Pensions Accounting and Regulation
In terms of the economics, pensions are simply claims on future production. This elementary observation carries with it some profound consequences for both their valuation and management. These claims can, of course, be expressed in either real or nominal forms, but the distinction between these is not material in this article.
There are only two forms of asset, that is to say claims on future output, which participate directly in (or own) future production – government debt obligations and private sector equity. In the economic terminology, these are the assets in positive net supply; this also known as ‘outside’ money, meaning outside the private sector. The game under which productive returns accrue to these assets is simple; it is a game against nature. We are striving to maximise production for a given set of inputs; it is constrained by human, physical and natural resources and capacities. Risk is exogenous.
There are also many forms of asset which are in zero net supply in the private sector; this is simply recognition that one man’s asset may be another man’s liability. Corporate bonds are a classic example; they are issued by companies and purchased by individuals. In accounting terms they are in zero net supply in the private sector. In economic terminology, if these assets circulate they are known as ‘inside’ money. Derivative instruments are a prime illustration of assets in zero net supply. Like equity and government debt these assets also promise productive returns, but the game is different – it is more complex. Here the game is among the various claim-holders; the returns of a corporate bond, for example, result from a game played between a company’s debt-holders and its equity-owners. The concern is with the distribution of the productive returns of the company among these different classes of investor. This is a mixed game, since it is partly a game against nature (if there are no productive returns there can be no distribution effected.) and partly a game against others. Risk is now partly endogenous and partly exogenous. Financial markets and the asset prices which arise from them possess this mixed-game risk property, but also have further significant complications which were discussed in the longest blog here.
If the State awards a future pension to an individual, it is promising a share of future production. If it wants to estimate the current cost of that liability it should discount it at the expected growth rate of the economy’s production. Note that this is not the expected growth rate of the public sector, which if we believe the economic orthodoxy of the 1980s is likely to be lower than both the private sector and the aggregate economy. This difference arises from the ‘special’ nature of the State, which may, for example, raise future taxes on the private sector, should the need (or desire) occur. The ultimate payment and discharge of the pension liability may be met in a number of ways; higher taxation or borrowing at that time are just two of them. Investing in private sector equity would be another. Buying government bonds suffers a variant to the zero net supply problem; if the government issues bonds to finance the pension award cost, then it must invest these funds, but if it chooses to invest these funds in government securities, then it negates its own facilitating issuance in an accounting sense.
If the private sector awards pensions to individuals, it is also promising a share of future production. If it wants to estimate the current cost of that award, then it should discount it at the expected growth rate of the private sector in the economy. This is the return on equity of the private sector. At the level of the individual company, the relevant discount rate is its own prospective return on equity. The ultimate discharge of that private sector liability may also be met in numerous ways. Investment in government bonds is one of them. Investment in its own equity, of course, leaves the employee and pensioner with a potential problem of risk concentration.
If we take a very simple view of the role of the State and consider it only to serve a redistributive role within a society, then we observe that all growth in production emanates from the private sector; that is to say private sector equity drives everything. The relation to the State is merely redistributive through taxation. There is no inherent risklessness to State obligations as all production occurs in the private sector; the State, through its powers of taxation, can however prioritise its own obligations.
When the State chooses to borrow to invest in productive activities, such as public goods supply, there are strong arguments for the private sector to invest voluntarily in these debt securities. These arguments are based upon a combination of taxation, risk diversification and public goods spill-over benefits. Education is perhaps the best example of a modern public good.
The description of pensions this far has them written as direct obligations of the employer, either the State or the private sector firm; they are contracts to deliver an income over the life-time of an employee spent in retirement. There is no dependence in the pension contract upon the levels of interest rates. These contracts require that the State and the private firm continue to exist for the period of time that its pensioners will live, but one of the principal differences between the State and private sector enterprises lies in their degree of permanence; firms can and do fail relatively frequently. This problem gave rise to attempts to create institutions which have a greater degree of permanence than private sector firms; these are the pension schemes and funds which (used to) dominate much of our financial landscape.
There is, of course, the polar opposite; individual self-sufficiency. In this case, other than for differences in taxation, the firm’s contribution is set, without further recourse, as a current payment and really does not differ from any other employment expense. (DC) Only if the employee values this pension contribution higher than the same sum as wages is there an incentive for the employer to make these contributions; the evidence seems to be that most employees do not prefer pension contributions of this type to current wages. Neither the firm nor the State can be considered to be providing a pension, a retirement income; they are merely making contributions to a tax-advantaged savings scheme. The individual alone bears all of the risks associated with the investment of these funds and their conversion to a retirement income, as well as all of the idiosyncratic risks of his personal circumstances. In practical terms, this means that the individual has significant exposure to financial markets; in terms of the magnitudes of these exposures, the dominant concerns arise with the total value of the pension savings at retirement and the use of these funds for the purchase of annuities or drawdown, the progressive sale of these assets. These uncertainties are substantial; the individual must live with this uncertainty during their working lifetime, and if drawdown is the chosen conversion mechanism, post retirement also. One of the greatest problems with this dependence upon markets is that we really do not understand what drives market prices at the day to day level.
The typical defined benefit pension scheme (DB) is a far superior form of organisation to this individual provision. This is true for the individual and the firm. Here the company makes contributions for each employee and promises to pay a retirement income related to the career average or final salary of that employee and the length of service of the employee. The employee may also make contributions. This is a true pension. The sponsor firm underwrites the balance of costs of the scheme should these contributions and their related investment income prove insufficient to pay pensions as promised. It also owns any residual assets within the scheme after the full discharge of all pension liabilities.
This collective structure has far lower dependence upon financial markets. It is the net cash-flows, pensions paid less contributions and investment income received, that need to be invested or realised by sale in markets. Some schemes, such as UK local authorities, are in cash-flow surplus and are net investors in financial markets, others such as the declining industries, which once employed large numbers of people, are in cash-flow deficit and are net sellers of securities. The important point here though is that the primary issue is not the market price of an asset but its income generation characteristics. The firm may choose to make additional contributions when the scheme is in cash-flow deficit – this would be a marginal pay-as-you-go arrangement; it may also choose to make additional contributions to increase the investment assets of the scheme and their income generation. This latter option should be determined by the relative returns to assets in financial markets when compared to the earnings of the sponsor firm.
The collective scheme structure also pools the idiosyncratic risks of life-time experienced among the membership, reducing that uncertainty. These cash-flow and longevity characteristics, in turn, mean that the firm may provide pension benefits under DB at a materially lower cost than under DC, which supplies it with an incentive to offer this form of compensation in preference to wages. The scheme has a form of permanence which extends beyond the life of the sponsor. It is most surprising that official recommendations and actions should favour the provision of DC rather than the more efficient DB pension. There is actually an argument here for State subsidy of DB rather than DC provision. It is most surprising that the effect of DB regulation has been to penalise and deter its ongoing provision. In search of certainty and security for DB, regulation has raised the costs of administration and provision to intolerable and highly inefficient levels.
The sole risk faced by the scheme is sponsor insolvency and termination of the firm’s underwriting commitment. However, it is not meaningful to evaluate the scheme’s permanence given its current level of funding; that must be done from the point of sponsor insolvency and consider the level of funding and income generation at that point in time. Obviously, with no further contributions being made to it, this is radically different. The simplest solution to this problem is pension indemnity assurance; the substitution of an insurance company for the sponsor firm as underwriter of the scheme in the event of insolvency of the firm.
However, the scheme could also operate on a stand-alone basis, but to do so would require it to be sufficiently well-capitalised to cope with unexpected variations in the realisations of its risk factors. Now these are far wider, with inflation and longevity figuring prominently. If insurance company ‘buy-out’ quotations are a fair guide, this capitalisation needs to be of the order of 40% of the present value of total liabilities. This excess capitalisation is also problematic; it is not expected to be lost, paid away in higher pensions or sales of assets under adverse conditions. The question of ownership arises; the creditors of the failed firm may reasonably argue that these are residual assets which are the property of the firm and belong now to the creditors.
We should note that the evaluation of such a stand-alone scheme would utilise its return on assets as the determinant of its solvency; this is the analogue of the earlier return on equity. If the present value of liabilities using this discount rate is higher than the market value of assets, the scheme is insolvent.
As the scheme is now effectively a mutual enterprise, a third possibility emerges: capitalisation of the scheme by its members. This is another form of risk-sharing; variation of benefits receivable upon the occurrence of adverse events. The Dutch variable indexation model has this form. The disadvantage is that this introduces a degree of uncertainty as to the future pension receivable.
 I ignore, for simplicity, the possibility that the State may purchase private sector assets, though, of course, quantitative easing permits precisely this.