Written evidence from Jonathan Camfield, Partner, Lane, Clark & Peacock (LDI0050)

In the first half of the first evidence session, Professor Iain Clacher (and others) expressed concerns that higher interest rates had led to schemes losing assets this years (£100bns).  This was also picked up in a final question to Leah Evans at the end of our session.  I agree with Leah’s answer that, broadly, this doesn’t matter, but thought helpful to elaborate. 

First, this is not to do with actuarial “magic” or obscure measurements. 

Second, imagine a simplistic safe pension scheme, where there is a promise to pay pensions in the future, and the assets are invested solely in basic gilt investments.  This is to make the scheme really safe, in order to protect members and their pensions.

• Imagine that these gilts have been chosen so that they deliver interest payments to the scheme, in the future, that exactly match the pensions as they are due to be paid to members. So the gilt pays the scheme £100 at the same time that the scheme needs to pay pensioners £100, and the scheme immediately pays those pensions. 

• In such a case, it is clear that today’s market value of those gilts doesn’t matter at all.  The gilts can fall massively in price, or rise massively in price, but the gilts will still deliver exactly the same future cash to the pension scheme, at just the right times, so that the trustees can still pay the same future promised pensions. 

• The law (originating in European legislation, but sensible in my view) requires asset values for pension schemes to be assessed at market values from time to time.  Therefore, it makes complete sense to use a gilt discount rate to assess liability values too.  Doing so, reveals that this pension scheme is always just about “fully funded”, which it clearly is, even though the value of the assets will have fallen massively this year.

• If insurance companies and pension schemes instead measured liability values in a different way, the result would be to reveal big deficits (ie problems to be filled with cash) or surpluses (ie too much money, not needed) as gilt market values swung around.  But actually, such a pension scheme needs no more money or no less money – it clearly has just the right amount. 

• This thinking is at the heart of actuarial science and underpins the financial management of insurance schemes and pension funds.

Third, as the committee may know, the long term future of most pension schemes is with insurance companies – through the purchase of bulk annuities.  This is an even more secure regime for pension scheme members, and a good thing.  Therefore, most trustees are trying to head towards being able to afford the cost of those annuities, and then their job is done, and done well.  And the cost of those annuities is similarly very volatile, and broadly follows gilt prices.  For example, one scheme might have got full insurance quotes for all its pensioners of £5 billion a year ago, and now it might be quoted just £3 billion for exactly the same insurance.  This is because insurance companies, influenced Solvency II, also appropriately invest in gilts (and bonds, and LDI etc), and these assets therefore influence their pricing of annuities.  Therefore, even though pension schemes’ assets have fallen significantly in value this year, schemes don’t mind, because the cost of insurance has fallen by a similar amount.  (Note: you can also see this impact in the individual annuity market this year.)

Fourth, a simple analogy might help.  Imagine you own a house worth £500k, and you want to sell it and buy another house that is worth £600k.  If house prices go down by 20%, are you sad or happy?  Even though you have lost £100k on the value of the asset you hold, the answer is that you are a little happier than you were, because the house you want to buy now costs £120k less.  This is what has happened to pension schemes this year, relative to the value of their liabilities, and relative to the cost of insuring them with bulk annuities.  And, significantly, it is LDI (appropriately managed) that enables schemes to do this.

I hope that this helps.

November 2022