There is a paradox besetting defined benefit pensions. The Pension Regulator’s proposed DB funding code insists schemes take risk off the table while the person TPR reports to , Guy Opperman is busy asking them to put it back on again.
The paradox is beautifully explored in this great talk from Con Keating, which asks why accounting standards have led to discount rates so low that DB schemes are always chasing their liabilities only to see deficits widen as real yields remain negative.
In this webinar, Keating examines the role of discount rates in IFRS19 (Employee Benefits) in the reporting of defined benefit pension schemes. He considers the fundamental properties of discount rates and uncertainty and goes on to demonstrate that the approach in the current standard produces liability values which are counterfactual to the true liabilities of a DB scheme.
Crucially, as a result of the decades-long declines in interest rates, the standard has and continues to overstate the magnitude of pension liabilities. Con Keating considers a range of alternate methods which are in use, e.g. those utilising the expected return on assets as the discount rate, and show that all of these rates are exogenous and produce counterfactual values for liabilities.
He finishes by proposing a new method, the contractual accrual rate (CAR), to evaluate pension liabilities. This rate is endogenous to the pension contract(s) and accurately reflects the accrued value of pension liabilities of the scheme’s sponsor employer.
It is flattering to receive all of the credit for the contractual accrual rate but in fact, Iain Clacher and I arrived at this independently of one another at pretty much the same time.
The issue here is how to get the actuarial and accounting professions to take notice and comprehend the magnitude of past errors, and how to enable TPR & DWP to adopt more appropriate funding standards. If this requires legislative change, what changes are needed and who needs to take ownership of the change process.
However I fear it is too late to save DB private sector schemes, but the Government may find adopting CAR, might solve some deficit funding fears for public and quasi public sector schemes.
Bob, I couldn’t agree more that we need to find a way to enable TPR & DWP (as well as USS!) to adopt more appropriate funding standards. We need to provide a suitable ladder for them to climb down. I suggest the way to do so is to move away from a system that determines the health of a DB pension scheme according to the capital value of its liabilities discounted at an arbitrary rate of interest.
We should adopt a funding standard based on the scheme’s cash flows and time horizon. A scheme with a long time horizon would pay benefits from predominantly equity income (** see below) and contributions without needing to sell investments. Only schemes with a short time horizon and a negative cash flow would need to be invested predominantly in bonds.
We have lost sight of the fact that the principal determinants of long term investment returns are the rate of income generated by investments and the rate of growth in that income. Let’s get back there!
Where Con Keating is wrong is when he somehow thinks companies have very long term lifespan, which is not true at all.
If you look at UK companies which have DB pension liabilities, the majority are companies which is hard to believe they will be around in 20 years. For example banks – with the advent of stable digital currency, they would lose a lot of their role they have today.
Many oil and gas companies too, should either manage to reshape themselves or will disappear.
The way it works today, is that we have the PPF. So if these schemes are to inevitable fall into the PPF, they better do this close to fully funded at least at the PPF level.
We have had this discussion before. The simple fact is that neither the national insolvency statistics nor the PPF experience support your assertion. I would refer you to the relevant chart from the Purple Book – page 55 – that shows the failure rate among DB schemes was around 1.2% in 2008 and has fallen to around 0.8% in 2020. That is an increase in half life from 55 to 86 years. That is actually an overstatement of the corporate failure rate as there are many companies which have multiple schemes.
Your argument re funding and the PPF is specious and in any event is completely irrelevant to CDC schemes.