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.
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