Holistic Balance Sheets
The Consultation paper shows figure 1 as the balance sheet of an IORP which stands alone, that is, has no recourse to further sponsor support. This is intrinsically the same as the treatment of an insurance company under Solvency II.
Figure 1: Holistic balance sheet for stand-alone IORP (EC Consultation)
In the case of an insurance company, the excess of assets over liabilities and the risk buffer (Components 3 and 4) are the property of external shareholders; this is the total equity of the firm, even though the risk buffers are earmarked as risk provision against the existing liabilities. However, when we consider a stand-alone, the ownership of this equity is unclear, leading to some ambiguity.
Ordinarily the first place for management to turn for recapitalisation in times of distress is to its equity owners. If these are The members of the scheme, employees of the firms which made the initial contributions, then this should not technically be considered an occupational scheme. The distinction that we draw here is that the pension is not supported by a producer employer. In the case of DC arrangements, this argument similarly applies and is further compounded by the absence of a pre-determined conversion of assets to retirement income.
If it is the members who own the IORP, this is a member mutual; an affinity group. This immediately suggests that they should receive both pensions arising from that liability and dividends arising from their equity ownership. From the standpoint of corporate governance this appears to be the incentive optimal organisation. It allows for two layers of protection in the event of distress, dividend distributions may be suspended and only after that, pension benefits reduced; it contains a form of early warning mechanism. Though it is usual with member mutuals to prefund the equity capital commitment, there are some mutual insurance companies which rely upon variable premium rates – the P&I clubs operate on the basis of an initial premium which reflects the ship-owner’s exposure and a supplemental premium which is set in the light of the year’s aggregate experience. However, member mutual IORPs lack (and should not possess) the ability to control admission to membership based upon that individual’s credit standing. It really is not feasible for such member mutual IORPS to rely upon new funds from members should the need for recapitalisation arise.
There is also a variant to Charles Goodhart’s station taxi analogy for banking liquidity regulation here. Local licensing regulations require there to be a taxi at the local railway station at all times, so the weary traveller, arriving late at night, is pleased and relieved to see a taxi at the rank only to be told that the taxi cannot take him anywhere because the regulations require there to be a taxi there at all times. We shall deal with this and the related issue of pro-cyclicality in regulation in a later note.
While it is feasible to increase the contributions of active members, it should be realised that this ‘solution’ is profoundly inequitable among members. However, that would not preclude the IORP from offering an option choice to members – recapitalise the IORP or accept pension benefits cuts. It is also possible that an IORP of this form in distress might be able to raise external capital; however it is clear that this external capital should participate in the performance of the IORP at a lower level of priority (equity or subordinated debt) than pension entitlement-holders.
There is a further difficulty with such arrangements as to when members may extract their equity capital investment, which arises from the inter-generational nature of the IORP. It appears that the simplest feasible treatment would be to make this heritable property. It is possible to envisage scenarios in which the equity participation of a member declines with their age in retirement, but the uncertainty of the life-span of any individual member would make such ‘solutions’ arbitrary in one or more regards.
This extended discussion of this form of IORP is warranted by the fact that the capital of the IORP has a cost and that brings ramifications for the actuarial fairness of pensions, that is to say the value for money of the pension contribution. If the contribution supports both the pension and ‘orphaned’ equity and all returns are attributed to pensions, then there is a real problem for transfer values – these would have to be based upon the pension liability value alone as the equity has no value if it can never pay dividends or distribute capital. It also creates problems for the concept of market consistency.
Next we examine accounting in a ‘holistic’ framework for the polar extreme of a funded scheme, which is the book reserve arrangement, rather than the UK model of funded pensions. It is interesting to note that such ‘unfunded’ pension arrangements were the norm in the UK until the Finance Act 1921 allowed the deduction of contributions from taxable corporate income. This is shown below as Figure 2. It is consistent with the ongoing concern, true and fair concept of English law and accounting practice.
Unfunded, book-reserve, occupational pension schemes are rightly entirely without the ambit of the IORP Directive and the Solvency II Directive. The reason that this treatment is appropriate is that the risk buffers and capital resources shown in Figure 1 are contained within the sponsor enterprise and are commingled with its operating capital resources. Obviously to make demands upon the capital structure of such producer enterprises falls within the ambit of national industrial policy rather than financial regulation or even unconditional social policy. The Consultation and the Commission’s Call for Advice are wrong in believing that occupational pension ‘schemes’ should be considered as financial institutions.
This relates to the difficulty which pension regulators and supervisors have with respect to the management of the likelihood of sponsor insolvency, the sole risk faced by pension scheme members. (See earlier note, “The Time line”)
Notice that the liabilities reported are the technical provisions for liabilities, the best estimate not some biased ‘prudent’ variation to these. In fact, it is arguable in the case of pension scheme accounting and valuation that ‘prudent’ in fact means no more than that estimates and projections are derived in a rational and well-informed manner. These liability values are those of interest to the sponsor employer in the management of their commercial activities.
There are further technical issues related to the use of ‘prudent’ estimates in cash-flow projection or discount function choice. These are biased choices of parameters but their effects are, in combination, opaque. Ex-post attribution of the magnitudes to these individual ‘prudent’ choices is dependent upon the order in which they are considered – attribution is a conditional process. Make no mistake, these differences can be very large. In one recent case, a scheme reported the conditional effect, which is to say after certain other adjustments, of a conservatively chosen interest rate to be £215 million. The unconditional effect of this rate adjustment was £296 million. It seems simpler and more transparent to make an ex-post adjustment to the best estimate value which are both published, say 10%. It is difficult to understand why there should be an explicit risk margin in addition to ‘prudently’ chosen parameters and determinants of cash-flow projections and discount rates.
Notice also that management of the risk exposures is correctly the management of the sponsor’s aggregate exposures to these risks and not the misguided variant to this which has developed at the instigation of asset managers and investment bankers, encouraged by regulation which operates on scheme funding. These approaches are known variously as liability driven investment or more generally, pass under the rubric ‘de-risking’.
It is immediately obvious in this elementary and most simple form of occupational pension provision that the pensioner is entirely dependent upon the ability of the sponsor to continue to pay pensions. In the UK willingness is not an issue as the liability to the firm is defined by statute as a debt, equal in amount to the Pensions Act section 75 value (sometimes referred to as the ‘buy-out’ value).
The claim on the sponsor is untraded. The assets represented by the liabilities are also untraded. This is a matter of social policy; if they were to be traded it is possible that some members would sell their pension rights and subsequently become dependent upon the state in their retirement having squandered the proceeds. It is not all evident that there is any supporting rationale for pension liabilities to be financial market consistent in this context. The value of these liabilities is entirely dependent upon the value of the claim on the sponsor, which is itself untraded.
Indeed, the Consultation correctly concludes that taking credit, a discount in valuation for ‘own credit’, which would be market consistent for those with traded debt, is inappropriate. This aspect of market value accounting has been widely criticised in the context of banking, where material proportions of their declared profitability arises from the low valuations placed upon their debt securities by market participants. This would be appropriate only if they had retired the debt at these prices.
The question of the appropriate discount rate to be used if a present value presentation is desired is also evident from this simple balance sheet. The value of the liability is entirely supported by the sponsor’s returns on its capital; this is the appropriate rate at which to discount the best estimate of projected cash-flows. It is interesting to note that the IORP allows the discounting of pension liabilities based upon the expected returns to assets and that this has recently been adopted in the new Dutch regulatory regime. It is a pity that the current accounting standard is so wrong is specifying the rate evident on a AA corporate bond. Using a so-called risk-free rate, with the proxy a government security’s yield, is even more inappropriate.
The Consultation offers three supporting arguments (shown in blue font below) for the use of a risk-free rate:
a. 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. The security of the contract is determined by the sponsor employer’s wealth and prospective earnings on that wealth. The use of such rates introduces financial market dependencies into the scheme and sponsor balance which are simply not present in the majority of sponsors’ commercial activities. When combined with explicit funding requirements based upon traded financial assets it generates increased negative feedbacks in the form of pro-cyclicality, with increased market volatility and scheme and sponsor instability.
Most importantly the use of a rate evident from market-traded securities prices 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 fact, when this rate is below the sponsor’s rate of earnings it overstates the present value and security of the pension obligation.
b. IORPs providing defined benefits schemes operate in the same market a s many life insurance undertakings. There are positive experiences in some countries having regulations that require IORPs to calculate technical provisions in the same manner as life insurers.
This misunderstands the fact that life insurance companies do not provide occupational pensions though they may provide defined benefit pensions to external third parties. (See earlier note, “The Time line”, for this distinction. They may provide occupational pensions to their employees. Given the dependence upon securities markets of life insurance companies, it is difficult to see how the assertion with respect to positive experience can be evidentially supported. If pension liabilities are calculated in the same manner, only if the capitalisation structure of both employer sponsor and insurance company are similar in variability resulting in similar insolvency likelihoods would we expect the liability values, which are defined by their security, to be similar. Note also that the lower volatility of private non-financial sector companies earnings, or returns on capital, relative to financial markets implies that the insurance company would need far higher capital resources than the private non-financial sector to achieve this outcome.
c. Market consistent valuation of both assets and liabilities allows for transparency regarding the financial position of IORPs and enhances risk management from an ALM perspective.
This may be better expressed as: market consistent valuation induces financial market dependence into the valuation of occupational pensions; an action which may be as unwise as it is irrelevant. In an ALM context it currently results in risk-hedging behaviour by schemes using financial market traded instruments. In other words it encourages funded schemes to focus on speculation rather than their correct objective investment. This raises the cost of provision of pensions by diverting funding to inappropriate activities.
The accuracy of these valuations and differences between them in the occupational pension context are in any event highly suspect and in fact, usually incorrect – see b. above for some of the reasons.
Now most of the schemes we observe in the UK are funded not unfunded book-reserve arrangements. Regulation explicitly seeks to ensure full-funding of schemes and in practice many schemes are seeking to take funding up to the level of self-sufficiency, more than 100% of technical provisions. We shall examine the wisdom of these strategies by reference to the performance of the past 35 years of market traded bonds, equities and private non-financial companies. The descriptive statistics for these returns are shown below as Table 1.
The question which we will address is what was the optimal allocation of assets among these three classes and use th