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The case for 'smoothing'

03 April 2013

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"Fortunately there is a way for pension funds to smooth their funding levels without having to resort to averaging historical values or other dubious techniques," says Cardano's Helen Prior.

There was a collective sigh of relief among many in the pension fund industry when it was announced that the Government will drop the idea of allowing pension funds to artificially smooth their asset and liability values. The idea was rightly condemned as a backwards step by many industry voices and it seems there was little support for the idea when the Department for Work and Pensions (DWP) consulted on the concept.

Those who worry that daily market gyrations have too big an impact on pension funds may have a point: a typical pension scheme's funding level (the ratio of its assets to its liabilities) can move significantly from one day to another, especially in the sort of market conditions that have prevailed since the financial crisis. The 'luck' of which day in a three-year period a scheme's triennial valuation falls on can have a big impact on the contributions that a business might have to pay into a scheme. If the funding level could somehow be smoothed then this would reduce the extent of the 'valuation date lottery' and be fairer to all.

Fortunately there is a way for pension funds to smooth their funding levels without having to resort to averaging historical values or other dubious techniques. Most pension funds continue to take three big bets:

- A bet on equity markets rising

- A bet that long-term interest rates will rise

- A bet that inflation expectations will fall

It is these same three bets which are often causing the volatility people wanted to smooth.

Longevity risk is also an important factor, although one that is less important on a year-on-year basis (the equity market can halve in value and then double again in a period of a few years whereas life expectancy won't). If pension fund trustees focus their efforts on reducing the potential impact of these factors on their funding levels then they can achieve the benefits of 'smoothing', with the result being much more secure pensions for their members. And rather than just locking into the current funding level by cutting down all risks, trustees can introduce or increase their exposure to other factors where they expect to be rewarded, such as different forms of credit risk, taking on more illiquidity or investing in strategies that can generate positive returns in recessions as well as recoveries in order to build a portfolio that will deliver stable growth in their funding level.

None of these ideas are new or untested. In fact they have been around for many years and are used by many financial institutions. Indeed, large numbers of pension schemes are already using many of the concepts of liability hedging and 'alternative' investments (i.e. anything other than equities and bonds); the issue is that they are used in too small a size to meaningfully impact the stability of the funding level.

It essentially comes down to good risk management; helping pension funds become more stable and resilient to the consequences of financial market shocks. Let's not try and fudge the issue.

Written by Helen Prior, senior client manager, Cardano UK