P&R’s £2bn pension punt

ON THE basis you’re familiar with ‘jokes’ at the expense of actuaries – you know, ‘an actuary is someone who wanted to be an accountant but didn’t have the personality for it’, sort of thing – you might also recall this one: ‘Actuaries do it with varying rates of interest.’ Phwoah, one’s tempted to say. Just look at the discount rate on that.

If that last one’s lost on you, don’t worry. We’re in pensions territory here. That arcane world of funding targets, mortality tables, investment strategies and, yes, discount rates, which only actuaries and experts really understand.

That’s why it’s simultaneously possible to describe the latest actuarial valuation report on the States superannuation fund, which pays public sector pensions, as both a triumph – taxpayers to save £9m. a year in contribution payments – and a gamble with £2bn* of your money.

The reason for that is down to time. At the end of 2020, the States’ pension pot – happily separate from Social Security’s, which pays the OAP – stood at £1.6bn. It’s an impressive sum, equivalent to around £42,000 per taxpayer. Wouldn’t it be nice to get that back, eh?

The point is, these funds are created to provide members with more security for their pensions than if they relied on their employer to pay them directly on retirement. It also benefits the employer (and taxpayer) because without it, the States would be paying £55m. a year out of general revenue to the 4,645 current retired employees.

But bear in mind there are also 5,304 working employees coming up behind them and by the time they retire, the cost of paying their pensions will have risen four-fold to £215m. a year. That’s why getting the size of the pot to meet its liabilities is pretty important. It’s also very complex, which is why we love actuaries despite the jokes because they help to get us there.

By nature, they’re cautious souls. Prudence is the watchword. As is minimising risks and avoiding surprises. That’s because the funding and investment strategy aimed at ensuring the pool of cash and assets is big enough when needed is crucial if nasty shocks are to be avoided.

As BWCI Consulting says in its latest report to Policy & Resources, ‘the fund’s future finances also depend on uncertain factors such as future investment returns, pay and pension increases, how long members live and employee turnover’.

That means making certain assumptions and these ‘should therefore reflect the outlook for the long term rather than recent experience or the experience expected over the period until the next actuarial valuation’.

Where this gets exciting is in the normally staid world of pension planning. Instead of investing the fund into things (index-linked gilts and derivative instruments, since you ask) that closely match what the fund needs to pay out, the committee has chosen to play the stock market instead to chase higher returns. As BWCI drily notes: ‘funded occupational pension schemes may choose not to hold assets which match the liabilities…’

That means the fund is heavily invested in equities and other return-seeking assets and the report adds P&R has decided – admittedly after taking advice – to take part of this higher expected return into account in setting the funding target and to accept the risks that this involves.

On the latest valuation, that’s possibly a smart move. Buoyant markets have turned an earlier deficit of £91m. into a surplus of £115m. – a positive turnaround of more than £200m. in four years. This is where time, and timing, come in.

This cheering news, that taxpayers can reduce the amount of funding going into the scheme, is now, however, obviously out of date. Since then, markets have crashed and inflation, another variable that significantly affects pension assumptions, is going through the roof.

P&R itself notes: ‘If investment returns exceed the assumption of inflation plus 2.5% then the funding position will improve; conversely, if investment returns are below the assumption, then there will be a deterioration in the funding position.’

As BWCI says, the majority of the fund’s liabilities are linked to inflation via either pension increases or pay increases, but there’s a discrepancy here because P&R has chosen to invest in riskier assets in the hope of higher returns longer term.

‘The more mismatched the investment strategy is, the greater the potential risks,’ say the actuaries, and that’s compounded where additional returns from equities are anticipated in the discount rate (effectively the assumed growth from equity investments). That’s why BWCI says the fund faces some ‘significant risks’ – including the States being unwilling to pump in extra funds if P&R’s strategy proves to be the wrong one.

In all, it lists seven key risks for the fund, including climate change. This last one is particularly problematic because there is ‘material uncertainty’ in all aspects of BWCI’s modelling in this area.

‘It is important for [P&R] to understand the situations in which shortfalls could arise, to form a view on the willingness and ability of the States of Guernsey to support the Fund, and to consider what actions to take if this view changes,’ say the experts.

It looks at 13 variables and only two are on the upside. The rest are firmly negative and, if they arise, could cost the taxpayer millions. As BWCI puts it: ‘Under the three climate change scenarios modelled, climate change would be expected to reduce the surplus by between £49m. and £212m., mainly due to the assumed reduction in asset returns.’

That’s bad enough, but it further warns that the modelling adopted is ‘quite likely’ to be biased to underestimate the potential impact and effects on the fund.

In fairness, P&R could well counter that it has time and past experience on its side – average fund returns of 3.6% above inflation a year over the last 10 years. But that’s why it’s a pensions punt. Can past performance be relied on again given today’s high inflation, market volatility, supply chain issues and climate change?

P&R evidently thinks so. Get it right, and they’ve saved us a packet. Get it wrong and they’ve cost us millions.

*The actuarial value of the pension fund at the end of 2020 was £1.6bn and its liabilities were £1.5bn, meaning it was £115m. in surplus. However, adopting the accounting standards used by P&R in its States Accounts, the obligation that then existed to pay pensions totalled £2.8bn, meaning the fund was massively underfunded by well over a billion pounds, hence the figure used in the headline.

. Richard Digard is a freelance writer, consultant and a former editor of the Guernsey Press.

Email: newsroom@guernseypress.com