Death by discount rates

death 3.jpg

mat cern

Q: When is a million dollars not a million dollars?

A: When it is not yet a million dollars.

The pensions business is all about the long term. Fund managers like me are responsible for ensuring we have sufficient funds to meet our obligations not just today and not just tomorrow, but many years from now. And when it comes to defined benefit pension schemes in particular, future liabilities can appear daunting. Fortunately, nobody expects fund managers to be sitting on mountains of cash, all stuffed into envelopes marked with the names of their future recipients.

Instead, our job is to plan for the future, taking into account forecasted cash flows in both directions. But how can we be sure the contributions from pension scheme members and their employers, even when supplemented by investment income, will be sufficient to cover those liabilities? The truth is we can never be certain. But if we plan carefully and invest wisely, we can be fairly confident that we’re in a good position.

The difficulty is that regulators and accounting bodies are understandably reluctant to take our word for it and require financial statements to be prepared in accordance with the relevant accounting standards (including FRS102, IAS19 and IPSAS39). There has to be some agreed way of assessing whether a pension fund is viable, and the current standard techniques are to apply a discount rate to future liabilities. In essence, this determines how much the current assets on the fund’s balance sheet can fall short of future liabilities and the fund still be considered fully funded, on the understanding that the value will increase in time to meet pension obligations.

In the classic James Bond book and film Goldfinger, the eponymous supervillain plots to contaminate the entire US gold supply at Fort Knox, thereby increasing the value of his own hoard by a factor of ten. It’s a bold plan, but even without 007 bent on foiling it, such a scheme would hardly meet the ethical requirements of modern business. That’s why discount rates are rather more conservative than ten percent! For a long time, however, it has been widely recognised that current discount rates are too conservative.

Of course, you can always look at the worst case scenario. What happens if the company behind a pension fund goes bust tomorrow? Or as Goldfinger tells the captive 007 when he asks if the villain expects him to talk, ‘No, Mr Bond. I expect you to die.’

In reality, we do not operate on the assumption that all businesses are about to die. But discount rates do tend to assume that pension funds invest only in government or corporate bonds, which have very low yields, when in fact they are just as likely to invest in public equity, real estate, private equity or a range of other higher returning assets. So it’s widely acknowledged that many funds that are performing very well in terms of annual returns and overall growth will appear to have worrying deficits when considered in terms of discount rates.

Why does this matter? Well, because businesses make decisions based on these faulty assumptions. They often divert money into plugging the pensions ‘deficit’ rather than investing in the business itself, with obvious opportunity costs. Or the pension scheme fiduciary may decide to alter their asset mix, moving away from what would be better long-term investments in favour of less volatile bonds. And of course this drives up demand for bonds, which in turn drives down yields. And since discount rates are based on yields from those very bonds, we have a vicious cycle of pessimism and poor performance.

Global AA Corporate 10+ Bond Yields, Jan 2016 to Jan 2020, Bloomberg Intelligence.

Chart: Global AA Corporate 10+ Bond Yields, Jan 2016 to Jan 2020, Bloomberg Intelligence.

So what’s the solution? I don’t claim to have a ready-made answer to that. There are pros and cons to any means of assessing the health of a fund. But there are two possibilities that strike me as being better than the status quo.

One is using a long-term cash flow forecast methodology. This is less straightforward and less easily applicable to different schemes using different investment strategies, but that’s the point. Rather than a one-size-fits-all approach, it takes into account the particular strengths and weaknesses of a particular fund.

A second possibility is presenting two separate funding figures in financial statements. The first would be on an existing accounting basis using government or corporate bonds, addressing the concerns underlying the current approach. The second would be on an ongoing basis, offering a more nuanced picture of the fund’s actual investment strategy and portfolio. This approach would have the added advantage of making it clear that neither figure is definitive or infallible, an impression that’s all too easy to take away when just one figure is presented.

Whatever solution is adopted, reform cannot come soon enough. And I hope that, at the very least, an open and wide-ranging discussion of the matter will help pension scheme members, employers and indeed the financial press develop a better understanding of how pension funds work and how better to assess their viability. The whole process needs to be shaken, if not stirred!


Matthew Eyton-Jones is the CEO of the multi-asset and multi-strategy CERN Pension Fund, which provides pension and social security benefits to the staff of the European Organization for Nuclear Research (CERN) in Geneva

the post was originally published here

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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11 Responses to Death by discount rates

  1. Derek Scott says:

    “…. using a long-term cash flow forecast methodology …. is less straightforward and less easily applicable to different schemes using different investment strategies, but that’s the point. Rather than a one-size-fits-all approach, it takes into account the particular strengths and weaknesses of a particular fund.”

    In my experience a cash flow budgeting and forecasting approach is easier to monitor than trying to rein in volatile balance sheets. It compares undiscounted expected cash flows with actual cash flows for a start.

    Our funding framework in the UK is supposed to be scheme-specific, although an ongoing consultation by The Pensions Regulator suggests a one-size-fits-all discount rate, masquerading as “Twin Track”, where “Fast Track” is gilts yield plus a quarter or a half, ie a discount rate somewhere around 1%, and “Bespoke”, the slower branch line, is nevertheless to be assessed relative to “Fast Track”.

  2. Byron McKeeby says:

    Other discount rates are available.

    UK Government uses a SCAPE discount rate of CPI plus 2.4% for its unfunded pensions like the Teachers Pension Scheme.

    EIOPA, a regulator the U.K. may have less interest in after Brexit, publishes an annual “ultimate forward rate”. Its sterling rate for 2021 is 3.6%.

    UK 10-year gilts plus a quarter is currently 0.375%.

    Some actuarial comment on this timely blog would be helpful, I think.

  3. ConKeating says:

    It is reassuring to read such a heartfelt plea for sanity, particularly when all too many have become inured to the looking glass world in which we find ourselves.
    It is not necessary to abandon the practice of discounting. This technique can be demonstrated to be optimal in exponential (or growth) space – and that is the most appropriate framework for pensions analysis. The problem with all of the accounting standards is that they specify exogenous discount rates, and that means that they are all counterfactuals to the true position. As Iain Clacher and I have asserted on many occasions, the correct rate is endogenous. We refer to it as the contractual accrual rate (CAR).Simply put it is the rate required for the contribution to accumulate to the projected benefit liabilities. It possesses all of the properties that we might desire of a measure. Changes in it can only arise from changes in the amount of projected benefits or their timing – that is to say, changes that have real meaning for members and the scheme. Changes in the projected benefits can arise from experience varying from the assumptions made or from changes to the ongoing assumptions.
    We would be happy to engage and explain this further, but a blogsite is hardly the best venue for that.
    I should add that Iain and I are co-authors (of four) of a forthcoming paper on the theory and practice of discounting that we are preparing for the Scots accountants (ICAS) and EFRAG (the European Accountants Group). It would be good also for us to have a conversation with you in that context.

  4. Bob Compton says:

    Bearing in mind in the UK with TPR’s proposed new funding regime deferred a year by Covid 19, now is the time to get an Independent Enquiry to provide the opportunity to have a high level debate on future DB funding reporting..

    The current fixation with bond based discounting is killing DB schemes, and their Sponsors, Further it is transferring wealth from Companies who need the capital for development, to wealth managers with IFA’s creaming off their “advisory” fees, for the management of individual drawdown schemes.

    The Enquiry should be as high a priority for the Government and Treasury as dealing with the repercussions of Covid 19.
    Bob Compton.

  5. jonspainwp says:

    Well, I am really pleased to see this posted, thank you Matthew. In fact, for quite a while, I have been arguing on that the discount process is actually a really awful way of considering long-term financial entities (yes, I am a DB actuary). The four principal points are as follows.

    There IS one uniquely correct view of long-term future but we don’t know it, hence assumptions are needed. We need to aim at avoiding the “fog of certainty” (actuarial noise).

    Risk quantification is very poorly captured by scalars, with liquidity problems not identifiable in advance. Single numbers are not appropriate results for representing many future uncertainties, especially when the result is never fully specified (mean? median? mode? specified percentile?).

    Prudence can only be identified from a best estimate, which is never provided to the stakeholders. There has been a huge concentration on risk – without reward recognition.

    Using discount rates alone, which are virtually impossible to assess reliably, should be banned. Instead, we should be looking at multi-dimensional results with confidence intervals because the deterministic approach fails to recognise variations. Sensitivity analysis around a point without credibility is singularly uninformative.

    • Derek Scott says:

      Jon, some trustees are provided with information about the differences between “prudent” and “best estimates” (which were briefly called “neutral” estimates within actuarial standards, since amended).

      Paragraphs 6 through 9 of TAS 300 Reporting Standards (which used to be TAS M) still require the following, I think:

      6. Communications shall include sufficient information to enable the user to understand the level of prudence in the assumptions and the resulting actuarial information.
      7. Communications shall include an explanation of, and reason for, any material change in the level of prudence from the previous exercise.
      8. Communications shall explain how the discount rates used, or proposed for use, compare with the return that can be expected from assets invested according to any stated investment strategy, including any anticipated changes in that strategy.
      9. Communications shall explain how the return on assets assumed in a recovery plan compares with the return that can be expected from assets invested according to any stated investment strategy, including any anticipated changes in that strategy.

      • jonspainwp says:

        Thanks, Derek, I don’t believe those TAS 300 requirements are often complied with. The scheme actuary is only allowed to talk about TPR stuff. In my experience, best estimates were almost never discussed, except perhaps for megalarge clients.

      • Derek Scott says:

        If so, Jon, that’s a shocking indictment of some actuaries, and I hope someone at FRC is overlooking these blogs.

        I have admittedly seen a reluctance by some actuaries to confirm these “best estimates” in writing. For example, they may feature as part of a PowerPoint presentation, but not included in the formal valuation report, although I guess that’s why the TAS standard uses the word “communications” as a cover-all.

        I do think “engaged” trustees (and I’ve known quite a few) are capable of asking for these things.

        But I can also remember times within the last decade when many trustees seemed to be blissfully unaware of the choices around discount rates (for the present anyway) within the Occupational Pension Schemes (Scheme) Funding Regulations 2005 or the original IORP, and these “flexibilities” have to a large extent been retained within IORP II.

  6. Bob Compton says:

    Could the issue here be most Actuaries or Actuarial Consultancies are more concerned with sticking to a “perceived” view of TPR requirements rather than catering the need for both Trustees and Sponsors who need to have a realistic presentation on where a scheme currently sits in its on going journey to deliver member benefits. I suspect the real client has been forgotten. If this is the case this should be brought out into the open, as it is a damaging practice that should be modified.

  7. jonspainwp says:

    Thanks, Derek, I was unaware that there had been any such disclosures, so I’m grateful for the update. However, there is a real problem with that, which I’ve mentioned at the URL below. Although I thought I’d also covered it in various actuarial presentations, it seems not.

  8. Eugen N says:

    Interesting comments. One important question here: are all businesses expected to die?

    There are many which are expected to die, either in the next 10 years, 20 years, or 40 years. Businesses do die, mainly due to disruption and technological advances. One argument is that coronavirus has brought this forward for some companies.

    I would argue that even Universities are not immortal businesses, even if some were around for 100+ years. They could be disrupted too.

    The second issue is that Pension funding rules are drafted like all businesses going to die tomorrow or very soon. Somehow in the tPR opinion a business should have its entire funds in bonds (fully LDI) before the business dies, irrespective of the age and life expectancy of the members. I do think that is wrong, and clearly a different approach is needed, in fact the whole funding rulebook must be rewritten. At this moment, the rules are written to increase the dependence on the sponsoring employer, instead of diversify it away and take other equity risk. The existing rules just make the business life shorter, diverting important resources to fund the pension scheme, from investing in the business or increasing DC pension contributions for younger employees. In fact many businesses work hard now to pay high DB contributions to secure good pensions to people who do not work anymore in their business, paying small DC contributions for its exiting employees, something quite strange!

    Not last, I have seen a few situations when trustees have invested poorly the funds, the USS is one example. They have taken investment risk and results were well below the MSCI World equity benchmark for their risky assets. In the end, if risk is taken, risk needs to pay and performance should be very close to the benchmark!

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