DB scheme value Valuation – the long way round
Our blog (May 28th) calling for a bonfire of pension regulation led to a surprising amount of interest and a wide range of questions and even some requests for expansion of subjects touched on within that short piece. Given this, we will do so now, and in two further blogs.
Liabilities and assets
We will start with the relation between a corporate liability and its corresponding asset.
The identity here is one of rigid rotation (multiplication by -1) i.e. the cashflows are equal and opposite in sign, and so £1 paid to the holder of the liability is a cost of £1 to the firm.
However, the value of the asset to its holders is determined by its utility to them whereas the market price of an asset is determined by its utility to the marginal buyer.
There is no reason to believe that the company creating a liability and its holders share a common utility, and, as we shall see later, good reasons why they should not.
This means that it is inappropriate to use the market price of an asset to evaluate the cost of the liability to the company, as the bases for valuation are so clearly and fundamentally different.
This also extends to pension liabilities, and so even if the pension liability were tradeable and traded, it would be wrong to use of the market yields[i] on gilts or corporate bonds as the discount rate because the utility is different depending on perspective i.e. member vs sponsor.
The pension contract
Another key aspect of understanding this problem is the ambiguous effect of the non-negotiability of the pension contract, and the fact that pension contracts are complex and non-tradeable assets from the perspective of the member.
The terms of the pension contract may be changed, but only by a process of negotiation and agreement.
However, the pension contract may not be freely traded or even charged e.g. a member cannot sell their pension rights to a third party. Ordinarily, if an asset is traded it commands a higher price than if the same asset were to be non-tradeable i.e. liquidity has a value.
However, in the case of pension schemes, there may well be members who value the pension fund’s futurity; that is, the fact that the pension cannot be accessed until retirement without incurring punitive tax penalties.
Dangers of market prices
Another missing part of this debate is the fact that an asset may serve speculative, short-term purposes for trading.
Ignoring this means market price is therefore considered to wholly impound its future returns and their distribution, which is not true.
A consequence of the relation between an asset (the pension to the member) and corresponding liability (the sponsor’s obligation to the member) is that the symmetries of these distributions are reversed; the company’s cost/(risk) is the asset holders’ gain/(return).
Add to this the overwhelming empirical evidence that risk and return (gain and loss) are not valued (priced) in a similar manner, and the case against using market prices to value liabilities is obvious.
Using inappropriate methods can also be expected to yield paradoxical results e.g. the use of market prices to value corporate debt during the 2008/2009 financial crisis. During this time, we saw the prices of the debt of many financial institutions plummet as their viability came into question.
However, the actual obligations of these companies had not changed, and indeed in many cases had become harder to service, but this ‘valuation’ resulted in many companies reporting substantial, often multi-billion dollar, profits. The paradox is obvious.
The use of market yields therefore introduces bias and volatility into the valuation by sponsors of their pension liabilities. The exogenous nature of the market yield leads to a further problem, an absence of time continuity. The value of the liability arrived at by discounting at this rate will not equal the amount arrived at by accrual of the contributions at this rate.
This is problematic, as it can materially distort sponsor performance and as a result, corporate behaviour.
One case of this being liability driven investment.
LDI can be seen as an attempt to counter the volatility introduced by the valuation method;- and so sponsors are managing the volatility in measurement rather than underlying risk, as the contractual obligations remain unchanged. But these are hidden by a yield-based valuation approach.
Expected Return on Assets
Determining the discount rate as the expected return on assets is a method permitted by legislation. However, the amount of a company’s liabilities is independent of the way in which they are funded.
Pensions are no different.
There is no economic linkage between the amount of the pensions ultimately due and the assets held by a scheme as security for the accrued pension promise.
This is important and warrants repetition: a company’s liabilities be they pensions or otherwise do not rise or fall in amount with either actual or expected performance of the assets held to meet the promise.
There is also a question of achievability in the sense that subsequently realised returns rarely accord with assumed expected returns.
While the expected return method was discontinued for assets, the method is not entirely useless. The use of the expected return does provide an indication of the degree of scheme dependence upon the sponsor.
Whereby, if the value of the pension assets and discounted present value of the pension liability (using the expected return on plan assets) are equal( i.e. there is no deficit), then there would be no deficit recovery calls on the sponsor at that point in time.
Likewise, if there were to be a deficit then this would show the extent to which the scheme is reliant on the sponsor to make good any shortfall via additional contributions.
There is an assumption in such an analysis however, that implies that deficits may be one, immediately funded, and two, earn the same expected return as the existing portfolio of pension fund assets.
This method is also exogenous and will introduce spurious volatility and bias, though to a lesser extent in practice than gilt or bond market approaches. It lacks time consistency, and so both methods specified in legislation are counterfactuals to the question: what is the accrued amount of sponsor liabilities?
Contractual Accrual Rate (CAR)
The problem of liability valuation at a point in time between its award and its discharge by payment is generically one of amortisation.
There are many possible schemes for amortisation e.g. straight line. Indeed, it is possible to argue that many are superior (notably those which are time invariant) to the existing methods currently in use, as they do not have the property of being time invariant.
We choose an amortisation or accrual method which is consistent with the manner in which the projected benefits actually evolve and crystalize, namely standard compound growth. We call this rate the contractual accrual rate (CAR).
In the case of a single year’s award to an individual, it is the rate at which the contribution must compound to meet the projected benefits. The projected benefits are derived using standard actuarial techniques and the contribution is a matter of record. For a scheme, the CAR is the aggregate of these across members and time.
As was noted in our previous blog, this rate is time-consistent and fundamentally invariant.
It, and the liability valuation, will only vary to the extent that experience of the factors determining the projected liabilities varies from that expected;- or those assumptions or expectations are themselves revised.
In other words, these variations are all based in real changes to the amount of the pensions promised.
The second theme to our first essay concerned the role and level of funding, which we will cover in a later blog.
However, a prerequisite for the proper level of funding is the accurate and consistent valuation of liabilities and the use of the CAR delivers that, in addition to providing true and fair values for corporate accounts.
[i] A bond yield is an alternate form of presentation of price.