Pension accounting is mixed attribute in nature, meaning that the measures of assets and liabilities are different. Market prices are used for assets, but liabilities are stated as discounted present values; these differ in some very important ways. Regulation operates on these reported balance sheet figures, and funding or reported scheme deficits are all-important.
A highly stylised illustration of this problem is appropriate. Suppose that a scheme has a commitment to pay a pension of ten pounds per year to its former employee, Methusaleh, who proves to be immortal. Suppose also that the scheme is endowed with £100 in current cash assets and has no future income or other contributions. It is then immediately obvious that the scheme will run out of money in ten years time and be unable to pay Methusaleh any further pension beyond that date.
Now suppose that perpetual interest rates are 10%, then the net present value of Methusaleh’s £10 annual perpetuity is £100. The scheme has current assets of £100 and liabilities with a net present value of £100. It appears to be solvent, in perfect balance, but yet we know that it will incapable of sustaining Methusaleh’s pension beyond ten years.
Next suppose that interest rates fall to 5% with all else unchanged, then the present value of Methusaleh’s perpetual pension payments is now £200. The standard now reports a deficit of 50% of liabilities or £100, as we have just £100 in current cash assets. The situation is, in fact, unchanged; the scheme will be unable to pay any pension after ten years. Even if the scheme had £200 in current assets, it would be unable to pay beyond twenty years.
It is clear that the deficit figures reported under this accounting standard have little or no meaning. Certainly they are unsafe as a basis for any management action, but pension regulation is based upon them. The problem arises because the present value estimation process operates on future events; it contains implicit future returns while the market value does not. This can be seen immediately by substituting for the current cash held, a perpetual bond with an income yield of 10%.
Only if the assets held replicate perfectly the interest rate used as a discount function does this status of solvency apply. In all other cases, including those where changes only occur in the future, this standard produces incorrect results with respect to the sustainability of the scheme’s pension arrangement. The balance sheet view is biased in that it brings these future liability events to the present but not those associated with assets.
This stylised illustration also illustrates the futility of a scheme hedging interest rates; the fundamental position is unaltered by changes in these rates. Moreover, as these hedges are costly, they can only serve to worsen the fundamental position. The sole possible justification is that the Regulator uses these deficit figures as the basis for further contributions. This is a form of regulatory avoidance, though perversely actively encouraged by further policies of the authorities.
This balance sheet view is often justified by the assertion that this is sound risk management; in an inter-temporal context it is not. Sound risk management would be based upon survival times, that is to say the time to equitable insolvency, predicated on the current state of affairs.