Smoothly does it
Underneath the headlines of today’s Autumn Statement was a commitment to consult on ‘smoothing’ for pension funds. Funded DB schemes undergo a valuation process every three years, overseen by the Pensions Regulator, whereby scheme assets and liabilities are calculated. Typically valuations are a ‘snapshot’ in time, but smoothing would mean that asset values over a longer period could be taken into account.
Smoothing would essentially mean that a higher discount rate could be used when valuing scheme liabilities. Liabilities would be reduced, meaning deficits (the gap between assets held and the size of liabilities) would also come down. One of the consequences of this is that employers sponsoring DB schemes would be under less pressure to increase their support for those schemes.
As such, employer groups have been calling for smoothing for a very long time. They argue that the need to prop up their pension funds is directing investment away from more productive uses of capital, which might be a boost to economic growth. But even if we accepted the investment argument, does it necessarily follow that employers should be able to relax their support for schemes, potentially putting member benefits at risk?
The answer to this is that the huge increase in scheme liabilities we have seen in recent years may well be artificial; the discount rates that have been used to calculate liabilities have not reflected the reality of scheme funding. This is partly because the snapshot valuation approach has captured liabilities in very difficult economic conditions which may turn out to be temporary (especially over several decades, which is the most sensible kind of time horizon for judging pension schemes given the nature of liabilities in practice, i.e. paying a regular income to pensioner members). Asset values have also been volatile, as well as depressed, in recent years, meaning any attempt to define a discount rate at one particular moment is especially problematic.
And it is also because, so this argument goes, the Bank of England’s quantitative easing programme represents a deliberate manipulation of discount rates by government, because it depresses gilt yields, which are often the most important factor in setting discount rates. Depending on exactly what is permissible, smoothing could allow the impact of QE to be mitigated by considering a more ‘normal’ range of gilt yields.
It is therefore right that the government plans to take a look at the options for smoothing. This should not be something that allows the government to mask the impact of the economic downturn – because if the downturn has genuinely devastated DB provision over the long-term, then we need to know this. And it will be important to ensure that employers cannot use the additional flexibility in valuations that might be allowed to walk away from supporting the DB schemes. But if, as I suspect is more likely to be the case, the economic downturn has exposed some frailties in the valuation process that were always there, then some form of smoothing may represent an appropriate alternative to the snapshot approach.