Solvency and Funding
This is the second of our blogs answering questions which arose from our original essay written in response to the proposed DB Funding Code. It covers issues of solvency and funding.
Solvency estimation involves the comparison of assets with liabilities. Current practice is to use market prices for assets and discounted present values for liabilities, making this approach mixed attribute in nature. The consequence of a mixed attribute approach is to introduce spurious volatility and bias into the solvency estimate.
In an ideal world, we might consider projecting the cash-flows associated with the asset portfolio and compare this with the projected pensions payable. The comparison is most easily done in terms of their present values using a common discount rate. Regardless of the rate chosen, any deficit would be proportionately correct but measured in terms of the value attributed to assets. However, the value attributed to liabilities would not accurately reflect the obligations of the company sponsor, unless this discount rate were the contractual accrual rate. Moreover, the value arrived at using a present value discounted cash flow would mean that asset values would likely differ from the current market price of those assets.
When this projection method for assets was in use it frequently led to higher values for assets than their market price, and was open to abuse, which led to its discontinuance. For the avoidance of any doubt: we advocate the use of market prices for assets and a discounted present value using the CAR for projected liabilities.
Best estimates, prudence, and dual discount rates
Projected benefits should be derived using standard actuarial techniques using the best estimates of the factors which determine those ultimate pension payments e.g. mortality and inflation. As time passes, experience will mount and any errors arising from faulty factor or parameter assumptions will diminish; put another way, the projected values of benefits will converge to the ultimate pension over the life of the pension promise, even if those factor assumptions are not revised.
The value of liabilities calculated in this manner is the best estimate of the accrued corporate obligation. There is no place for estimating this value in a conservative manner in the mistaken belief that this is ’prudent’. So-called ’prudent’ values imply inequitable treatment for other stakeholders and mislead scheme members by overstating the true amount of their pension accrual. It is also worth noting that accounting practice has also abandoned ’prudence’ in favour of ‘faithful representation’ i.e. economic substance has been substituted for legal form.
Some actuaries have developed the practice of using two different discount rates to value liabilities; one, usually bond-based, for pensions in payment and another, usually higher, for the pre-retirement accrual period. This approach is also present in the proposed Funding Code. The usual justification for this is that growth assets are attractive in the accumulation phase and bonds best suited to meet the cash-flow demands of paying pensions in retirement.
This is problematic in several ways. First, as noted in previous blogs, the amount of the liabilities of a company, and by extension, its pension scheme, is independent of the manner in which those liabilities are funded. Second, all the pension liabilities, regardless of their class (in accrual or payment), are secured by all the assets of the scheme, and the sponsoring company. Third, members must be treated equally; there can be no segregation of the assets of a scheme for the benefit of one or other class of members. Preferential treatments within the membership are prohibited.
The purpose of pension fund assets
Implicit, but unstated, within the practice of dual discount rates is the idea that the fund exists to pay the benefits when due rather than to secure the accrued liabilities of the sponsor. It is also evident in the proposed Funding Code’s ambition to reduce or eliminate the scheme’s dependence upon its sponsor. This is motivated by the principal risk faced by a scheme and its members, sponsor insolvency. However, this difference in purpose for the fund is not some subtle and nuanced philosophical distinction, it is substantial and important, and merits close examination.
The pension promise is a long-term liability of the sponsor company and is created by the company as part of the terms under which staff are employed and compensated. It is in many regards comparable to a long-term debt security issued by the company. A corporate bond promises a return on the subscribed amount and the return of the full principal at maturity. With a DB pension the company promises a return on the initial contribution(s) and payment of the pensions in retirement. DB pensions share a common characteristic with zero-coupon corporate bonds, whereby the interest accruals are much larger than contribution or subscription amounts, often by an order of magnitude.
As the concern is with sponsor insolvency, we should consider the treatment of ordinary long-term corporate debt in such situations. The amount of the claim of a bond holder is the return of the original subscription plus any unpaid interest due to the date of insolvency. With a zero-coupon bond, as no interest is due or paid until maturity, the majority of the claim is usually unpaid interest. Note that the rate is endogenous to the insolvency process, drawn from the original contract terms; it is not some arbitrary exogenous discount or accrual rate. It is also not a replacement cost of the future elements.
If this is a secured bond, this claim amount is the amount of collateral security required; it is the amount arising from the due performance of the company accrued to the date of insolvency. If collateral security is held to this level, then the bondholder has no further claim on the insolvent corporate estate. It is usual to hold such collateral security in a trust, to ensure their bankruptcy remoteness.
The duties and concerns of bondholder trustees are light. These trustees are concerned only with ensuring that the current value of collateral security equals this amount and if there is a shortfall requiring cure of that deficit within the term specified in the contract. This is usually a very short period of time e.g.90 days.
Given the immediacy of the situation, mark-to-market is an appropriate valuation technique for these assets. Here, trustees are not required to consider what may or may not happen in the future; they are not required to consider whether the assets held will generate the returns needed to service the promise made by the company. These practices have come about because they are equitable among all stakeholders of the company.
DB pensions belong to the same class of creditor and so they should be treated in the same manner. Any other treatment will be inequitable to one or more other stakeholders. Of course, Section75, PA1995, defines the pension claim amount as an open market replacement cost estimate, less the value of assets held by the scheme. This is inequitable to other stakeholders and should be expected to result in other creditors making arrangements under higher priority status and requiring more restrictive covenants for their advances. It is notable that many private equity and turn-around specialists will simply not engage with companies with DB schemes because of this.
While the section 75 value is relevant for solvent companies wishing to abrogate their obligations, it is wholly inappropriate in insolvency.
The ambition of the proposed code is to have schemes funded to levels which eliminate any dependency on the sponsor company. This is far higher than current levels. It amounts to raising the cost to that of purchasing an insurance policy externally. It is one thing for a company to offer a generous pension when the cost of that generosity will be borne over the life of the pension but quite another when that cost must be fully borne immediately.
To understand why such an approach is wholly inappropriate, it is useful to go outside of DB pensions and consider another stakeholder group i.e. shareholders. Shareholders have two sources of return: capital gains and dividends. Dividends are a major source of income for shareholders, but dividends are risky and can only be paid if the company exists.
If the company becomes insolvent, then as the residual claimants, shareholders will get very little once everyone with higher priority has been settled. If a company were to decide to direct corporate funds to set up a fund that paid dividends to shareholders irrespective of whether the company existed or not, then this would be challenged in court.
This is the logic of self-sufficiency. The aim of trying to remove risk from members is laudable but misconceived in this way. Member risk has been reduced via the existence of the PPF. Any funding above best estimate is, effectively, to give one stakeholder group preferential status and to misdirect corporate capital, which could be used for a myriad of purposes e.g. higher wages, expansion, dividends etc.
However, if schemes were to be funded to replacement cost levels, we would expect the application of section 75 in insolvency to be challenged in the courts. It is one thing for other creditors to tolerate inflated claims when the recoveries are highly uncertain, but quite another when there are substantial and visible assets involved.
The argument could rightly be made that funding to this level was improper in the exact same way as the placement of some company assets in bankruptcy remote vehicles for the payment of dividends to shareholders after insolvency or more generally under the principle of equity.
The problem which all the regulatory paraphernalia is seeking to resolve is that of sponsor insolvency and the desire to preserve member pensions as promised. This is a question of credit and may be addressed by credit insurance, which will be discussed in the third of our explanatory blogs.