Adding shareholder value through pensions The Discount Rate Quandary Richard Jones FIA January 2018
Legislation on Scheme Funding “…the rates of interest used to discount future payments of benefits must be chosen prudently, taking into account either or both – i. the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns, and ii. the market redemption yields on government or other high- quality bonds…” No requirement to use gilt yields in discount rate Most schemes use method (i) but effectively tied to (ii) 2
Setting the expected return on assets Expected returns on assets commonly set based on historic out-performance of the asset relative to gilts Bond assets have returns highly correlated and intrinsically driven by gilt yields No intrinsic reason why returns on other assets should also follow the gilt yield Many alternative ways of considering the return on risky assets exist 3
Propose alternative equity return methods Gilts Inflation Intrinsic plus value plus Expected return = Expected return = Expected return = risk-free return expected inflation dividend yield + equity risk + real equity + expected inflation premium return + expected real dividend growth Each method requires an assumption 4
Gilts plus method Return on equities = return on risk-free asset + equity risk premium • Rooted in Capital Asset Equity risk Period Pricing Model and Modern premium (UK) Portfolio Theory 1900 – 2015 3.7% 1900 – 1950 • Equity risk premium is 2.2% 1950 – 2015 4.9% an assumption 1990 – 2015 0.0% • Historically extremely 2005 – 2015 -0.1% variable • Best estimate assumption as at 31 December 2017: Return on equities = 1.7% + 3.7% = 5.4% 5
Inflation plus method Return on equities = expected inflation + real equity return Real return on UK equities per annum • Rooted in the 120% “Fisher equation” Average: 5.3% p.a. 80% • Real equity return 40% is an assumption 0% • Again, historically -40% extremely variable -80% • Best estimate assumption as at 31 December 2017: Return on equities = 3.3% + 5.3% = 8.6% 6
Intrinsic value method Return on equities = dividend yield + expected inflation + expected real dividend growth • Based on the “dividend discount model” developed by Myron J. Gordon • Expected real dividend growth is an assumption • 1950-2000 real dividend growth = 2.3% p.a. • UK GDP 1948 – 2015 = 2.6% p.a. • Possible “dilution effect” • Best estimate assumption as at 31 December 2017: Return on equities = 3.6% + 3.3% + 2.0% = 8.9% 7
The three methods as at 31 December 2017 Inflation Intrinsic Gilts plus plus value Expected inflation 3.3% 3.3% 3.3% Real yield (1.6%) - - Dividend yield - - 3.6% Equity risk premium 3.7% - - Real equity return - 5.3% - Real dividend growth - - 2.0% Equity return 5.4% 8.6% 8.9% • To align the methods either: - Increase equity risk premium from 3.7% to 6.9% or 7.2%, or - Reduce real equity return and real dividend growth in excess of 3% – implying a negative real dividend growth 8
Divergence of expected UK equity returns 11% Implied equity returns per annum 10% 9% 8% 7% 6% 5% 4% Gilts plus Inflation plus Intrinsic value 9
Best estimate calculation of discount rate Discount rate = (proportion of assets that are “matching” x gilt yield) + (proportion of assets that are “risky” x return on equities) Example Calculation as at 31 December 2017 for a scheme with: 50% of assets in government bonds 50% of assets in equities Gilts plus Inflation plus Intrinsic value Return on bonds 1.7% 1.7% 1.7% Return on equities 5.4% 8.6% 8.9% Discount rate 3.6% 5.2% 5.3% But what about covenant? 10
Set prudence based on covenant • Various options available for allowing for covenant • For example: create a lognormal model which compounds the expected return over a number of years – Can select the return with the required level of confidence % per annum Gilts plus Inflation plus Intrinsic value Equity return 5.4% 8.6% 8.9% 55% confidence 4.9% 8.4% 8.7% 60% confidence 4.2% 7.7% 8.0% 65% confidence 3.5% 6.9% 7.3% 70% confidence 2.8% 6.2% 6.5% 75% confidence 2.0% 5.4% 5.7% Gilt return 1.7% 1.7% 1.7% 11
Is a change of approach required? • Each method implicitly makes economic assumptions • Assuming one method is right implies the others are wrong Dividends are about to Future dividend be cut dramatically? Gilts plus growth is actually GDP growth is expected is right negative to be zero or negative? Inflation Investors currently more risk Equity risk plus OR averse than historically? premium above intrinsic bonds is around Abnormal monetary policy value 7% , not c. 3.7% has broken gilts / equities link? is right 12
Discount rate and funding volatility • Using gilts plus when significant proportion of assets are in equities causes funding volatility • Annual returns Annual returns of equities and 40% bonds have 20% correlation of 0% -0.4 -20% • Mis-match -40% between value placed on liabilities and non-gilt assets Equities Gilts 13
Summary Scheme funding legislation allows for discount rates to be derived with reference to the expected return on a scheme’s assets No intrinsic reason why returns on other assets should also follow the gilt yield Gilts plus , inflation plus and intrinsic value are examples of methods which can be used to derive best estimate equity returns Retaining the gilts plus approach implies certain economic beliefs and may lead to funding volatility in some schemes 14
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