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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions Board news


The Bannerman Case (Royal Bank of Scotland v Bannerman Johnstone Maclay) has successfully stirred the disclaimer pot and auditor circles are naturally taking a close interest in the recent Appeal Court judgment. Meanwhile – and as nothing can really be done until the House of Lords has come to a conclusion – the Pensions Board is watching and thinking about the issues it raises for actuaries.

Pensions actuaries – conflicts of interest

The board wishes to draw members’ attention to the increased scope for conflicts of interest in the current environment. This arises both as a result of the increasing desire of some companies to reduce their pensions commitments, and as a result of the government announcements of draft changes to the winding-up legislation and further changes to come in 2005.

Our professional conduct standards (PCS) set out clear principles in Section 5. Members must always consider whether it is improper to give advice to one or more clients involved in a conflict or an apparent conflict. Further, clients must be notified of the conflict at the earliest opportunity.

There is a statutory duty which applies equally to a scheme actuary and to a professional adviser (see the Scheme Administration Regulations 1996, Regulation 5, and also A1.1.1 et seq of GN29) to agree in writing that he or she will notify his or her trustee client of a conflict, immediately he or she becomes aware of its existence.

The board is currently giving this issue a high priority and will consider what further information and guidance can be given to members in due course.

Essentials of corporate bonds for pensions actuaries

To help build awareness of the investment issues for pension funds in relation to corporate bonds, a paper has been produced by a working group set up by the Pensions Board. The paper was designed for actuaries working in pensions who wish to increase their knowledge of this important part of the investment market but it may also be of more general interest. The paper itself is available on the profession’s website and this article highlights some of the more distinguishing features of corporate bonds.

The first point is that the term ‘corporate’ is a misnomer. It is loosely used in the UK to describe any bond that is not guaranteed by the UK government. While some of them are issued by companies, many are not, and they tend to fall into one of several categories, including foreign government and multinational agencies which accounts for about one third of the market value.

Most corporate bonds, including those issued by governments, are rated by the credit-rating agencies. These ratings help investors to assess the default risk and therefore an appropriate yield margin over some reference yield. But it is supply and demand in the market that will determine the actual margin at any time. Historically, the reference yield was a gilt of the same duration but, more recently, market convention has gravitated towards the swap market as a point of reference.

After issue, a bond’s price fluctuates with the general level of interest rates for its duration and with changes in its perceived default risk. There is ‘rating drift’ in the market with bonds tending to slip down, rather than up, the league table over time. The chart above shows the average percentage of ratings moved up or down by one or two notches in the course of a calendar year, based on Moody’s database for the US and Europe from 1985 until 2001. More detailed figures are included in the paper. One of the key features masked by the chart shown here is that the degree of rating changes is inversely proportional to the quality of the rating at the start of the year. For example, just under 90% of the highest-quality bonds retain their rating during a year, whereas at the low end of the scale, fewer than 50% do, although a significant number at that end improve rather than deteriorate. Investors need to be alert to such changes, as the market price of a bond will tend to fall in anticipation of a cut in the rating as well as when it is announced.

The possibility of corporate bond default marks these investments as having downside risk characteristics similar to equities. In practice, default does not necessarily involve total loss and the paper illustrates the average amount historically paid out in such cases. However, a key point for investors is that, unlike equities, there is no unlimited upside potential. The yield margin may contract if the perceived default risk lessens and investors selling before maturity might benefit from this. But the upside potential is constrained by downward movements in the reference yield.