Con Keating | Comment
was to dismiss the use of expected return. To quote: “IASC rejected this approach because the fact that a fund has chosen to invest in particular kinds of asset does not affect the nature or amount of the obligation.” “Consequently, the measurement of the obligation should be independent of the measurement of any plan assets actually held by a plan,” it added.
provisions as defined in legislation are problematic. These regulations specify pru- dence in all economic and actuarial assumptions, and explicitly in the discount rate. These regulations offer a choice of either the market redemption yields on government or other high-quality bonds, or “the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns”. (Emphasis added) Note that the explicit view of the fund here is as servicer of the pension obligations. The concept of prudence in the estimation of scheme liabilities is another instance of the fund as servicer of the ultimate obliga- tions. The level of funding needed exceeds the
accrued employer.
One of the few things that the IASC got right in their deliberations of discount rates
liabilities of the sponsor
In fact, both of these approaches will return counterfactual valuations of liabilities; val- ues as if these rates applied. The value we are actually interested in is the accrued value of the sponsor’s obligations. The accrual of these obligations over time is and was determined by the terms of award, the contribution to the scheme and the projec- tions of benefits ultimately payable. Awards were made on many different terms in many different market conditions over many years. The contractual accrual rate is a complex long-term average of these; it is slow moving. The volatility of this contrac- tual accrual rate is an order of magnitude less than gilt yield volatility. In fact, the dis- count rate measure within the contractual rate is deterministic; the uncertainty all lies within the projections of the pensions ulti- mately payable.
It is interesting to note that the IASC view is consistent with putting the obligation with the sponsor and viewing the fund as collateral, but this is unsurprising given the wider potential application of the standard. There is a further issue which arises with the calculation of the solvency ratio; this compares the market price of assets with the discounted present value of liabilities. This is a mixed attribute in nature; the implicit discount rate embedded in, for example, equities is unknown and indeed unknowable. However, the higher historic returns from equities suggest that it is far higher than the rates of government or cor-
porate bonds. This is problematic for those who see the fund as a source of liability; the values of the discounting metrics are differ- ent and one of the most basic tenets of measurement is that for comparison to be valid and accurate, the same measure must be used for both objects. This was the moti- vation for the historic practice of projecting asset cash-flows which were then discount- ed at the same rate as liabilities. One of the more subtle shifts here has been the shift of terminology, from solvency ratio to funding ratio; an illustration of the power of the narrative and its reinforce- ment. By contrast, the use of market prices for assets is not problematic for those who see the fund as collateral, as here we are interested in the current value of the collat- eral security securing the present value of liabilities. Any demands for further fund- ing in this viewpoint arise from the explicitly obligations of the sponsor. Demands do not arise from changes in the measure. This is consistent with practice in the secured corporate bond and loan mar- kets; we do not get to call for more collateral just because market rates have declined or corporate credit deteriorated.
The downside to seeing the fund as collat- eral is that this collateral security may or may not be sufficient to discharge the pen- sion liabilities as they fall due; that is a mat- ter of market conditions at the time of dis- continuance of the scheme. Resolution of this issue should have been the true voca- tion of the Pension Protection Fund. Ordinarily, as biases will be resolved by the passage of time, we might not be overly concerned by errors in the discount rate, but regulation ensures that these errors and biases are the basis for action, and unnecessary cost. The new DB code is a prime example of compounding problems, piling Ossa on Pelion. It will lay siege to the few remaining open DB schemes.
Issue 82 | March 2019 | portfolio institutional | 17
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