The Discount Rate Quandary Richard Jones FIA January 2018 - - PowerPoint PPT Presentation

January 2018

The Discount Rate Quandary

Richard Jones FIA

Adding shareholder value through pensions

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Legislation on Scheme Funding

“…the rates of interest used to discount future payments

• f benefits must be chosen prudently, taking into account

either or both –

• i. the yield on assets held by the scheme to fund future

benefits and the anticipated future investment returns, and

• ii. the market redemption yields on government or other

high-quality bonds…”

No requirement to use gilt yields in discount rate Most schemes use method (i) but effectively tied to (ii)

3

Setting the expected return on assets

Expected returns on assets commonly set based on historic out-performance of the asset relative to gilts Bond assets have returns highly correlated and intrinsically driven by gilt yields No intrinsic reason why returns on other assets should also follow the gilt yield Many alternative ways of considering the return on risky assets exist

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Propose alternative equity return methods

Gilts plus

Intrinsic value Inflation plus

Expected return = risk-free return + equity risk premium Expected return = expected inflation + real equity return Expected return = dividend yield + expected inflation + expected real dividend growth

Each method requires an assumption

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Gilts plus method

• Rooted in Capital Asset

Pricing Model and Modern Portfolio Theory

• Equity risk premium is

an assumption

• Historically extremely

variable

Return on equities = return on risk-free asset + equity risk premium

Period Equity risk premium (UK) 1900 – 2015 3.7% 1900 – 1950 2.2% 1950 – 2015 4.9% 1990 – 2015 0.0% 2005 – 2015

• 0.1%
• Best estimate assumption as at 31 December 2017:

Return on equities = 1.7% + 3.7% = 5.4%

6

Inflation plus method

• Rooted in the

“Fisher equation”

• Real equity return

is an assumption

• Again, historically

extremely variable

Return on equities = expected inflation + real equity return

• Best estimate assumption as at 31 December 2017:

Return on equities = 3.3% + 5.3% = 8.6%

• 80%
• 40%

0% 40% 80% 120%

Real return on UK equities per annum

Average: 5.3% p.a.

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Intrinsic value method

• Based on the “dividend discount model” developed by

Myron J. Gordon

• Expected real dividend growth is an assumption
• 1950-2000 real dividend growth = 2.3% p.a.
• UK GDP 1948 – 2015 = 2.6% p.a.
• Possible “dilution effect”

Return on equities = dividend yield + expected inflation + expected real dividend growth

• Best estimate assumption as at 31 December 2017:

Return on equities = 3.6% + 3.3% + 2.0% = 8.9%

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The three methods as at 31 December 2017

Gilts plus Inflation plus Intrinsic value

Expected inflation

3.3% 3.3% 3.3%

Real yield

(1.6%)

• Dividend yield
• 3.6%

Equity risk premium

3.7%

• Real equity return
• 5.3%
• Real dividend growth
• 2.0%

Equity return

5.4% 8.6% 8.9%

• To align the methods either:
• Increase equity risk premium from 3.7% to 6.9% or 7.2%, or
• Reduce real equity return and real dividend growth in

excess of 3% – implying a negative real dividend growth

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Divergence of expected UK equity returns

4% 5% 6% 7% 8% 9% 10% 11% Implied equity returns per annum Gilts plus Inflation plus Intrinsic value

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Best estimate calculation of discount rate

Discount rate = (proportion of assets that are “matching” x gilt yield) + (proportion of assets that are “risky” x return on equities) Example Calculation as at 31 December 2017 for a scheme with: 50% of assets in government bonds 50% of assets in equities But what about covenant? Gilts plus Inflation plus Intrinsic value

Return on bonds

1.7% 1.7% 1.7%

Return on equities

5.4% 8.6% 8.9%

Discount rate

3.6% 5.2% 5.3%

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Set prudence based on covenant

• Various options available for allowing for covenant
• For example: create a lognormal model which compounds

the expected return over a number of years

– Can select the return with the required level of confidence

% per annum Gilts plus Inflation plus Intrinsic value Equity return 5.4% 8.6% 8.9% 55% confidence 4.9% 8.4% 8.7% 60% confidence 4.2% 7.7% 8.0% 65% confidence 3.5% 6.9% 7.3% 70% confidence 2.8% 6.2% 6.5% 75% confidence 2.0% 5.4% 5.7% Gilt return 1.7% 1.7% 1.7%

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Is a change of approach required?

Future dividend growth is actually negative Dividends are about to be cut dramatically? GDP growth is expected to be zero or negative? Equity risk premium above bonds is around 7%, not c.3.7% Investors currently more risk averse than historically? Abnormal monetary policy has broken gilts / equities link?

Gilts plus is right

• Each method implicitly makes economic assumptions
• Assuming one method is right implies the others are wrong

Inflation plus OR intrinsic value is right

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Discount rate and funding volatility

• Using gilts plus when significant proportion of assets are in

equities causes funding volatility

• 40%
• 20%

0% 20% 40%

Annual returns

Equities Gilts

• Annual returns
• f equities and

bonds have correlation of

• 0.4
• Mis-match

between value placed on liabilities and non-gilt assets

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Summary

Scheme funding legislation allows for discount rates to be derived with reference to the expected return on a scheme’s assets No intrinsic reason why returns on other assets should also follow the gilt yield Gilts plus, inflation plus and intrinsic value are examples of methods which can be used to derive best estimate equity returns Retaining the gilts plus approach implies certain economic beliefs and may lead to funding volatility in some schemes

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