Accounting and Risk-Based Regulation for Pensions
Accounting and risk-based regulation for pensions remain contentious. The accounting standard is mixed attribute in nature using market prices to value assets and net present values, based on an exogenous market observed discount rate, for liabilities. Regulation and regulatory intervention operates on current balance sheets reported in this manner.
Let us consider a perpetual pension payable of £10 p.a. due from a scheme which has a current endowment of £100 held in cash and no future income. It is immediately obvious that this scheme will be insolvent, unable to pay any pension beyond the tenth year. This is the point of equitable insolvency, the inability of the scheme to meet current liabilities.
The net present value of scheme liabilities and solvency ratio for this scheme are shown in Table 1 together with regulatory interventions based upon balance sheet solvency.
Though the fundamental position is the same in all cases with the scheme surviving until the tenth year equitable insolvency, the reported solvency and regulatory intervention vary wildly. In the 10% discount rate case, this regulatory intervention reduces the scheme to a pay-as-you-go basis after one year though it has assets of £90 at that point in time. In the 5% discount rate case, £50 is required immediately and the scheme then continues beyond that point in time on a pay-as-you-go basis. By contrast, under 15% discount rates no intervention is made until three years have elapsed and then it is that fourth year’s shortfall of £3.33 which is required, and thereafter, it continues from year to year on a pay-as-you-go basis.
It is clear that under this accounting standard, solvency is, at best, a very noisy signal of equitable insolvency, which may even be positively misleading. The discount rate used contains an implicit required survival time. There are, respectively, 20, 10, and 6.67 years for the 5%, 10% and 15% discount rates; the lower the discount rate, the greater the implicit survival time. The solvency ratio is merely the ratio of the actual to the implicit survival time.
The now wide-spread activity of pension schemes hedging changes in interest rates can clearly be seen as futile in the context of equitable insolvency and as hedging changes in regulatory interventions in the balance sheet view. The difference between balance sheet and equitable insolvency is one of timing and liquidity demand. Interventions based upon the balance sheet are calls for liquidity before equitable insolvency has been reached.
The relevant form of insolvency in bond markets is equitable insolvency. In the absence of further covenants, a debtor must default on a payment, and fail to cure this within an indenture-defined period, before action can be taken by the creditor. Balance sheet insolvency will occur prior to this; with fixed liabilities the survival time to equitable insolvency is a function of the discount rate. In other words, the standard, and regulation based upon it, is not market practice consistent.
A practical man will recognise that between balance sheet insolvency and equitable insolvency management may intervene to create additional income. Only in the abstract and unrealistic world of elementary financial theory is liquidity always perfect and complete. Only in this situation are all future revenues, pledge-able future income, fully reflected in current asset values. In this view, there is nothing which can be done to retrieve the situation. In most states of the world, management may restructure or refinance.
If market traded bonds were to trade on the basis of strict balance sheet insolvency rather than equitable insolvency, investors in them would demand higher yields, since the incidence of balance sheet insolvency is earlier and higher in likelihood than equitable. It is notable that, in times of market distress, when the options to refinance and restructure are restricted or entirely unavailable, the yields demanded by investors increase beyond those explicable by increases in a firm’s insolvency likelihood. This may be viewed as a shortening of the balance sheet / equitable time gap; it is a liquidity effect.
There is a voluminous literature on management diversions and principal-agent effects which result in non-pledge-able revenues. In times of distress, when scrutiny or monitoring are intense, the opportunities for management diversions are limited; indeed, management may even have an incentive to forego these perquisites entirely in the short-term to retain them in the long-term.
At the height of the recent crisis, the widening of corporate credit spreads above government securities far beyond anything explicable by increases in balance sheet based insolvency likelihoods was taken by many as cause for concern. Caution and conservatism in pension scheme discount rate assumptions was widely and wrongly counselled.
The idea that ‘risk-free’ rates, with government securities the proxy, were more appropriate also gained ground in those times. Indeed, it persists today. The recent EC consultation on the application of Solvency II to pensions offers the following argument in support of their use: “The valuation of liabilities reflects the character of the pension scheme (the level of security that is provided by the contract).”
It does no such thing. This is an exogenous rate. The use of a rate evident from market-traded securities does not confer the properties of the obligor of that security to any other entity which chooses to use that rate for evaluation of anything. Using a low rate inflates the present value, no more or less; it tells us nothing about the security of the obligation.
In pursuit of the “correct” discount rate for pension liabilities, let’s consider a simple scheme in which the sponsor employer promises to make an annual contribution of 15% of salaries in lieu of wages which will contractually entitle the employee to an income for life in retirement set according to an agreed formula – in other words, an occupational defined benefit scheme. For simplicity, this salary contribution will be retained within the firm. The situation is clear; we have an actuarially defined expected outflow, the pension payments, and a defined inflow, the pension contribution. This latter item is, in fact, a reduction in current working capital requirements for the firm.
Standard financial analysis would be to calculate the internal rate of return required for the contribution to deliver the pension payments. Note that this rate is endogenous, internal to the process. It is not an exogenous market observed rate. This is a book-reserve arrangement, though sometimes misleadingly referred to as an unfunded arrangement. In other words, the internal rate of return is the cost of this capital, the contribution amount, to the firm. It is fixed and remains fixed unless the pension benefits are altered. It is not related to bond market yields or any other external point of reference.
The question of whether this represents fair value to the sponsor firm is a question of the costs of alternative sources of such capital. However, it should be recognised that this contract is an ongoing affair, repeating annually with ongoing employment and wage bills. Markets transactions, by contrast, are simple one-off affairs with no certainty with respect to future funding costs or availability. This is a highly efficient form of institutional design.
Whether this represents fair value to the employee is a question of the return promised, adjusted for the likelihood that the sponsor will be unable to perform, by comparison with alternate investments. There are two points to note. Firstly, the sole risk faced by the pension beneficiary is sponsor insolvency. Secondly, such pension promises cannot be easily or practically replicated in financial markets. For the beneficiary, it would be necessary to buy a small deferred annuity and to repeat this every year on the same terms as are offered under the pension scheme.
The security of the contract is determined by the sponsor employer’s wealth and prospective earnings on that wealth. The use of market-derived rates introduces financial market dependencies into scheme and sponsor balance sheets which are simply not present in this contract or in the majority of sponsors’ commercial activities.
Funding is a security mechanism which can only mitigate the dependence upon the sponsor and it does so at the cost of lowering incentives for the sponsor to offer pensions. A detailed discussion of those aspects is not the subject of this article.
The valuation of assets at market prices is also suspect. Bond yields are lowered, and prices raised, in the presence of unpledgeable future income under equitable insolvency, but equity prices would be depressed. While this proposition has never been formally investigated empirically, it is consistent with many other findings, such as the ‘myopia’ literature, which finds that equity securities deliver future returns which require discounting at very high (myopic) rates to return the current market price. An alternate interpretation, here, is that there are some future revenues which are disregarded by the market, considered unpledgeable.
The nature of the institutional liabilities is also relevant in a regulatory context. Balance sheet insolvency may be relevant for banks whose liabilities may crystalise and ‘run’ in the blink of a rumour; far faster than assets can be liquidated at fair prices. However, for pension schemes where ‘runs’ are not possible, and liabilities are highly predictable in both timing and amount, the balance sheet view is both inappropriate and extremely costly.