The picture above shows Con holding forth at a lunch in Whitechapel, I think he was talking of this very subject. “What oft was thought but ne’er so well expressed” – thanks Con!

Prompted by the publicity surrounding DB pension transfer values, an old friend obtained a quotation for his pension. It was 33 times the initial pension payable. He found this surprising, and asked me do a little analysis, in return for the traditional “old fashioned” lunch.

Using the longevity expectations and other assumptions of this scheme, the total future (undiscounted) pensions payable to my friend, over his lifetime, will be just 38.5 times the initial pension. A little reverse financial engineering delivers the discount rate implicit in this valuation – it is 1.13%.

As my friend observed: “If I leave the money where it is, I will only earn 1.13% on it in future. I can surely do better than that.”

This transfer valuation is not particularly extreme – I have seen multiples as high as 43 times and stories abound of values as high as 55. That latter value is simply incredible – with assumed pension inflation at 3%, an implicit life expectation of 32 years (at age 65) is needed for the total future pensions to equal this value. A 1% discount rate would extend this to almost 37 years.

This quotation of my friend’s pension represents quite a remarkable (weighted) return on the contributions made – 18.45% – a spectacularly good investment, over several decades. The implicit return[1] promised under scheme terms on these contributions was 7.95%. In other words, my friend should have been expecting a transfer value of 15.4 times the initial pension payable, not the 33 times quoted. This lower figure was the commitment originally underwritten by his sponsoring employer.

“Freedom and choice” has introduced a new option into scheme arrangements. It is an option which is staggeringly expensive to sponsor employers, more than doubling the real cost of provision. It is a long-term option on discount rates written by the sponsor, which after the many decades of declining interest rates is now deeply in the money, so much so that it would be a churlish cavil to consider, at this time, the value of the residual term of the option arising from market volatility.

In my friend’s case, the credit status of his former employer, or the level of scheme funding do not enter consideration. It has been earning over 10% p.a. on its capital for decades, is likely to continue to do so, and is large relative to the pension scheme (even at these valuations).

Ordinarily, we might argue that discount rates do no matter, that they are just a pace of funding calculation for a particular liability. “Freedom and choice” changes that. They are now counterfactuals which create real costs. Make no mistake, both current accounting and actuarial valuation standards are counterfactuals, addressing the question: what would the present value of these liabilities be, if this rate applied. Neither is an appropriate method of valuation. As has been argued many times before, the appropriate discount rate is the implicit rate of return determined by the pension contract.

The public debate has been focussed on the desirability of taking scheme members taking transfers, and it appears that the desire to leave bequests to surviving spouses and children is a powerful motivating influence. This has always been a concern with annuities, and DB pensions are just deferred annuities – the prospect of outliving our resources or the optimal rate of consumption do not capture our imaginations in quite the same way that “losing” capital on death does. Regulatory intervention has been focussed almost exclusively on protection of member “rights” and benefits.

There has been no discussion of the fact that no “right” to scheme assets has ever existed – Professor Sir Roy Goode made the point, many decades ago, that scheme members have an interest in the trust, not its assets. Nor has there been any discussion of the fact that these transfer values are gross overstatements of the value of the pension promise made. The amount of the so-called “rights” that are being so diligently “protected” are extortionate, and the authorities have become the enforcers of these claims.

This raises the question: where does the Pensions Regulator sit in this. Unfortunately, their narrative treats valuations conducted under the discount rates specified in the Pensions Act as facts, as reality. This is just one of many problems which arise under the Regulator’s narrative (for an extensive deconstruction of that, see:  http://www.longfinance.net/publications.html )

Why is the Regulator not raising concerns over the costs to sponsor employers, given that it has a statutory objective which they describe as: “making sure employers balance the needs of their defined benefit pension scheme with growing their business”. In a single word: arrogance. As Iris Murdoch’s definition of humility – a selfless respect for reality – makes clear, this misplaced belief in the veracity of current valuations leads directly to arrogance. And if the Regulator is serious about achieving excellence, humility is necessary prerequisite.

In the meantime, finance directors must content themselves with the rather cold comfort that actuarial “valuations” are usually lower than their accounting standards counterpart, throwing up an accounting gain as well as a liability reduction when members exercise the option and transfer out. And this method of discharging liabilities is far cheaper than using the bulk annuity market.

[1] This calculation assumes perfect foresight with respect to longevity and inflation, and ignores ancillary benefits, such as death in service benefits.

This piece first appeared in Portfolio Institutional