Time for a New Liability Measure?

Spiraling deficits indicate a change to traditional methods is necessary, argues one asset manager.

The strain on UK pensions amid record low gilt yields is a sign that liability calculations should be rethought, according to JP Morgan Asset Management (JPMAM).

The Bank of England’s decision yesterday to cut interest rates to a new record low and expand its quantitative easing (QE) program pushed the yield on 10-year UK government bonds well below 1%. The assets were already trading at record low yields following the Brexit referendum on June 23. Index-linked gilts, key to liability-driven investment strategies, are trading at negative real yields.

Pensions should be looking to other asset classes, in particular physical assets, to meet cashflow needs, argued Sorca Kelly-Scholte, head of pensions advisory and solutions at JPMAM.

“Most investors consider losing money to be a key risk, but if pension funds continue to hedge liabilities even as yields turn negative, this effectively equates to losing money with security,” Kelly-Scholte said of index-linked bonds. “It is already happening in real terms. This fundamentally undermines the notion of pre-funding [liabilities], yet that is what we appear to be determined to do.”

Kelly-Scholte advocated a broader approach to matching assets and new thinking for liability calculations—but stopped short of proposing a solution.

“It throws into question whether we can find a reasonably transparent and objective means of valuing the liabilities that is more consistent with the broader opportunity set,” Kelly-Scholte said. “At the moment we are valuing liabilities based on nominal yields that are pricing in deflation, real yields that are pricing in inflation, and relying on assets that have already priced in growth to repair the resulting deficits.”

QE is “unlikely to be unwound any time this decade,” according to Shajahan Alam, head of solution research at AXA Investment Managers’ LDI team, exacerbating the shortage of government debt.

“Those schemes looking for higher yields before doing some hedging may want to reconsider their [LDI] entry levels, if not abandon them altogether,” Alam added.

US public pensions face similar problems: Liabilities are calculated based on return assumptions, which are in many cases far higher than most investors believe is achievable.

Related: Pensions Brace as UK Cuts Rates