Pensions and Growth - Smoothing in Pension Scheme Funding Valuations
In response to continuing deficits in UK defined pension benefit schemes since the start of the millennium, various parties have asked the UK Government to allow pensions schemes to calculate liabilities using a smoothed average of bond yields over several years. This paper explores the reasons for this request, and looks at multiple evidence of what impact such a move could have.
Deficits in UK defined benefit pension schemes have been attributed to poorly performing stock markets, increased longevity and to low bond yields. The situation has been exacerbated by the economic crisis dating from 2008, which saw both the movement of capital into government bonds and the monetary policy of quantitative easing take place.
Pension liabilities are measured by discounting promised pension benefits using long-term interest rates. Very low bond yields therefore inflate liabilities. However, pension scheme assets consist of bonds as well as equities, property and other asset classes, and these are generally less sensitive to long-term bond yields. Because the deficit in a pension plan equals its pension liabilities net of assets, any mismatch between assets and liabilities means that low bond yields will inflate the pension deficit. This triggers special contributions to be paid by pension scheme sponsors in order to fund these deficits, at the very time when many of these sponsors may be struggling.
To moderate the impact of low bond yields and contain the size of the deficits that emerge, various parties have asked the UK Government to consider allowing pension schemes to calculate liabilities using a smoothed average of bond yields over several years. In this paper, Dr. Owadally examines evidence of smoothing from a range of international research. He considers how smoothing already operates, albeit implicitly. Methods of smoothing are listed and it is debated whether in fact smoothing actually contributes to risk. Amongst his conclusions, Dr. Owadally argues that inefficiency is an unavoidable feature of markets and cannot be assumed away. The demand for government to allow smoothing effectively constitutes a request for state intervention to counter market failure. Such intervention is rarely successful.
The complete draft paper can be downloaded at the link below. It has been submitted to the Department of Work & Pensions in response to a consultation on pensions that they are conducting.