Pension schemes could be overestimating pension liabilities by up to 3.5% following COVID-19. One year on from COVID-19 being declared a pandemic, the full impact of COVID mortality rates, plus the consequences of Long COVID, delays to healthcare treatments for illnesses like cancer or dementia and slow economic growth, will lead to a higher death rate. It means pension funds should factor this into their strategy, funding and investment decisions, according to in-depth analysis by XPS, an actuarial firm.
XPS calculates a potential reduction in UK company accounting pension costs of between £25bn and £60bn. XPS research also shows that over 60 companies which reflected the pandemic in their end December accounts made an average adjustment of 2.5%, equivalent to a £40bn fall in UK liabilities if extrapolated to all schemes.
Of course, the impact of the pandemic will vary between schemes based on the socio-economic and demographic characteristics of the membership, explains Steve Leake, Head of Demographics at XPS. He advises using tailored assumptions that drive liabilities and future expected cash flows, such as how long scheme members will live. This will allow schemes to have an accurate assessment of funding levels and produce better estimates of future cash flows.
Having an accurate assessment of a scheme’s funding level is significant, given the reliance that is placed on this when making strategic decisions about how much return is required. Where a funding position is better than expected, all else the same, this means the scheme could be taking less risk for a given long term target. Where triggers are used to de-risk they can often trigger action in step sizes of 2-3%, so this level of improvement can be material, adds Simeon Willis, Chief Investment Officer at XPS
Cash flows are vital for good hedging strategies and other investment decisions. Cash flows generated from overly prudent assumptions can result in schemes having more hedging than is required, which is a particular issue as schemes mature and approach 100% hedging strategies.
Factoring in reduced liabilities is particularly important in today’s low-rate environment. Over the past 15 years, the average real discount rates used by pension schemes has been decreasing dramatically, explains Leake. This has the impact of materially increasing the effect of changing demographic assumptions, such as life expectancy assumptions. For example, a one year change in life expectancy may have changed liabilities by only around 2.5% back in 2006, but in 2021, we can expect the change to be up to 5%.
“In a lower interest rate, low yielding environment small differences in target return can involve considerable changes in asset allocation. Therefore, the low yielding environment we find ourselves heightens the need to get the return target right,” says Willis.
The duo says that on the whole, treasury teams understand that how long pension scheme members are likely to live may be impacted by the pandemic and that this will have a direct impact on their liabilities. However, treasury may be unaware of the extent to which the liabilities may fall. For example, whilst tragic, the additional deaths over the course of the pandemic are unlikely to have a significant impact on pension scheme liabilities. Instead, factors which have been caused by the pandemic are likely to be more material, such as the knock-on impact of the recession, longer health care waiting times, lower levels of diagnoses during the pandemic and the potential health implications of Long COVID.
They conclude by explaining it is predominantly an issue for DB schemes. However, it may impact members of DC schemes in the future if it becomes cheaper to purchase an annuity as a result of people not living as long as expected before the pandemic. It is likely that it may impact schemes across Europe and the US, however XPS has not done as much research into the impact of the pandemic on hospital waiting times, unemployment rates and other factors not related to the disease itself.