The trend towards using market values

Jon Exley, Shyam Mehta, and Andrew Smith identify the need to undertake a radical examination of actuarial investment and pension fund valuation techniques and of actuarial training.

The past few years have witnessed a heated debate about whether there should be a switch to using market-value based techniques in place of UK actuarial methodologies. We use the word 'debate' rather euphemistically, since there has been no coherent response to financial economic arguments in favour of a switch. As discussed below, it appears that a new debating strategy is being employed to sow confusion, for example by renaming old approaches 'market-related'. However, there is now, we believe, widespread agreement that:

• UK actuarial techniques cannot tell pension funds when equities are cheap or expensive.
• Investing in equities does not reduce the cost of pension liabilities.
• The best match for pension scheme liabilities is a mix of fixed-interest and index-linked bonds.
• Viewed from a shareholder perspective, defined benefit pension fund investment in equities, compared with the alternative of investing in bonds, destroys value.
• Equities do not match salaries.
• The practice of not clearly identifying which of the many parties to a pension scheme are being advised should be changed.
• Traditional methods are not useful when advising trustees and companies on the solvency position of the scheme and the risks they are running and, further, these should not be used when advising on the cost of providing benefits.
• Actuarial 'funding valuations' are also not efficient in the stated aim of smoothing contributions, since this could be achieved more simply by fixing the contribution rate at an arbitrary level and then not undertaking any reviews.

Historical development
The past 40 years have seen substantial shifts in pension fund valuation methods. The 1960s method of taking assets at book value and using liability discount rates of 4% pa or so gave way in the 1970s to showing assets at market value, in conjunction with liability discount rates of between 7% pa and 9% pa. A mystique and jargon had been built up such that advice recipients, scheme trustees, and company management relied on the actuary's opinion with relatively little questioning. One person could use book values and 4% while another, for the same valuation date, could use market values and 9%. In fact there was enormous scope to report any level of funding or contribution required. The difference between an 8%/6%/4% (interest/salary/inflation) and a 7%/6%/5% basis was huge but broadly unfathomable by the client. The only criterion by which an answer might be called 'wrong' was if the client did not like it.

A potential difficulty for the actuary arises when he or she takes over from another actuary who has used a radically different basis. How is one to communicate to management that the scheme has suddenly developed a large surplus and that the company's contributions will have to be spent on benefit improvements rather than being required to meet pre-agreed benefit levels? Another embarrassment is when two schemes with the same actuary merge, since different bases can be used for different clients! Professional judgement and flexibility of basis were (and are) viewed as crucial.

During the 1980s there was a shift to 'realistic' valuations, which in practice meant weaker valuation bases. Actuaries who adopted these techniques gained very significant market share. Company management preferred to hear that the pension fund was 120% funded and that a contribution holiday could be taken, than to hear that the scheme was 100% funded with 10% pa contributions required. The basis was quite possibly viewed by clients as being conservative, merely because the assets were valued at a discount to market values by choice of dividend growth assumption. The fact that liabilities were undervalued to a far greater extent was not appreciated, because clients did not understand the valuation method. Furthermore, company management liked equity-orientated investment strategies that ran in tandem with these valuation techniques, perhaps because:

• Volatile market values could be used as an excuse for subjective adjustments; an equity strategy indirectly enabled accounting profit to be smoothed or inflated by choice of valuation basis.
• Advance credit for possible future outperformance of equities over bonds was being given, without any deduction for the corresponding risk cost.

Trustees were happy, as pension funds appeared solvent, and smoothing meant they could not be blamed for being unaware of the degree of risk being borne.

FRED 20
The ASB, with FRED 20, has proposed a very straightforward, market-value based approach to accounting for pensions costs. In the past pensions accounting has used 'actuarial values' with the result that users of accounts were unable to assess:

• the amount of pension fund surplus or deficit;
• the cost of the accruing pension promise (and hence also the level of company profit for the year);
• the amounts of risk being borne.

Disclosure will be of major benefit to all concerned:

• Executives, shareholders, and trustees will become aware of the risks they are running, and this could well lead to the adoption of more prudent investment strategies in the future.
• Management and trustees will become able to focus on their core duties rather than being distracted by pension fund profits and losses, as prudent policies take hold.
• Trustees and shareholders will find out the degree to which many schemes are underfunded and understand better the value of their investment.
• Understanding the true cost of running a defined benefit pension scheme may lead employers to question their worth, and employees to ask for higher pay or defined contribution arrangements instead. Alternatively, the additional clarity as to cost may encourage employers to continue with defined benefits. Rational decisions can be made.

Not to disclose this information penalises managements and trustees that do wish to adopt prudent policies.

Clearly, there is significant opposition among many actuaries to the proposals in FRED 20. This may appear slightly surprising, given the supposed trend in the actuarial profession towards 'market valuation'. In reality, however, market valuation as currently practised often means little more than disclosing assets at market value, while leaving enormous scope for actuaries to discount the liabilities using arbitrary margins above the 'fair value' discount rate. The effect is usually to understate the economic cost of defined benefit pension provision and (by manipulation of the margins chosen at future valuations) to disguise the underlying mismatch between the assets and liabilities by smoothing the results. With the implementation of FRED 20, the main concern of actuaries may well be that the arbitrary margins added to discount rates may come under more scrutiny, and the costs of operating schemes, together with the risks involved in pursuing equity investment policies, may be questioned. In our next article we will discuss whether it is in the public interest for a profession such as ours to promote or collude in the understatement of the costs and risks associated with the status quo existing in UK defined benefit pension funds.

The actuarial profession's position statement (SSAP 24 Review, November 1999), argued that it is not in the public interest for volatility to be disclosed, or for the cost of benefit improvements to be recognised immediately. We suggest that it is very much in the public interest to find out about the costs and risks associated with pension benefits.

The review also states that FRED 20 'assesses liabilities in a way which ignores the assets actually held'. We agree and believe that this is yet another good reason to prefer FRED 20 to actuarial valuation approaches. After all, the liabilities are largely independent of the assets held and therefore any other approach would be rather illogical.

The ASB did in fact try to introduce equity returns into the valuation basis used to account for UK pension funds. This relied on the ability of UK actuaries to deliver some backing for the 'match' between equities and the liabilities. The existence of some match may have seemed a natural assumption to accountants, given the appearance of so much equity investment in the results of asset and liability models.

Unfortunately, there is something terribly wrong with the modelling technique that arrives at these conclusions. Instead of homing in on assets that are linked with the liabilities, these models simply home in on the assets showing the highest risk and return characteristics. On closer inspection it turned out that a link between equities and pension scheme liabilities could not be established and that, provided the time horizon is long enough, equities appear in these models simply because they are assumed on average to return more than bonds.

In the next article we propose to examine whether investment and pensions actuaries will move away from off-market approaches, and to look at the factors that may encourage change.

The follow-up article: The trend towards using market values: Jon Exley, Shyam Mehta, and Andrew Smith urge actuaries to take an enlightened view of new developments, can be found at: https://bit.ly/2QkV8tg