Never Knowingly Understood
This blog concerns itself with not what’s wrong with marking-to-market but with how pension liabilities should be valued in a true and fair accounting presentation.
The question as to which discount rate is appropriate for corporate liabilities has become vexed in the context of pensions. The accounting standards specify market-derived interest rates which can be demonstrated to result in time-inconsistencies. They also result in “hedging” strategies which seek to remove the volatility arising from the use of these interest rates as discount functions; most liability driven investment strategies involve some hedging of the discount function.
Some believe that modern financial economics specifies the use of these interest rates; it does not. This note considers the use of the prospective rate of return on shareholders’ funds as the discount rate for pension liabilities.
When we are concerned with a company’s ability to discharge a current liability we need to consider whether it possesses sufficient assets to do this. When the liability is deferred, we need to consider whether the company will possess sufficient assets as the future date. This depends upon the company’s current assets and the expected returns on these. For simplicity we will consider just a company which is entirely equity financed. It is then obvious that the introduction of a liability current or otherwise diminishes shareholders’ funds. It is also obvious that the current liability arising from a deferred liability such as a pension payment is the future value of that liability discounted at the rate of return on assets, which is this case is equal to shareholders’ funds.
Changes in this discount rate are meaningful. An increase in the rate of return on shareholders’ funds lowers the present value of the liability implying that it is easier to meet, or equivalently more secure than one which uses a lower discount rate. Similarly, a lower return on shareholders’ funds implies that the future obligation is currently more onerous. This contrasts starkly with the position when bond-market derived interest rates are used where the changes in the present value of liabilities may bear no relation to the changes in the sponsor company’s commercial prospects and ability to pay and perform.
The value returned for a deferred liability using this return on shareholders’ funds rate is the amount of current shareholders’ funds that it displaces. Obviously if the present value of these deferred liabilities using this rate exceed shareholders’ funds, the company is insolvent.
There is a naturally occurring funding strategy which arises from the use of this rate. When the rate of return on shareholders’ funds is low the present value of liabilities is high. If this rate is lower than may be achieved from the purchase of other investments, then it is in the interests of both shareholders and owners of the deferred liabilities to purchase those investments. The higher return on shareholders’ funds benefits shareholders and it increases the security or ease of payment of the deferred liabilities. There are two situations which need to be considered here – 1) these investment assets are held within the company, and 2) the investment assets are segregated as security for the liability owners.
In the case that these investment assets are held within the company, the company’s return on assets increases and total shareholders’ funds net of the present value of liabilities increases. These shareholders’ funds are a buffer against default by the company, which means that the liability-holders are more secure.
In the case that the investment assets are segregated to serve as security for the liability, by consolidation the return on assets is still increased and the pension liability is over-collateralised. This arises because the investment assets yield more than the blended return on assets of the company which determines its return on shareholders’ funds.
This allocation basis is economically efficient. Investments are made where they are most productive – in the company when it has high prospective returns to equity and elsewhere when they have high returns.
The overcollateralization is also interesting when the sponsor is idiosyncratically ailing and in distress. In this situation its return on equity will be very low and that of other investments normal. The blended return on assets is now far above the return on the company’s operating assets and of course the return of segregated assets even higher. In this situation, the segregated fund is very highly over-collateralised, precisely when it needs to be – since post-sponsor insolvency it needs more than 100% of best estimate of its liabilities to be assured of permanence and sustainability.
The shareholders’ funds remaining after deduction of the present value of liabilities measured in this way is a direct measure of the security of the pension promise – unlike the residual values that arise when using mark to market bond rates.
The special case of a scheme without a sponsor is particularly enlightening – here we have a pool of investment assets and a pool of pension liabilities. To know whether or not those liabilities will be met, we need ask no more than will these assets earn sufficient to discharge the liabilities as they fall due.
Some seem to believe that we cannot estimate a company’s earnings – in fact that is far simpler than trying to forecast markets or many other economic variables. Some argue that it is open to abuse – indeed it is – but an inappropriate earnings projection is rapidly evident from the company’s performance. The accounting rule could even be written such that adjustments due to over and understatement of earnings were reported as restatements of previous year’s financial statements. In any case, what are auditors for if not to provide sanity checks and the many assumptions and parameters that are used in the preparation of financial reports.
Over the weekend, I’ll elaborate on the question of why we do not want in pensions to rely upon, or induce dependence on, markets – something I signally failed to do last evening.