What's in a name?

A rose by any other name would smell as sweet…

… but if we routinely called it a “hand-gouging thorn-bush” you might think twice about putting one in your garden.

The names we use matter. Names conjure images of what we should expect, they influence our behaviour and the decisions we take.

There are many names, many terms, that we use in the world of pensions. Some have good purpose; some make logical or intuitive sense; some, perhaps, do not.

Into this last category, I would place the oft-used term “self-sufficiency”

You see, the idea conjured up is that a “self-sufficient” pension scheme should be able to provide the benefits promised to its members without reliance on a supporting employer. After all, we, as individuals, would not think ourselves “self-sufficient” if we relied on being able to borrow from the Bank of Mum and Dad when it suited us.

But the phrase is often used very loosely. I think that creates a risk of confusion: confusion around what is meant by the term; confusion around the consequences for our clients of being (or not being) “self-sufficient”; and confusion in the decisions that are taken by our clients.

Dear perfection?

You see, purists I know would argue that for a scheme to be truly self-sufficient, it should have enough money to buy the benefits out immediately with an insurance company plus a reserve to cover the risk that future market conditions and / or insurer pricing move against you. That view has logic to it. Very few, however, really mean this when they use the term “self sufficient”.

Others would argue that “self-sufficiency” means having enough money that you don’t need to use anything riskier than Government bonds and swaps to pay the benefits. Such an approach could give a very high likelihood of being able to provide the benefits without further support from the employer, but it is not without risks and flaws, for instance:

• If running costs are not included then you’re not self-sufficient as you still need the employer to cover those costs;
• For pensioner members, the amount you look to hold under such an approach could actually be higher than the cost of buying the benefits out, as insurers rarely invest in gilts alone; however,
• For those who have yet to retire, many versions of this “gilt only” approach could still involve holding less than an insurer would hold. The very long term of benefit payments for non-pensioners means they carry high levels of uncertainty: insurers look to reflect this uncertainty by holding more assets. At a basic level, insurers and pension schemes (especially those seeking to be “self sufficient”) aren’t such different beasts: if you don’t have comparable assets, are you truly “self-sufficient?”
• The liabilities of many pension schemes are dominated by a few members with very large benefits. Substantial surpluses or deficits can emerge depending on when these few individuals live or die, and whether or not they have dependants. Without longevity hedging or insurance in place, you could need significant funds set aside – much higher than is typically assumed – to cover the risks associated with these individuals if you are to minimise the risk you run out of money, with no employer to fall back on.

The “gilt-only” approach involves holding very significant amounts of assets – in some cases more than an insurer would hold – and yet still falls short of the true meaning of “self-sufficiency” in many respects.

'Tis but thy name

The most common view seems to be that a “self-sufficiency” target should allow investment in other income generating asset classes, such as corporate bonds and property. In many cases, a simple allowance might be made, perhaps adding 25 or 50 basis points to the gilt yield. Mercer’s 2016 Asset Allocation Survey suggested around 60% of schemes used a long term target between gilts +0.01% and gilts +0.50%.

A better approach, often, is to look at the approach taken by insurers themselves: you could build a portfolio of corporate bonds, property and gilts that provides the cashflows the scheme needs to pay the benefits. 

There are, of course, greater risks here than if you used government bonds only: some companies do fail to meet their debt payments; you need also to make assumptions about what it might cost in future to buy bonds to cover your longest term payments. 

However, you can reflect those risks in the way you construct the target. The yield on the portfolio, adjusted for these risks, can give the discount rate – in current conditions that might be around 50 to 100 basis points above gilt yields. Such an approach has many advantages – after all, that is why insurers use it – but it can become impractical for less mature schemes (where reinvestment needs become significant). Although risks can be substantially reduced under this approach, they are certainly not eliminated.

I have seen some advisers argue for “self-sufficiency” targets with discount rates around 100 to 150 basis points above gilts – less conservative than many Technical Provisions approaches used today. While it may be possible to construct a portfolio to support such a discount rate, there could be higher risks that assets run out if things do not turn out as expected. 

I’ve even seen advisers argue that “self-sufficiency” can reflect continued investment in equities, using models calibrated on past performance to argue that the benefits can be provided. Maybe they can, but, as the past two decades have shown, the income and returns from equities are far from certain. Schemes with high levels of pensioner members are hugely sensitive to when returns are achieved: even if the model is “right” in the long run, bumps along the way could mean the scheme runs out of money and needs employer support. Is that self-sufficient?

Whatever liability measure one adopts for “self-sufficiency”, risks will remain if your investment strategy and liability measure are not perfectly aligned. Even if you measure against gilts, but hold credit, the investments and funding strategy could move in different ways, creating a deficit and a need for further funds. Without perfect alignment, or enough funds to be able to absorb the bumps, you are not “self-sufficient”.

O, be some other name!

Does any of this really matter? 

In practice what most people mean when they talk about “self-sufficiency” is an “approach-that-means-taking-less-risk-than-we-have-today-but-stops-short-of-buy-out”. Surely we all know that?

Well, differences between the different measures can be enormous – the purist approach could need 50% more money than the equity approach. That’s pretty significant.

Names also matter. How can we – or our clients – sensibly base decisions around a term that could mean so many different things? 

There are arguments in favour of each of the various approaches, depending on client circumstances, but can it be right to use a single term – “self-sufficiency” – to encompass them all? Surely it would be better to do away, finally, with the vague and devalued term “self-sufficiency” and, instead, say what we really mean.