LONDON - The U.K. government signaled it will ease its minimum solvency test for pension funds in legislation to be proposed later this year, allowing funds to use average market values instead of a single day's valuation.
Still, many pension experts believe the test and the increasing maturity of British pension funds will cause a sharp move into bonds and out of stocks - particularly non-U.K. stocks. Alternatively, companies may choose to buoy their pension contributions.
A new survey of top corporate executives found 34% expect to change pension investment strategies to minimize risk, while 31% plan to boost contributions. Another 17% said they will switch to money purchase plans, according to the survey by the Confederation of British Industry and William M. Mercer Ltd., London.
William Hague, minister of state for social security, said the government favors smoothing pension asset values instead of using market values on one particular day. "This should limit the risk of schemes becoming insolvent because of unusual short-term movements in the markets," he told the Confederation of British Industry's annual pension conference.
The announcement marks the second significant shift by the government from the solvency standard proposed by the Goode Committee a year ago. That committee, set up in the wake of the Maxwell scandal to review pension rules, had said the test should be based on the price of purchasing annuities to cover all accrued pension liabilities. Employers complained using annuity prices would cause many plans to be considered underfunded.
In its white paper on pension reform issued last June, the government loosened that standard. Based on recommendations from actuarial groups, the Department of Social Security said liabilities for younger workers could be based on equities, while those for workers approaching retirement age will be valued based on a blend of equities and bonds. The cash equivalent for retiree liabilities would be based on bond yields.
The minimum solvency test would require employers to make immediate cash injections if their pension plans fell below 90% funding. It would provide three years for bringing plans up to full funding if funding declined to below 100% but above 90%. The standard is slated to go into effect in 1997, but will have a five-year transition period.
To protect against sudden dips below solvency levels, and thus cause an immediate cash call on the corporation, experts say pension officials should move away from stocks and into lower-risk bond investments. Some pension experts warn the requirements will cause a major shift from equities to bonds by British pension funds.
Financial firms and pension consultants especially are urging officials of mature plans, with high retiree-to-active employee ratios, to re-examine their investment policy. Also, plans with guaranteed indexed benefits are more vulnerable to shifts. The pension reform proposal would mandate indexing benefits up to 5% a year.
Roger Urwin, head of Watsons Investment Consultancy, Reigate, England, told a recent Goldman, Sachs & Co. conference there is a growing convergence of asset allocation but a growing divergence of liability among U.K. pension funds.
The average allocation to stocks in the United Kingdom is 84%, the highest in the world for pension funds, and is about the same regardless of a fund's maturity, according to a sample survey conducted by Watsons.
At the least, said Mark Griffin, an executive director at Goldman Sachs International, London, pension funds should use the minimum solvency standard as the benchmark for risk-control strategies.
A risk-neutral strategy for a typical U.K. pension fund would have a much higher element of bonds and index-linked gilts - at 50% - than the average 15% bond component now.
More striking is that the benchmark would contain no foreign equities, which currently comprise 26% of the average U.K. pension fund portfolio, according to the Combined Actuarial Performance Services Ltd., Leeds, England.
The minimum solvency benchmark supports the government's contention that overseas equities would be most affected by adoption of the minimum solvency rules.
Mr. Urwin said, however, he thinks investments in overseas equities will be sustained and U.K. equities may shrink slightly, perhaps five percentage points over five years. Tim Gardener, head of asset planning at William M. Mercer, predicts an overall drop to 75% in stocks from 85% now during the next three years.
Other investment options exist to reduce the risk of market volatility. U.K. pension funds could adopt dedicated or immunized bond strategies, suggested Sandy Rattray, a Goldman, Sachs analyst.
Dedicated bond portfolios permit matching expected cash flows against liability flows and have been used widely in the United States. Immunized bond portfolios, which are less costly, maintain the original surplus of assets over liabilities. They do not match cash flows precisely but can be used to match long-term defined liabilities.
Other options include the use of derivative strategies. In a recent paper, Salomon Brothers officials suggest varying strategies for hedging underperformance of the U.K. stock market. "Using derivatives to control solvency risk is much more efficient than selling stocks directly," the paper said.
An alternative to shifting the asset mix could be to boost funding of the plan. Analysts suggest a cushion of 10% could sustain many funds from volatile market swings.
Anthony Simpson, an executive director at Goldman Sachs, added the firm officials are not saying all U.K. pension funds will adopt a minimum solvency benchmark. But he said each pension fund must develop its own benchmark and not rely on the industry median.
In a related matter, Mr. Hague suggested the government will not require every company to poll employees as to whether they want to appoint one-third of pension trustees. The proposed legislation would give employees the right to select at least one-third of the trustees.
Employers had complained that mandating a vote would be expensive and cumbersome. Instead, they urged a referendum be held only when a certain proportion of plan participants are unhappy with the present arrangement.