The liabilities are the benchmark

Most investing starts with a simple question: what return can I earn for the risk I take? In much actuarial investment work, there is another question that comes first: what are the assets ultimately needed to pay?

This course focuses mainly on pensions and life insurance because their liabilities can stretch decades into the future. A pension scheme or annuity insurer may still be making payments 30, 40 or more years from now, so interest rates, investment returns and how closely the assets match those future payments can have a major effect on its financial position.

Investments matter in other actuarial areas too. General insurers, for example, invest the assets held to pay future claims. But many general insurance claims are paid over shorter periods, so long-term investment strategy is usually less central to the actuarary's work. Some claims can take many years to settle, so this is not an absolute distinction.

We will start with DB pension schemes because they provide the clearest example of the central idea of this course: the assets should be judged against the liabilities they are there to support.

A promise, priced

A defined benefit (DB) pension scheme has promised members an income that may be paid for decades. Across thousands of members, that creates a long stream of future cashflows: some due next year, some many years from now.

The liability is the value placed on those future payments today. Actuaries calculate it by discounting the expected cashflows back to the present using an appropriate discount rate. For UK pension schemes, market interest rates and gilt yields are important reference points when setting that rate.

The relationship is simple: higher discount rates mean lower liability values, while lower discount rates mean higher liability values. So pension liabilities generally move in the opposite direction to yields.

For more details on this see the pensions course.

Run the seesaw

The example below is deliberately simple. The scheme pays £10m at the end of each year for 30 years. Real pension payments would vary over time and may increase with inflation, but this is enough to show how market interest rates affect the value of pension liabilities.

Interest rates is the broad term for the return available on lending money. A bond's yield is the market return implied by its price. Actuaries then use yields when choosing a discount rate to convert future pension payments into a value today.

So, in this simplified example, when we change the rate from 4% to 5%, we are modelling what happens when market yields rise and the discount rate used to value the liabilities rises with them.

Increasing the discount rate from 4% to 5% reduces the liability from about £173m to £154m, a fall of roughly £19m. Nothing about the pension payments themselves has changed; only the rate used to value them has changed.

If you reduce the discount rate to 3%, the same payments are worth roughly £196m today. This shows why long-term pension liabilities can be very sensitive to changes in interest rates: the further into the future a payment is, the more its present value is affected by the discount rate.

The ratio everyone watches

A scheme also owns things, its assets, and the standard health check is a single division:

Funding level = assets ÷ liabilities.

Above 100% is surplus; below it, deficit. Because the denominator reprices every time yields move, as you just proved, the funding level moves when markets move, even if nobody buys or sells a thing.

Reframe one: why rising yields can improve funding

Higher interest rates are not automatically bad news for a DB pension scheme.

When yields rise, the discount rate used to value future pension payments usually rises too. That reduces the value placed on the liabilities.

What happens to the funding level then depends on the assets. If the assets are less sensitive to changes in yields than the liabilities, the liabilities may fall by more than the assets. This is called being under-hedged, and in that situation the funding level can improve.

This was an important part of what happened in 2022. Gilt yields rose sharply and, for many schemes, liability values fell substantially. Although asset values also fell, many schemes still saw their funding positions improve as the assets fell by a smaller amount.

How much a scheme is affected depends on how much interest-rate risk it has hedged. A more fully hedged scheme holds assets designed to move more closely with its liabilities, so changes in yields have less effect on its funding position.

Reframe two: cash is not necessarily low risk for a pension scheme

Cash is often described as a low-risk asset because its value does not move much from day to day. But a pension scheme should measure risk against the benefits it has promised to pay.

The value of those liabilities can move significantly when long-term yields change, while cash does not move in the same way. For example, if yields fall, liability values may rise while the scheme's cash remains broadly unchanged. The gap between the assets and liabilities can therefore increase.

For a pension scheme, a low-risk investment strategy is one in which the assets are designed to move more closely with the liabilities. This is a liability-matching approach.

The key idea is that risk is not just how much an asset's price moves. It is also the risk that the assets and liabilities move differently.

The liabilities are the benchmark.

Next lesson: how big this client actually is, counted in schemes, members and the surplus that is redrawing the industry.