Why more funding doesn’t mean safer pensions.

I published this article last week under a different title and it didn’t get read much . I’m publishing it again because it is  very good  and because it challenges current received wisdom on DB pensions. Pensions have become needy and as the article explains, for all the wrong reasons.

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The funding gap

Con Keating and Iain Clacher

Scheme funding is now the principal risk management tool for DB schemes, a development which has been encouraged by parliament and the regulatory authorities.

It appears that the answer to everything is ever more funding of the pension promise and at the heart of this approach is the risk of sponsor insolvency.

The purpose of funding appears now to differ between secured accrued debt and paying pensions obligations. Historically, for DB pensions, this purpose was to provide security for the promise accrued, or earned and unpaid, up to the date of insolvency.

It has changed to funding being adequate to pay all pensions as they become due or to purchase a contract replacing the as-yet unearned future benefits promised in the case of DB pensions.

This change of purpose significantly raises the level of funding required, which is costly to the sponsor employer. In previous blogs we have commented on the inequitable nature of this latter interpretation.
In this blog we shall investigate the costs that these funding strategies impose on the sponsor employer and conduct a small thought experiment to illustrate the nature and magnitude of the issue.

We abstract from the complexities of a full DB pension scheme, and consider a zero-coupon 15-year bond issued at a yield of 6% p.a. which we can view as a simplified approximation of the costs (of the employer) and benefits (to the employee) of a pension scheme.

The bond matures at par (£100) and the initial subscription is £41.73 (the discounted present value of the par value, where the discount rate is 6%). We choose 6% as the yield on this bond as our analysis of a small number of DB pension schemes has shown the average contractual accrual rates (CAR) of their stock of undischarged awards to lie in the 6%-7% range.
If this rate appears high, given current market yields, it should be remembered that it is the result awards made over a history stretching back as far as the 1960s and perhaps even 1950s. One notable feature of DB schemes is that awards made in the mid and late 1970s may have embedded very high accrual rates – in many cases over 14% at the time of award.

Subsequent experience and revised projection assumptions have lowered this rate materially, to less than 9%. This is principally the effect of far lower than assumed wage and price inflation, countered by increasing longevity.
Returning to our thought experiment, we next consider the position after one year, when the accrued value of the liability is £44.73 on the contracted terms. As above, this figure may be derived as the discounted present value of the ultimate payment (benefit) or the accrued value of the subscription (contribution) using the 6% contractual rate.

Let us also consider the effect of using an externally chosen discount rate, say, the gilt yield for the remaining 14-year term. Assuming the gilt-based discount rate is 1%, then the reported value of this liability is now £87.0.
Ordinarily, these values would be immaterial if no action is based upon them. However, to maintain the comparison with pensions we now introduce a collateral security funding arrangement for the obligation, in the amount of these reported values.

conian

The difference in required funding cash flows is stark. It is immediately obvious that these funding strategies cause this obligation to differ in its effective term or duration, and with that their cost.

The original unsecured bond was 15-years. The secured 6% CAR-based accrued liability has a duration of 9.06 years, and the 1% discount rate variant has a duration of just 2.70 years.

The cost to the sponsor company in the unsecured case, where the obligation is funded at maturity, is 6% p.a. This rises to 10.13% p.a. when funding to the CAR level is required, and 38.07% for the 1% discount rate case.
A sponsoring company might well be prepared to accept a 15-year 6% obligation, and perhaps even a 9.06 year 10.13% obligation, but it is difficult to believe that any company would knowingly sign up for a 15 year 6% bond which could be foreshortened to a 2.70 year obligation at a cost of 39.07%.
This thought experiment illustrates the method by which DB pensions have become ’unaffordable’ even though there has been no material increase in the ultimate amount payable. It is the arbitrary application of exogenously sourced discount rates.


Investment returns and funding strategies

To estimate the cost of these different funding strategies to the sponsor company, we have assumed no investment returns. However, if we assume an investment return, we observe a fuller picture.  A return of 6% p.a. (1) is particularly informative.  At this rate, there is no cost to the sponsor beyond the initial contribution made at the time of award.

By contrast, an additional contribution of £42.77 (2) is still needed for the 1% discount rate case at the year one valuation. This contribution like all other assets in the fund will need to earn 6% per annum. This means that, in future, it will result in surpluses relative to the 1% discount rate liability valuation (assuming the discount rate remains at 1% for the remainder of the liability and is not decreased by other exogenous factors such as government largesse and QE).

This contribution is effectively an advance to the scheme on which it will earns the subsequent surpluses. If the excess funding (relative to valuation) can be extracted (3) at the time of occurrence (which is unlikely) the advance has an average life of 7.19 years, and 14 years if it cannot be recaptured before the discharge of the pension(s).

The practice of spreading large contributions over several years as a form of ‘deficit repair schedule’ is now common with changes to average schedules published annually in the Purple Book.

While having a schedule may alleviate a sponsor’s immediate liquidity concerns, it does little other than shorten the term of the advance i.e. . and these contributions still all earn the investment return of 6% p.a. in our example.

It may be that a 6% p.a. return on capital is competitive with the long-term investment opportunities available to the sponsor company, but this has the unique feature that, when market discount rates are used, its timing lies outside of the control of the sponsor employer.


Concluding Remarks

As pension funds are often promoted because of their long-term nature, it is worth noting that any contributions to a scheme, beyond the initial contribution, which constitute part the long-term capital of the scheme come about by extinguishing a long-term liability of the company.

There is no net gain in long-term investment. In fact, it may be that there is a reduction in productive investment as the money that comes into the pension scheme is invested in the financial economy i.e. existing assets e.g. equity in the secondary market or credit that is already in issuance.

This thought experiment is intended to illustrate the extreme dependence of the sponsor company’s cost of provision on the level of funding imposed and the shape of this through time. We have kept this to a single valuation, but it is perfectly possible to extend this analysis to include multiple dates, stochastic variation, and adjustments such as ”prudence”,but there would be little by way of new insight to the logic illustrated here.

Taken together, funding is a very inefficient and incomplete solution to the risk management problem of DB schemes, namely sponsor insolvency.


(1) If the investment return is just 1%, the sponsor cost is the single contribution of 44.85% for the 1% discount
rate case, while the cost for the CAR case is 9.44% p.a.
(2)This figure is the discounted present value at 1% less the initial contribution and the accrual on that of 6%.
(3) We have ignored the taxable nature of withdrawals from the fund.
Ian con

Keating and Clacher

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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19 Responses to Why more funding doesn’t mean safer pensions.

  1. Pingback: Lets stop kidding ourselves about pensions | AgeWage: Making your money work as hard as you do

  2. Derek Scott says:

    There may be good reasons why this article first published last Wednesday was “barely read”.

    As a DB trustee for over 33 years, and one of the numerate minority (as a retired chartered accountant who qualified 42 years ago), I still struggled with the arithmetic and didn’t recognise the calculations, no doubt done to “simplify” the issues, but in the process taking us a long way from reality.

    In 1987 we didn’t have to fund one lump sum payable in 2002. Instead we had to enrol thousands of employees with different rates of pay, different lifetime earnings expectations, different mortality expectations, different retirement dates, and other unknowns like future inflation. We had monthly contributions and when pensions started being paid out to retired members we had 25% tax free lump sums and annual pensions increases based on inflation not interest rates. We also had to offer AVCs alongside DB pensions.

    Our scheme actuary told us “9+8+6” by which he meant we needed a net investment return of 9%, and he expected average earnings to increase by 8% pa, which was 2% higher than his RPI assumption of 6%. Was that a contractual accrual rate? He never called it that, and I’ve never heard the expression in practice, which is why I’d suggest not just many trustees but also many actuaries just do not recognise the simplified examples and concepts in the article.

    I know in other writing that Con Keating dismisses prudence as bias, but I’d argue that prudence properly applied in its full senses (and not as used by many actuaries and accountants and even some regulators, to mean you overstate your liabilities and understate your resources in terms of assets and expected cash flows to meet them as they fall due) means a margin of safety to use in uncertain times. Some of the historic margins get called in when markets are volatile, as we saw in February, March and April, and in my view such margins should be topped up when markets were peaking, for examples in 1999, 2007 and 2019.

    What would I have done differently looking back on 33 years? Maybe put executive pensions in a separate plan or individual plans so those with the best prospects of salary growth and longevity don’t spoil it for the rest. Keeping executive pensions separate would also have helped with transparency and remuneration disclosures. Incidentally, we beat the actuary’s 9% net investment return, and average pay did not increase by 8% pa, nor did RPI average 6% pa. And yet we have big deficits from time to time. I don’t think our original actuary was too off the mark with his mortality/longevity assumptions either.

    Finally, and this may be in defence of the less numerate among us, ie the majority of us: I think there may be slight errors in at least two of the Keating & Clacher numbers? I got £41.23 not £41.73, and then there are references to 38.07% and 39.07% in close proximity when I thought they should be the same. But perhaps that’s the 1% investment return which is the difference?

    Could I also suggest Keating & Clacher explain the various CARs they mention with illustrations of how much the pensioner was earning and over what length of career, whether it was 6-7% or over 14% or some of the 40-50% rates mentioned elsewhere in connection with the Bank of England DB pensions.

    If we’re going to try a new way of estimating and funding using CARs, I’d like to see more realistic examples in the context of real world pay and pensions, please.

  3. Robert says:

    On 17/06/2020, in the blog entitled “The best way to manage a DB Scheme (Keating & Clacher)” https://henrytapper.com/2020/06/17/the-best-way-to-manage-a-db-scheme-keating-clacher/

    Michael Otsuka took this quote from the blog…..

    “the indemnity assurer may either purchase these from another insurer/reinsurer at the time of sponsor insolvency or it may write these itself and run off the pension liabilities. Purchasing annuities on insolvency is less efficient from a return on capital standpoint as it reduces the modelled return on capital by between 15 and 25%.”

    He than asked the following questions…….

    “1. Would it be possible to spell out the explanation for the reduction in modelled returns? Does this have to do with application of solvency requirements to annuity provides (such as 99.5% confidence and Minimum Capital Requirement) which would not apply to your preferred approach to indemnity insurance?”

    “2. Would the assets of your indemnity insurer be invested much more heavily in ‘return-seeking’ equities and property as opposed to bonds than the portfolios of insurance companies that provide annuities or the portfolio of the PPF?”

    “3. If the answer to 2 is ‘yes’, how would you respond to the objection that the value of these return-seeking assets would be vulnerable to fall in price during an economic crisis which gives rise to extensive pension sponsor insolvencies, and that the insurer therefore needs to countercyclically invest the proceeds of the levy in bonds rather than equities and property?”

    “(Apologies for mistakes in the above that reflect my ignorance of how insurance is regulated).”

    As there was no direct reply, have the recent blogs (including today’s) which are co-written by Con Keating & Iain Clacher, answered Michael Otsuka’s questions? If so, would it be possible that you could explain the answers in layman’s terms?

  4. ConKeating says:

    Robert
    My apologies for the misunderstanding – I received Mike’s queries as an email and responded in that way. I try to avoid posting such replies here and I had not realised it was posted. We do try to deal with such queries not posted in subsequent blogs.
    I have also been having trouble posting responses today – I have lost two complete sets of responses – and almost the will to live.
    To deal with these queries:
    1) The15%-25%arisesprincipallyfromthecostofpaying the annuity providing insurance company’s profit margin but there are also other smaller effects. The 15%-25% are with respect to the indemnity insurer’s base margin- fI that is say 10%, the margin would lie in the range 11.5%-12.5% if it wrote and ran off the annuities.
    2) The asset allocation might be more inclined to growth assets. This depends upon the population of schemes it has covered and their characteristics. Obviously, it also depends on whether they write the annuities or buy them in. The latter can give rise to large cash flow demands. It also depends on the form of premium. If it adopts the dual premium structure of the German PSV ( and common in marine mutual companies such as the P&I clubs), then the asset allocation is largely immaterial and the indemnity insurer can be thinly capitalised. The dual structure is a small initial premium at the beginning of a cover period and then, a second “clean-up” call in the light of experience at the end of the period.
    3) If the indemnity insurer buys in annuities, then it would face liquidity demands in times of high insolvencies and low asset prices. If the indemnity insurer writes the annuities, the high insolvency rates bring substantial inflows of scheme assets – it suffers larger than usual losses, but these will be realised over time. It is to a degree operationally countercyclical.
    If anything needs elaboration or expansion, please let me know.
    Con

  5. Robert says:

    Con,

    Thank you for this information……it’s much appreciated 👍

    Robert

  6. Eugen N says:

    Funding defined pensions with highly volatile assets was never a great idea.

    Historical markets could perform badly for 20 years of so, sending pensions schemes and their sponsoring employers in big problems.

    So I can understand why sponsoring employers would make the effort and fully fund the DB scheme and close it for further accrual as soon as possible. These are 30 – 50 old companies, they are already before their prime, and highly disrupted by technology, new entrants with cheaper access to capital, the last thing they want to deal is a huge deficit due to low stock markets. At that time, probably they are in survival mode themselves, like may retail companies or airlines are today.

    Defined benefit pensions is a done chapter. It is closed. From now on, it could only be DC, or a variant of it, with no further interference from the sponsoring employer.

  7. Derek Scott says:

    Why so down, under, Eugen N? Why be such a pessimist? Asset prices are only “highly volatile” if you measure them too frequently – daily, monthly, annually. And that’s also why some of the consultants push illiquid assets or “private assets” because they’re not valued daily, or even monthly or perhaps only quarterly, and in arrears, often with lags.

    Historic markets can perform badly, although 20 years is usually long enough for “lost decades” to work themselves out. DB trustees faced with market falls don’t usually have to sell much, if any.

    Clacher and Keating wrote here on 3 June 2020 that “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”. I agree.

    Even the current pandemic, which has seen some equity dividends cancelled or deferred and some rents withheld, has only required DB trustees to sell maybe 1% of their assets to make up any shortfall in expected income. That’s not a big ask if prudent trustees hold liquid assets and maintain cash buffers for such times.

    But we agree that DB pensions is a done chapter for many. And I have some sympathy for sponsoring employers saddled with IAS19 accounting.

    • Eugen Neagu says:

      Unfortunately, you would have to mark to market the assets at least once a year, and try to figure out the liabilities and assets for the DB pension scheme. It is not only because accountancy rules says, it is because it is normal to keep accounts for the scheme and measure progress.

      The main problem for DB schemes is their “defined” pension, it cannot be adjusted in any ways for market conditions. It is paid the same irrespective if the productivity will increase at 3% or 2% over the next 20 years, which will have an influence on future investment return.

      In terms of market prices, they are a function of the free cashflow listed companies would produce over the next 20 – 30 years and the discount rate that investors attach to these free cashflows based on their utility. I would argue that coronavirus has reduced the free cashflow for the next 20 years for many companies, however markets are at the same level given that market participants attached to them a lower discount rate. They do this in relation to the prevailing lower interest rate, and also because of increases in money and credit due to Central banks printing lots of money.

      You should not think that flooding the markets with money has no economic effect. The main effect is a reduction of future productivity, and as a result a reduction of future free cashflows. More bad companies survive, and the ‘value factor’ disappears. Bad companies remain bad, but trodding along. Interest rates barely go up over an economic cycle, and excess capacity is maintained. As Ray Dalio explained, we have learned how to defeat the economic cycle, by flooding the markets with money and credit, but in the process we have not done ourselves any favour.

      For my part, I am an equity investor, so my clients. But I cannot give any ‘defined’ guarantees of how much their retirement income would be. I am fair with them, and explain all of the above to them too, trying to keep their expectations rather low.

  8. ConKeating says:

    Derek
    A response to your comments – for which we thank you. The bond analogy was intended as a simplification to enable clear exposition of the simple point that funding brings with it costs and that these go well beyond the liquidity cost to the sponsor employer.
    I will respond to your points in the order in which you made them. Our ambition in simplifying to a single repayment bond was to focus on the effects of funding on the cost to the sponsor of any debt obligation. Of course, this takes us far from the reality of the specifics of pension funds-for example, DB schemes are unusual debt obligations inasmuch as their ultimate cost is not known with certainty, though it can be, and is projected.
    We might have taken into account all of the elements you mention but our feeling was that this would just take us down into the weeds of scheme design, and that the central message on funding costs would be obscured. Incidentally, the most difficult element to model and project is in my experience, cash equivalent transfer values where the timing, if at all, of the exercise of this member option and its amount seem to be back of a fag packet stuff. It is, of course, always possible to reduce a sequence of payments to a single point in time amount. We might have taken a whole set of details and assumptions about some notional scheme and used the resulting figures. We chose not to do this, in part because it would involve long and tedious calculations, but more importantly because this would have opened the door to endless dispute over the similarity or dissimilarity to some other cases, which would have obscured the central points we wished to make concerning the cost of funding. We chose an arbitrary notional value of £100 occurring in 15 years time, which is obviously and easily comparable to a zero coupon bond of the same term.
    Your 9-8-6 example is very interesting, particularly with respect to your subsequent experience. Your experience is similar to that which I described in the blog, though differing in the amounts. Pensions awarded under those assumptions would have cost less to deliver than was originally projected. I have this morning had that phenomenon challenged by some who claim that pensions costs have only ever risen.
    Is 9-8-6 a CAR? No. The 8 and 6 elements (wage growth and inflation) contribute to the projections of benefits and are important determinants of the future amounts payable. The 9% might be the contractual accrual rate if the contributions were set such that accrual at that rate would produce the sequence of projected benefits ultimately payable. The contractual accrual rate may be defined in these terms. It is the rate endogenous to the award. It will only change if the projected benefits are changed, and that may happen if experience varies from the assumptions made or those assumptions are altered. You will not have heard the expression as I believe I coined it to distinguish it from the many other discount rates in use in actuarial practice. I have subsequently come across the contractual accrual rate in IASB Basis for Conclusions documents where it is referred to as the “effective interest rate”.
    I will step out of your order to make the point that the reason for the deficits you are from time to time having to report even though you beat the investment return target and had far lower than expected wage and price experience, is simply the discount rate that is being used. The secular decline in gilt yields over 40 years and the lower projected returns on assets (for which there is scant evidence) have inflated and grossly exaggerated the present value of your liabilities.
    The problem with ’prudence’ is that it is now code for overfunding. It is also nonsensical to apply prudence to a discount rate – that is a distortion of a measure. By all means have prudent or perhaps even conservative assumptions with respect to the determinants of the benefits ultimately payable but to then add a further layer of ‘prudence’ through the discount rate compounds the inaccuracy of the value returned; it is, in risk management parlance, pig on pork. It may suit an employer sponsor to have a buffer within the scheme to smooth market volatility and calls on its resources. That is not objectionable, a matter of pragmatic operational management. However, that is not best achieved by misstating the value of liabilities. It would among other things imply a relaxation of ’prudence’ in difficult times.
    I would have agreed with the idea of separating executive from other employees when many approximations were used for ease of calculation, but now with the advance of technology such approximations and generalisations are not necessary. Part of my concern here is that heterogeneity among the membership is a positive for effective risk-sharing among members in CDC schemes.
    You are correct in your calculation -the correct figure is 41.23 not 41.73. Similarly 38.07, and not 39.07, is correct. These were transcription typos, not caught because my eyesight is now so poor I can’t even read bus numbers. £
    We will take your point on earnings levels. And the like in future scribbles. We will revisit this with realistic examples but our immediate focus is in the total cost of regulation to corporate sponsors-we have seen over £150billion of deficit repair contributions and the PPF is reporting deficits now outstanding of £290 billion which it appears the Regulator now wants made good.
    Our simplification appears to have been something of a failure.

    • Derek Scott says:

      Thanks, as ever, for such a comprehensive response, Con. I do wish others would engage in point-to-point so that we get clarity and agreement on many points, if not all. Instead there seems to be a tendency to set out one’s stall and ignore all feedback, whether constructive or otherwise.

      One of my other concerns about the bond analogy is that I’ve heard for many years from so many consultants that “pensions are bond-like”. If that’s so, please show me the bonds which have the characteristics I describe, such as 25% tax free lump sums followed by monthly payments and annual increases to monthly payments based nowadays more often on CPI than RPI?

      We agree that pensions are unusual debt obligations.

      I fear the “bond-like” comparisons for pensions have contributed to gilts relative discount rates becoming the norm for almost all actuaries, whether the trustees and/or their sponsors plan buyout in the foreseeable future or not.

      As for a relaxation of prudence in difficult times, that’s one of the ways in which I think prudential reserving can proceed. Banks, for example, used to be able to build up bad debt provisions in the boom years, then to release some of them in the fallow years. But short-term, pro-cyclical accounting standards put a stop to such prudent practices.

      So I would encourage trustees to use lower discount rates (or use your preferred discount rate but add a provision to the estimated liabilities so derived, a margin of safety) when markets are considered to be “toppy” and then to release some of those provisions in difficult times such as we are facing just now. And use relatively higher discount rates (with no additional reserving) in difficult times if there can be some confidence in eventual economic recovery.

  9. ConKeating says:

    Eugen
    I would agree that volatile asset allocations are a poor idea in general, but the specifics of what that should be is a matter of the risk tolerance and capacity of the sponsor. Diversified allocations can contain volatility to 10% or less, with little penalty on returns. I will add that I find the proposed diversification rules of the new proposed DB funding code formulaic and unlikely to be helpful.
    There are few companies which ever grow to become goliaths and develop the problems you describe. The insolvency statistics in the UK, US, Germany and Sweden do not support the idea of 30-50 year lives for companies. Failures average under 1% per annum in all of those countries, and more than half of that occurs in companies which are less than 5 years old.
    I don’t believe that we will see a revival of DB while we have the regulation currently in place with the discount rate mandated perhaps the most important contributor. Indeed I think that regulation will ultimately suffocate the few private sector schemes that remain open. However, I do think that given a generation of abysmally inadequate pensions from DC will result in pressure for DB revival.
    No involvement from the employer would, of course, mean the end of occupational pensions. And that opens a whole new can of worms.
    This was written before I read Derek’s response on this – I find myself very much in agreement with him..

  10. ConKeating says:

    Eugen
    A few points in response to your longer comments. I am sorry that my replies are out of sequence but I am juggling a few other things this morning.
    Using mark to market for asset prices is justifiable when we are concerned with that point in time but we are not really concerned with that for long-term institutions such as pension schemes. Other valuation methods which more closely reflect their use might well be more appropriate. Iain and I favour mark to market because we see the role of the fund as being collateral securing the accrued obligation of the employer.
    The main problem really isn’t the defined nature of the obligation. If it were, then we would not see any meaningful conventional bond issuance. They are far more fully defined than DB pensions and certainly cannot be adjusted for prevailing market conditions. Nor may their terms be adjusted for productivity. It is possible that productivity will have an effect on current investment returns but that is subject in any case to the share being taken by labour. The effect on future investment returns is far more tenuous and would need more precise definition to be able to test empirically.
    I know that this long-term free cash flow valuation theory is taught in just about every business school, but empirically it simply just does not hold true. Indeed the empirical work on implicit discount rates returns figures which are implausibly high. (See the hyperbolic discounting literature). The most basic fact is that the overwhelming majority of activity isspeculative, not value based investment. Just look at the average holding period data which lie in the range from a few minutes to a few days.
    I really do not see QE reducing productivity. It may allow a few zombies to survive that would otherwise fail but they do not dominate the economy. The usual effect of lowering the cost of capital is to increase productivity. Ceteris paribus this increases free cash flows.
    This has all gone very far from the topic of this blog.

    • Eugen N says:

      You said “the usual effect of lowering cost of capital is to increase productivity”. Although this should be the expected outcome if market participants were rational, unfortunately this is not true when measuring the results. Economic growth has slowed down in the last decade. Japan has an even longer QE experience of poor economic growth.

      It was well explained by Richard Koo in his work, and also by Ray Dalio. He names it the ‘QE trap’ and Ray Dalio names it ‘pushing on a string’ to explain the ‘struggle to convert stimulative policies into increased spending’ and the diminished result of monetary policies.

      Printing money is very effective for financial assets, in pushing financial assets prices higher, but not very good at generating economic growth.

    • Eugen N says:

      Bond coupons and redemptions are defined, but not guaranteed. There is no PPF for bond issuance. Not all bonds are redeemed, some are redeemed at a lot less than the promise made when they were issued. As you know, there are different issuers, of different qualities. Governments are supposed to be the highest grade, backed by the possibility to raise taxes! In reality, the backing comes from Central Banks printing more money.

      Bonds do create some form of certainty, and to some extent that is true. You could just look at the speed with which the FED intervened in March and decided to purchase fallen angels bonds this time.

  11. ConKeating says:

    Derek
    I am familiar with reserving from my days in insurance, but two questions – why embed this in valuations and why should it be held within the scheme rather than the sponsor employer?
    I don’t know the answers to these but they would need to be addressed.
    .

    • Derek Scott says:

      I would embed these in valuations just as we also embed an element of future PPF levy liabilities and other expenses. Such unfunded costs are capitalised once a scheme closes to future accrual as there are no more employer and/or member monthly contributions (other than any employer deficit repair contributions) to fund such costs year-by-year.

      If we must use pensions balance sheets (and I have a preference for pensions cash flow statements and budgets) we at least have an opportunity to add some capitalised provisions to the actuary’s estimate of the present value of future pension liabilities, using prudence and foreseeable unfunded costs as our reasons.

      In practice, sponsors pay PPF levy costs and operating costs, or scheme pays, even if you could argue that the contingent beneficiaries of the levy and future administrative support are the members not the sponsors.

      I don’t think employers will get tax relief (or even relief from their auditors) for making the provisions in their own balance sheets as IAS19 and FRS102 are so prescriptive and based on an odd mix of AA corporate bond yields and so-called “best estimates”. Even corporation tax relief for deficit repair contributions is spread over up to three years since section 197 of the Finance Act 2004..

  12. ConKeating says:

    Derek
    Indeed the expenses of a scheme are often covered by the sponsor employer but for those where this is covered by the scheme.I have no problem embedding recurrent expenses (e.g. admin and levies) in the projections of ultimate liabilities. Note not the discount rate. But provisions are another matter. I think you are correct in saying that these would not be valid tax deductions if held within the firm, but clearly when paid they would become so and be subject ro the spreading rules. Incidentally I think that this would, for most, be over four years as they are likely to be in excess of”£2 million. That is my reading (actually my P.A.’s reading to me (my eyesight) of the current Pensions Tax Manual, The counter to holding within the scheme is the stranded assets problem – the firm cannot liberate these assets easily or costlessly.
    Given this it may even be worth considering the difference between reserves arising from the excess performance of assets and those directly arising from sponsor contributions – but I have not thought that through fully.

  13. ConKeating says:

    TEugen
    Don’t make the mistake of comparing things to the Japanese experience. Its demographics and immigration policies cloud everything. I know Japan rather well, and made a small fortune from calling the end of their great bull market in 1990.
    The link between productivity and monetary policy does not rely on rationality, it is simply mathematical. If we have easy conditions and lower rates. The cost of capital for existing investments declines as the floating rate debt elements of that are lower in service cost-and productivity rises. The second effect is that new projects may become viable.
    “Pushing on a string” was originated by Keynes. It deals with the asymmetry of effect of monetary policy. High rates and tight money will suppress demand and inflation. But low rates and easy money do not assure the converse.
    Richard Koo. I should disclose that I have known him and his work for a very long time-we worked together at Nomura for three years in the 1990s. My principal collaborator from 2002 until his death in 2017 was Chris Golden. In that period there probably was not a month when he and Richard did not speak. I think you are referring to his work which is probably best described as the Fisher-Minsky-Koo hypothesis. His contribution is that in times of recession, low rates and easy money the reflation of demand and inflation may not arise as companies instead choose to rebuild their balance sheets. The solution to this problem lies with stimulative fiscal policy – which we have seen in spades in this crisis. Government debt issuance serves to mop up the high levels of consumer savings and liquidity.
    Richard’s books are excellent and his first the best.
    Your points on bonds are well made. Perhaps you will find the attached charts useful
    It appears that I cannot post diagrams here but I was going to add charts of defaults by years and their geographic and ratings make-up. Happy to send that by email -my address below

  14. ConKeating says:

    Eugen
    The ONS has released the productivity statistics for Q1 tiday- they are quite shocking
    Con

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