Corporate bonds provide a good matching investment strategy in a defined benefit pension scheme, says Sathish Umapathy but a new approach to discounting the liabilities is needed
As a defined benefit pension scheme matures and its contributions decline, investment income becomes increasingly important in order to support the benefit payments and minimise the risk of a scheme having to sell growth assets. Corporate bonds offer a natural solution while also providing a spread premium over government bonds (gilts). However, the spread premium can vary over time. Care is needed in the choice of discount rate for the liabilities, in order to ensure consistency between the valuation of assets and liabilities and to avoid volatility in the funding ratio.
Life insurers have long encountered a similar challenge. The approach adopted by annuity writers is to hold corporate bonds on a 'buy-and-maintain' basis and to discount liabilities using the loss adjusted credit spread of their credit portfolio, where:
Loss adjusted credit spread =
market-implied credit spread - expected loss (due to credit rating downgrades and/or defaults)
Most UK pension schemes currently use a gilts-based discount rate for valuing the liabilities, which may include an additional spread inferred from a standard corporate bond index. Applying the insurers' approach would therefore require trustees and scheme actuaries to adopt a revised approach to valuing the liabilities.
Consider a scheme with assets of £85m in gilts and liabilities of £100m, valued using a discount rate equal to the yield on gilts - an 85% funding ratio. Replacing gilts with corporate bonds would generate more yield and thus more future cashflow, and that will be reflected by discounting the liabilities at a higher rate. For example, if the corporate bond portfolio provides a yield of 1.0% p.a. over gilts and expected losses are projected to be 0.25%, the loss adjusted credit spread would be 0.75% p.a. and the funding ratio increases to 92% (see Figure 1).
This approach to valuing the liabilities is particularly beneficial when credit spreads are volatile but underlying credit quality and fundamentals remain strong. Wider credit spreads with no change in expected loss will increase the loss-adjusted credit spread, and the resulting decrease in value of liabilities will offset the decline in asset value - moderating any change in the funding ratio. Similarly, tighter credit spreads and the associated increase in asset value will be partially offset by a higher liability value.
Insurers abide by precise cashflow matching guidelines and must meet regulatory requirements before modifying the method used to discount their liabilities. Pension schemes considering a similar 'buy-and-maintain' credit strategy would have latitude to determine the most appropriate discounting method, and are not bound by similar constraints as insurers.
This strategy is not without its limitations, as estimating the loss adjusted credit spread on corporate bonds involves an element of judgment. Scheme actuaries must ensure that the discount rate applied to the liabilities does not inadvertently capture returns in excess of an appropriate risk premium. They must also regularly ensure that default and downgrade experience and expectations are not at odds with the assumed levels in the loss-adjusted credit spread. Furthermore, the asset portfolio and addition of new investments must remain consistent with the scheme's liability-matching approach.
To summarise, a cashflow generating asset portfolio can help a pension scheme achieve its de-risking strategy, but it must be considered in the context of the scheme's actuarial approach. It requires good governance, and active engagement and coordination between actuaries, trustees and their investment team.
Sathish Umapathy is a member of Fixed Income Strategies at GSAM Insurance Asset Management
