More market consistent follies – Con Keating on DB and DB transfer values

Today we’ll be looking at DB transfer values at our pension play pen lunch. Con can’t be there but has asked that his thoughts be fed into the debate- here they are

con keating

Con Keating- author of this blog

These past few weeks, two new subjects have dominated the DB pensions blogosphere: cash equivalent transfer values and service costs. Required contribution rates of fifty, sixty and even seventy percent of salaries are routinely reported. Transfer values have reached multiples as high as 40. Both are artefacts of the market-consistent accounting regime, and in particular the low discount rates now being used in scheme valuation.

Both are important in another context, that of intergenerational fairness. However before considering that it is as well to understand the relationship between gilt yields and subsequent returns at long horizons. Table 1 shows the correlation between gilt yields and the subsequent returns over periods of ten and thirty years from both UK equities and gilts.


The weakness of these relations should put to rest, forever, the idea that gilt yields are reliable and strong predictors of subsequent returns; even their own.

Intergenerational unfairness is a complaint often levelled at collective schemes, including DB. It arises from the uniform annual accrual of benefits regardless of the age of the member. The idea being that younger members, say, a twenty-five-year-old, should not join as the implied investment returns for them are far lower than for a sixty-four-year-old about to retire.

Of course, the younger member will have a far longer life expectation in retirement, perhaps forty or fifty percent above the member on the verge of retirement, a far larger and longer set of ultimate payments. However, this is not sufficient to offset the apparent disparity.

What is not being taken into account in that level of analysis is that the twenty-five-year-old faces far higher uncertainty and risk than the sixty-four-year-old, on the verge of retirement. If we consider financial risk to be identically and independently distributed, 6.3 times as much at retirement risk as the sixty-four-year-old.

As risk is such an elusive subject, we shall express this in terms of expected future values of investments. Let us suppose that both acquire an asset with an expected (arithmetic average) return of 8% and 20 percent volatility. The sixty-four-year-old has an expected future value of 106%, 98% of the headline rate value, while the twenty-five-year-old has an expected future value of 1028%, but that is just 47% of the headline rate implied future value.

This risk does not decay linearly with the passage of time: a fifty-five-year-old is exposed to three times as much risk as the sixty-four-year-old and can expect an at retirement future value that is just 75% of the headline value.

The lesson in this for those considering transfer out to a DC scheme is that they need to consider not just the usual issues of post-retirement decumulation, but also the likelihood of a smaller lump sum at retirement and a smaller pot from which to generate income.

There are also issues for the management of a scheme. If cash transfers reach significant levels, this will require a more conservative, more liquid asset allocation, together with its associated costs. This will harm the prospects of those remaining in the scheme; the classic test of an externality. Let us make this absolutely clear, using a lower discount rates feeds back through this mechanism into investment strategies which produce lower returns and raise the cost of DB pension provision. It is a strong argument for transfer value exit fees set at levels which eliminate the harm done by these departures to those remaining in the scheme.

The question of service cost is somewhat more perplexing. Under UK standards, the scheme I advise has experienced rapidly increasing accounting service costs. This year 61% of salaries, up from 45% a year ago, and 20% a decade ago; £6.2 million in the current year, which dwarfs the level of cash contributions for new awards – £1.97 million.

Over the last year, we have paid pensions of £11.0 million, a figure slightly below projection as inflation was benign. This was financed from investment income of £8.5 million, contributions of £1.97 million, with the difference drawn from operating cash balances.

The interest cost of these paid pensions, the unwind of the discounting process, was £470,000; the interest cost on the residual stock of liabilities, the increase in the present value of those liability projections due to the effects of the passage of time, £2.0 million. These two figures are derived from the original terms of award of these pensions and are not based upon market-consistent discount rates.

The existing stock of pension projections declined in amount as experienced wage inflation over the year was below projection. Experienced mortality was, unfortunately, higher than projected, which further reduced the projected ultimate pension payments.

The new awards add £1.97 million to the present value of liabilities; exactly the same as the contributions made. In fact, as these were priced to yield 5.5%, slightly below the average internal rate of return of the overall scheme, they will lower the required investment return of the fund marginally.

Indeed, examination of the pensions paid in the year showed that these had been originally awarded on a wide variety of terms, from over 14% pa to as little as 5.5% and averaged slightly less than the historic average of contractual investment accrual rates at 8.14%. The discharge of these historically created expensive liabilities will also serve to lower the required rate of return necessary to achieve full and timely payment of the residual promised pensions.

With so many elements moving in favour of the scheme, lowering the cost of pension provision, the open question is how can it possibly be that the accounting or actuarial cost of new awards can have exploded. The answer is that this is another folly of the current ‘market-consistent’ valuation regimes. When a discount rate of 1.5% is used to discount the new awards, the required contribution is not £1.97 million but £4.66 million.

We are comfortable offering pensions which carry implicit investment returns to members of 5.5%, and with the idea that we have underwritten this rate of return. This is why we have contracted those terms with our employees.

For all the regulators and accountants arguing for ‘market-consistent’ approaches, let me offer them a variant to their own caution: current yields are, at best, a poor guide to future returns.

With such inflated estimates of the cost of provision, it is hardly surprising that so many schemes have closed to new members and future accrual. Contrary to popular belief, DB pensions have not become unaffordably expensive; the current metrics mislead badly and help to foster that misperception.

The greatest unfairness is that arbitrary accounting and valuation standards have inflated the reported values and costs of DB pensions and led to the effective cessation of DB provision, notwithstanding the fact that it is by far the most efficient form of pension organisation.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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