Defined ambition – a trap avoided

con-the-apeThis is a technical note from Con Keating that explains why mark-to-market accounting really doesn’t work for CDC. He sets out a more equitable basis for measuring funding. See if you can follow Con’s logic – I think I can and when I got it, the idea became simple and fun.

 


Defined Ambition – a trap avoided

Suppose that we are offered an investment promise[1] with some implicit compound rate of return (contractual accrual rate, CAR), say 6.47%, on a contribution of £10 – the pay-off to this promise is a defined income in retirement. Then obviously we expect this to be worth £10.65 after one year, and let us assume that this contribution has earned the requisite 6.47% in that year. The contract is performing as promised.

Now further suppose, that we wish to make a further investment with a similar pay-off, the next year. However, for whatever reason the implicit rate of return (CAR) that is offered is only 4.42%, then we need to find £30 as the contribution[2].

At this point, we have assets of £40.65 supporting the total claim. Now if we apply so called fair value, or market pricing to both contracts, then we arrive at a valuation of £60.00 for the total portfolio of two promises. The expected return on assets valuation method of pension regulation will deliver the same result. The “scheme”, the aggregate of these, is reported as 67.75% funded, even though the writer of these contracts has performed fully.

Of course, if this were a regulated pension, the writer of the contracts, the sponsor employer would now be pressured to make good this “deficit”.

Now let us assume that we have two different, but otherwise identical, investors in each year, and that an investor may make withdrawals from their contract, or transfers, and that this will take place at the aggregate net asset value. Then the initial investor who contributed £10 in the previous year, on withdrawing, will now get to take away £20.32. This investor has more than doubled the initial investment, making the remarkable return of 103.3%, when all that was initially promised was 6.47%. The second later investor has security only of £20.32, less even than their contribution of £30, and can only realise a loss.

The equitable interest of the first is £10.65 and of the second £30. The sponsor is facing a demand for an additional £9.68 contribution.

The moral of this tale is simple: the application of fair value, or mark to market accounting, or the methods specified in the Pensions Acts (which are counterfactuals) for valuation will result in inequitable outcomes. In the case of DB schemes, it is usually the employer sponsor who bears these costs, but “Freedom and Choice” extends this possibility to scheme members. In the member mutual collective world of Defined Ambition schemes, it is certainly the case.

The correct form of accounting for DA (or CDC, CDB or whatever) involves the calculation, monitoring and subsequent aggregation of the scheme members’ equitable interests, a matter of historical fact, and pseudo-solvency, the comparison of that with the market value of assets held. It really isn’t difficult.


[1] In these pedagogic illustrations, the investment promise is a pension – a particular if arbitrary stream of cash payments from age 65, and the contribution is made, again arbitrarily, at age 25. However, these values are irrelevant to the point to be made.

[2] £30 is the contribution necessary to achieve the same pension payments as were initially buyable for £10, that is when the investment return on the contribution falls from the earlier 6.47% to 4.42%.

About henry tapper

Founder of the Pension PlayPen, Director of First Actuarial, partner of Stella, father of Olly . I am the Pension Plowman
This entry was posted in CDC, pensions and tagged , , , , . Bookmark the permalink.

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