Imagine buying a bond at par, say a ten-year, ten-percent coupon issue; then let five years pass, when market interest rates decline to one percent. At this time, the bond is trading in the market at £143.68 percent. Now, rather than selling in the market, you instead present it to the issuing company for redemption at this value. This is the fundamental position when taking a Cash Equivalent Transfer Value (CETV) from a DB pension scheme.
This possibility of such redemptions presents several problems. For example, management of the cash flow under exercise of the option, as this is larger and occurs sooner than was initially contracted. It is an intriguing variant on the bank-run. The cost of this funding, which was contracted as 10% p.a. for ten years, has risen to 16.31% and reduced to just five years. The option has proved extremely expensive to the corporate issuer or equivalently the scheme.
The exercise of this option will lower the credit standing of the issuer. If that is difficult to envisage, just think of retiring another liability, equity, where it is more directly evident. The extent of the credit impairment is due the excess cost paid over book value, which in this case would be £100. This is also the value of a creditor’s claim in insolvency and solvent liquidation. Moreover, the range of assets which may, prudently, be purchased by the corporate treasurer is more restricted than might otherwise be the case without this option.
Defined benefit pensions contain an implicit investment return, defined by the initial contribution and the projected benefits payable, the contractual terms of the pension. For most DB schemes, by virtue of their historic stock of awards, this inherent investment return lies within the range 6% – 8%. Valuing these liability cash-flows using lower discount rates will throw up excess costs in the same manner as the previous bond illustration.
The guidance on cash equivalent transfers makes it clear that the basis for an initial cash equivalent (ICE) appraisal is a best estimate valuation, not the prudent assumption basis used in the estimation of technical provisions requirements. This removes the prudent conservatism which overstates liabilities in the assumptions about longevity, inflation and other risk factors. The discount rate rises, and the present value of liabilities falls.
If the level of scheme funding is below this best estimate, then, after an actuarial appraisal, the CETV may be lowered further to reflect the member’s proportionate share of those assets.
At first sight then, this arrangement appears to be fair between the departing member(s) and those remaining, but that would only be the case if the discount rate used in the best estimate valuation was equal to the implicit contractual investment return. When this discount rate is lower, we have the equivalent situation to the earlier bond illustration, and the departing member’s withdrawal has a direct cost to the remaining members, which include the sponsor.
The effect of a departure also has a deleterious effect on the risk sharing and pooling properties of the fund, though this is usually small for any single member. However, it is possible for higher paid members to game the presence of the Pension Protection Fund. With a company in distress, these members may take CETVs even though asset values are below the ICE value, because their pensions would be capped under the PPF. Even if the trustee had the power to refuse CETVs, it would not be possible for them to do so on the grounds of harm to remaining members, since by this “best estimate” methodology there is none evident.
Notwithstanding the guidance on valuation, there appear to be many schemes which are offering transfer values based on gilt yields and extremely conservative inflation and longevity assumptions, making for very generous transfer values. This raises the much more interesting questions: how and why did we get here? But that will have to wait for another blog.
