The five earlier articles in this series have introduced new methods for the objective and accurate evaluation of defined benefit pensions and their costs. They have shown that existing accounting and actuarial methods produce highly significant differences from these valuations. This article will reconcile these differences, by highlighting that differences are a function of the standpoint.
The proposed accrual method is the cost of production of DB pension provision by, and to the sponsor employer. This is also the value of the pension contracted for and expected by employees, the members of the scheme. By contrast, the existing accounting and actuarial methods are the cost of procurement of pension provision by others, by other means. However, it should immediately be recognised that this is not the contract that initiated the existence of pension liabilities. It is not the contract with the scheme member. This transition of viewpoint requires the use of different methods for the analysis.
The most obvious example of procurement from others is that of buy-out undertaken with an insurance company. The existing liabilities of the scheme are assumed by the insurer; the scheme is wound-up; the sponsor liabilities are fully defeased. The transaction is binary and irreversible. No new pension provision takes place under this arrangement. The insurer may, and usually does price this transfer by reference to the expected returns of gilts; in the illustrative case used in earlier articles, the quotation was gilts less twenty-five basis points (1.40%). The quotation received will be loaded to reflect the restricted investment opportunities available to this form of insurance company, together with allowances for its cost of capital and profit margin. It is both extremely expensive, and also inflexible.
The equivalent to the accrual method contribution is the price consideration required by the insurance company. The old pension sponsor contract has effectively been replaced by the new contract with the insurance company. This is now a purely financial arrangement. Market prices enter the evaluation of the contract at the time of transfer; they are of relevance to the sponsor employer only at that time. Market prices are relevant for all liabilities for the assuming insurer as these market prices determine the investments made by the insurance company at the time of acquisition. But they may be of very limited consequence subsequently. Take the instance of an insurance company which dedicates its investment portfolio by matching the projected ultimate cash flows of pension payments with gilt strips: this insurer is only exposed to market prices to the extent that its projections prove inaccurate.
It is perhaps less obvious that a trust arrangement or scheme may constitute procurement from others; this is a question of viewpoint, not reflective of the contract between the sponsor employer and the employee. Nonetheless, it is widely-held view. As one leading practitioner put it: “Pension funds are fully responsible for taking decisive action to ensure they can pay everyone what they are due to receive” and “We have a collective obligation to make absolutely certain that pension plans can pay those benefits, Inflation-linked and all.”
The advocates of this viewpoint go further: “Some of us prefer to believe, despite eloquent arguments to the contrary, that it is only by measuring and managing the pension scheme’s liabilities there can be any assurance of reaching a state of full funding; that a deep understanding of the complex relationship between assets and liabilities is the sole basis for an expectation of success.” This belief preference appears in practice to be shared by the Pensions Regulator and, of course, has been encouraged by regulation from the original introduction of the minimum funding requirement until the present day. It is notable that the objective has shifted from payment of the pensions to achievement and maintenance of funding.
There are many problems and costs which arise because of this stand-alone viewpoint; this procurement from others. Unlike the bulk annuity insurer, this arrangement covers an ongoing, repeated interaction, at least as long as the scheme is open to new members or future accrual (Here, accrual is used in its traditional actuarial meaning.). It receives the contributions of sponsor and employees and the associated benefits associated with the employment contract. In this sense, it is acquiring those liabilities on the same terms as they were created by the agreement between employer sponsor and employee; these have the same accrual rate as contracted by the employer and employee.
The ambition of the scheme and fund in this viewpoint has changed; it is to survive beyond the corporate grave, and fulfil the corporate promise. We should recall that the promise made by the employer was: I promise to pay you this series of benefits in retirement under these terms and conditions. It was not: I promise to pay you this series of benefits in retirement and in the event that I go bust, at that time I will make payment sufficient that you or your agents may buy similar benefits from whoever you chose.
Quite apart from anything else, such a contract would most likely be unenforceable in bankruptcy, even if the fund held sufficient assets to execute it. No other creditor expects or benefits from such an arrangement. The scheme would now have the status of a preferred, secured creditor.
This viewpoint also fails in another regard, that of transfer values. The departing member does not receive a sum sufficient to buy equivalent benefits in some other scheme or insurance company.
Moving from the contractual to the procurement viewpoint is strictly costly. It introduces new risk factors; interest rates enter when used as discount rates. Some factors even change nature. Early leavers among the deferred member classification are beneficial in the contractual perspective, but are negative developments under the procurement view. Deferred members are notoriously expensive to insure for precisely this reason.
With sponsor insolvency, the scheme loses recourse to that employer, and unlike the employer, it has no other resources to support its newly-acquired underwriting of those promises. There are no longer any new pensions being awarded, and no new contributions being received. There is not even any possibility of capitalisation of the underwriting from the contributions of current and future generations of members. The scheme is running down. It has no access to income other than from its investments.
The change of status of the scheme on sponsor insolvency does not, itself, require or warrant a change of the accounting basis from contractual to market-consistent. The contract being honoured is that originally generated by the sponsor and employee; the liabilities are unchanged.
The quite separate question is whether the scheme has sufficient assets and a sufficient expectation of returns from those assets to discharge those liabilities. It is trivial to calculate the return required from those assets necessary to achieve that full and timely discharge objective.
Assessment of the likelihood of achieving that rate is more difficult, but it depends principally upon the portfolio already held and only marginally upon the gyrations of market prices and yields. First Actuarial’s Best-estimate Index is an important and valuable contribution in this regard.
The discount rates used in valuations are implicitly rates of return expected to be earned on assets; the contractual rate clearly so, by its very construction. However, these are independent of the required rate of return on assets and overwhelmingly irrelevant to the objective of paying the pensions fully, on time. This is the Achilles heel of solvency as a measure of member security; it is intensely dependent upon the prices and rates used in its estimation. It also highlights the nugatory nature of asset and liability modelling, and its associated catechism of nostrums.
When we view the purpose of the fund as being to offset or defease the employer’s cost of production, the rate of return on the investment fund is irrelevant to scheme members but of prime concern to the sponsor. With sponsor insolvency, it should become the members’ prime concern.
The greatest irony is that regulation and practice should have resulted in the effective cessation of DB provision. Its preoccupation with a relatively rare event, sponsor insolvency, and member security beyond the corporate grave has worked to the detriment of a generation of workers. Its costs have blighted both the finances of a wide swathe of companies, as well as their human resource management practices.
In its wake, this has left only defined contribution; an investment fund lacking any provision for a pension. This is harmful to the extensive majority for the benefit of only a small minority. It really is past time to correct the accounting and regulatory standards and practices.