilities that are well matched to the CDI cashflows and assign them the value of the CDI assets; this is how buy-ins are often accounted for. Alternatively, we can derive the credit spread on the CDI assets and allow for this within a ‘gilts+’ type discount rate, which raises the issue of how to allow for prudence.
“Actuaries have the flexibility to consider the best approach for prudence on a case- by-case basis”
Prudent discount rate
Part of the excess yield over gilts is compensation for credit risk (either from default or sale at a loss before maturity).
The gross redemption yield assumes that all promised cashflows will be paid, which is the maximum possible yield. A reduction (or ‘haircut’) should be made to allow for expected defaults to derive a best estimate, and a further haircut made for prudence.
Actuaries have the flexibility to consider the best approach for prudence on a case-by-case basis. There are several different options, with a range of complexity. Two of these are:
- Reducing the observable credit spread by a fixed percentage. This has the advantage of being easy to calculate, transparent and dynamic to movements in credit spreads. However, it is not term-dependent; the same haircut would be applied to short-dated and long-dated bonds, whereas in reality a longer-dated bond has more potential for downgrades over its life.
- Referencing haircuts published by the European Insurance and Occupational Pensions Authority (EIOPA). An alternative approach is to take inspiration from the insurance industry, where haircuts are applied based on EIOPA’s published rates (fundamental spreads). These rates reflect market experience and are term dependent and updated monthly. However, insurers treat these haircuts as ‘best estimate’ and then hold additional capital for prudence.
Pension schemes have no additional capital buffer, so prudence must be allowed for through the liability discount rate. One option is to treat all assets as if they were one or more credit notches below their rating for EIOPA purposes. Some insurers use a similar approach for private credit assets.
The scheme may also want to consider how to allow for prudence with regard to future fixed-income purchases. The risk is that these assets will be more expensive than at present, implying a lower yield. To allow for this possibility in the discount rate, one option places more weight on long-term average credit spreads than on current spreads.
There are other practical questions that need to be resolved when setting a CDI strategy.
Which credit spread?
Is it preferable to use the credit spread of the asset actually held, or a reference credit index? Using actual assets requires there to be a strong governance framework between the scheme actuary and the investment adviser, as the investment allocation will drive the strength of the funding basis directly. It will also necessitate the calculation of the credit spread (after haircuts) before the funding position can be estimated, which introduces complexity in the funding monitoring process.
Using a reference credit index is simpler, but this introduces a basis risk to the extent there is a mismatch between CDI assets held and the index.
What about residual interest rate risk?
Given that benefit payments are typically long-term and inflation-linked, pension scheme liabilities are sensitive to long-term interest rate and inflation expectations alike. Schemes typically hedge some or all of their interest rate and inflation risk using liability-driven investment (LDI) – in other words, they hold assets that offset the sensitivity of the liabilities to these risk factors.
For schemes following a CDI strategy, there are some associated challenges and trade-offs to navigate. Is the hedge predominantly designed to reduce balance sheet volatility, or to improve the match between asset cashflows and expected benefit payments? Is the scheme hedging on the credit-based funding basis, or on a more traditional gilt basis? Can we credibly monitor the interest rate and inflation exposure of highly illiquid assets that are infrequently priced?
There are benefits and drawbacks around using a credit-based or a gilts-based hedging basis when following a CDI strategy. The most appropriate solution will be scheme specific, but care should be taken to avoid constructing a hedging framework that leads to excessive trading and hedge rebalancing.
As with all scheme funding, sponsor covenant is key. In the context of CDI, it may be appropriate to ask:
- Are there particular economic drivers that the sponsor is vulnerable to? Is it possible to tilt away from such risk factors in the CDI construction process to increase diversification between the robustness of the investment strategy and sponsor strength?
- To what extent should the strength and visibility of the sponsor covenant drive the term and liquidity of assets held?
- Should covenant strength drive the haircuts applied for prudence?
One drawback of a long-term CDI strategy is that in the event of sponsor default, any illiquid assets may need to be sold at a discount. Under this scenario, if scheme assets are used to secure whatever level of benefits is affordable with an insurer (assuming this is above the level offered by the Pension Protection Fund), transaction costs of illiquid assets will directly hit the value of benefits ultimately received by members. Going forward, the emergence of consolidators may ease this risk to a degree, if they can take a greater proportion of these assets in specie under this type of stressed scenario.
Phil Hardingham is senior risk modelling consultant at Hymans Robertson
Keith McInally is a senior solutions director within the Pension Solutions team at abrdn
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