## The ABC Pension Scheme - Part 1

*This is the first in a series of blogs that aims to build understanding of the complex interplays between investment, covenant and funding, by examining their impact on a very simple defined benefit pension scheme. *

*Part 1 deals with investing and covers cash-flow matching, interest rate risk and equity risk for a fully funded scheme.*

**The ABC Scheme**

The ABC Scheme is a very simple defined benefit scheme. It has a single member who is due a lump sum benefit of £10,000 in ten years’ time. The Scheme is well funded and has assets with market value of £8,000.

The trustees are carrying out a review of investment strategy. The investment options they’re considering are; 1) cash, 2) equities or 3) invest in a ten-year zero-coupon fixed interest government gilt.

Short and long-term interest rates at the date of the review were 2.26% per annum exactly.

**Invest in Cash**

The trustees could invest all their assets in cash. The capital amount of their investment would be fully secure. A cash investment is fully liquid and available on demand. The value-at-risk (a measure of the risk of loss on an investment) of this portfolio would be zero.

At the date of review, banks were paying interest of 2.26% per annum on deposits. If this doesn’t change, the assets will grow to £10,000 in ten years’ time and the trustees can pay the lump sum benefit in full.

The risk with a cash investment is, of course, that deposit interest rates fall. If this happens the trustees will not earn the return they need to pay the benefit in full.

Despite the guarantee to capital invested, cash is a risky investment for this defined benefit pension scheme.

Investing in cash leaves the Scheme exposed to interest rate risk. Specifically, to the risk of a fall in interest rates. The PV01 metric (the change in the value of a portfolio after a one basis point shift in interest rates) under this strategy is zero.

**Invest in Equities**

The trustees could invest in equities.

The trustees believe they could earn a return of 5% per annum equities. Should this happen, their investment will be more than enough to pay the lump sum benefit in full, with a surplus to return to the sponsor.

This strategy is risky. Equity investors purchase shares in a company in the expectation that their investment will rise in value in the form of capital gains and / or dividend income. However, there are no guarantees. If a company’s management team and / or the wider economy perform badly, then these equity shares will fall in value. The trustees entire capital is at risk and dividend income is also uncertain.

The trustees may end up having more than enough to pay the benefit in full, but there is also every chance that their bet on equities doesn’t pay off and they can’t pay benefits in full when they become due.

#### Invest in a Ten-Year Gilts

Finally, the trustees could invest in a ten-year zero-coupon government gilt.

Redemption yields on ten-year gilts are 2.26% per annum. This means that the market value of a gilt that pays £10,000 exact in ten years time is £8,000. The proceeds from an £8,000 investment in ten-year gilts will exactly match the benefit outgo of the ABC Scheme.

As long as the trustees hold this gilt until it is redeemed in ten years time, they will be able to pay the £10,000 lump sum when it’s due.

This will be the case whatever happens with financial markets, and neither equity market volatility nor changes to interest rates will impact on the ability of this strategy to pay benefits when they become due.

#### Comments on liabilities

The value to place on a series of pension cash-flows is a matter of ongoing debate amongst pension actuaries. In future blogs we’ll explore the different liability measures (technical provisions, self-sufficiency, solvency, etc) used by actuaries.

For now, we’ll simply take the value of the ABC Scheme’s future obligations (that is, its liabilities) to be equal to the market value of the corresponding matching asset (that is, the market value of a gilt that pays £10,000 in ten years’ time, which is £8,000). Note that under this measure, a scheme’s liabilities would not depend on its investment strategy. Moving to equities in the expectations of a higher return would not reduce the ABC Scheme’s liabilities (although it may or may not result in a surplus) and holding physical cash would not increase the liabilities (although, as physical cash earns no interest, it will result in a deficit). In both cases the ABC Scheme’s liabilities remain at £8,000, and this only changes with the market value of ten-year gilts.

#### Summary

The ABC Scheme is fully funded with assets and liabilities both equalling £8,000.

If the trustees invest in ten-year gilts, their assets proceeds would exactly match and be equal to their liability outgo. The assets and liabilities would move in exactly the same way and the ratio of PV01 assets to PV01 liabilities would be 100%, which means the Scheme would be unaffected by changes in interest rates.

In addition, the deficit value at risk (a measure of the risk of an increase to the deficit) under this strategy is zero, which means the Scheme is also unaffected by equity market volatility).

Investing in ten-year gilts guarantees that the trustees can pay the £10,000 lump sum benefit in full when it falls due.

In part 2 we’ll consider the case where the ABC Scheme is in shortfall. We’ll introduce interest rate swaps and show how a leveraged Liability Driven Investment fund can help the trustees meet their obligations. Future blogs will introduce employer covenant, the sponsor’s obligation to fund prudently and the complex inter-relationships between covenant, investment, funding and the impact these items have on the ABC Scheme’s benefits.

**Please contact us if you would like to discuss this further**