Taking research seriously
Jon Spain’s letter (April) refers to my sessional paper on monitoring DB pension funding. This concerned a valuation that ‘takes stock’ of the financial position of a scheme (rather than budgeting and investment strategy). I support liabilities based on placing a value on cashflows independent of whether they are assets or liabilities (I recognise there are issues, eg credit risk and illiquidity, so there isn’t a ‘pure’ answer). Using a (deemed) risk-free discount rate produces liabilities that compare reasonably with the insurance buy-out cost (there are reasons for differences). Financial economics covers a wider range of issues; that is a different debate.
A major problem is that, contrary to financial economics, many pensions actuaries regard liabilities as regulatory-defined technical provisions, meaning that their value depends on investment strategy. But a new asset mix with a higher estimated rate of return doesn’t really reduce the liabilities, which depend on salary, service, mortality etc.
I would expect trustees to take stock of scheme finances with a valuation using a ‘risk-free’ discount rate. That is consistent with several papers in the British Actuarial Journal. But it is missing from The Pension Regulator’s (TPR) new proposal that the sponsor covenant is relevant for technical provisions, which surely cannot then be regarded as scheme liabilities, a point I would expect the Pensions Board to make to TPR. Pensions actuaries’ practice has ignored actuarial research for too long already; it must change if we are to be regarded as a profession that is serious about research.
15 April 2020
Different approaches to pension scheme funding
I write in response to Jon Spain’s letter of 16 March, where he states that he does not think it is possible that ‘evidence can be produced supporting the applicability of financial economics to long-term entities such as DB pension schemes’.
Financial economics, or at least the part of it that I think Jon is mostly referring to, is a group of abstract theories that can provide conceptual insights that are useful in some forms of financial analysis. The degree of usefulness of these insights will ultimately be a matter of judgment for the expert practitioner who has sufficient knowledge of both the theory and the potential domain of application for the insights it offers. But I would argue that the fundamental actuarial questions that arise in the financial management of DB pension schemes do not require particularly advanced or complex economic theory.
The fundamental question that must drive the financial analysis of DB pension schemes is: what is the purpose of the advance funding of DB pension schemes? This question has been debated by actuaries for as long as DB pension schemes have existed (and, indeed, long before the key theories of financial economics were developed). To my mind, there are two basic answers to this question: to generate future asset proceeds that can fund liability cashflows as they fall due; or to ensure sufficient assets are currently available to fund the transfer of accrued liabilities to a third party in the event that the sponsor is no longer willing or able to provide further funding for the cost of those liabilities. These two answers imply radically different approaches to the assessment of funding adequacy and the setting of pension scheme investment strategy. These implications are neither hard to identify nor reliant on advanced economic theory.
I am not a DB pension practitioner, and this may be an over-simplification, but it seems apparent that for many years the methods of UK pension actuaries, perhaps at the behest of their clients, have tended to be driven by the first of these two answers. The second answer would appear to have more direct relevance to the financial security of pension fund members’ benefits. If the second answer had been adopted more readily by our profession and the DB pension entities that we have advised, I think a reasonable case may be made, albeit with the benefit of hindsight, that UK DB pension schemes would, in aggregate, be likely to be in a healthier financial position than they find themselves in today. Of course, the funding adequacy of DB pension funds is not a UK-specific issue, and I suspect a similar point could also apply to the DB pension fund positions that may be found in a number of other countries.
11 April 2020