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The Actuary The magazine of the Institute & Faculty of Actuaries

The trend towards using market values

The 1990s have seen a number of papers question UK actuarial techniques and suggest instead the use of established financial principles. In life assurance, Mehta (1992) noted that the value of an in-force block was simply the difference between assets and liabilities both assessed at market value: use of embedded value discount rates selected without regard to risk and applied to accounting profit rather than cashflow was no longer appropriate. The International Accounting Standards Committee is currently investigating the possibility of introducing market value-based accounting for insurance contracts. Market value approaches have also been suggested for use in a general insurance context, eg Bride and Lomax (1994).
In pensions, Dyson and Exley (1995) and Gordon (1999) set out the logic for using modern financial theory. In the context of developments in modern finance, these papers revealed that much of UK actuarial ‘science’ is in fact no science at all, but rather a collection of ad hoc techniques evolving over time to suit the business objectives of clients and consultants. The move from book values to market values of assets in the 1970s and the switch to discounted cashflow values in the 1980s caused no aggravation because all three methods allowed the actuary professional judgement to choose, from a broad range of possibilities, the final valuation result.
There is resistance to the suggestion that one should use financial principles rather than primarily professional judgement, because:
– A switch would entail radical retraining.
– Consultants would be selected more on the basis of technical skill in their area of expertise (eg understanding of scheme liabilities and regulations).
– The questioning of actuarial judgement risks exposing an ‘emperor’s new clothes’-type scam. The result might be greater involvement by non-actuaries in areas where previously it was believed that there was some special actuarial skill.
For example, many pension schemes are 20% or 30% less well funded than they were two or three years ago, despite booming market conditions. Managers can perhaps shrug this off and ask for the result to be presented on a less cautious basis, taking advantage of professional judgement and smoothing principles. The removal of these actuarial freedoms would make the exercise of hiding shortfalls more difficult.
A look at the interests of the various parties involved may shed light on likely future developments.

Pension scheme trustees
Following the Pensions Act 1995, scheme trustees now have an even clearer obligation to look after the interests of the beneficiaries. Irrespective of the actuarial or other factors at work, the longer-term prospect may well be for a demand for pertinent information such as:
– Is the scheme solvent? Once trustees realise that their scheme is insolvent, they may start to take their duties more seriously than hitherto.
– To what extent, allowing for priority rules, are the pension promises to the various scheme beneficiaries secured by scheme assets?
– By adopting this investment strategy, what risks am I/is the scheme running?
Pure market value-based valuation is the only mechanism whereby this information can be determined. Indeed, the recent sessional meeting debate on pension fund valuations and market values was encouraging for the proponents of using financial theory, with several actuaries (not only the financial economists!) recognising the need that trustees have for accurate solvency information.

Shareholders and company managers
The paper by Exley, Mehta, and Smith (1997) highlighted the enormous cost to shareholders in British industry arising from investment in equities by defined benefit pension schemes because of:
– the possibility of unintended benefit improvements;
– a significant tax inefficiency of the value invested, compared with the alternative of bond investment;
– uncertainty as to company value, and the corresponding risk of mismanagement, resulting from the use of off-market valuations for disclosure in accounts;
– risk that a mismatched pension fund asset strategy will divert management from their core business of running the company.
Company managers’ interests are becoming more aligned with those of shareholders. Participation in equity upside through membership of the pension fund is less of an issue when the tax rules restrict the amount of salary that is pensionable. Executives often participate in share option and share schemes and therefore benefit less from earnings smoothing and manipulation and more from a higher share price. Shareholder value and economic value-added concepts are in vogue. There is substantial empirical evidence that investors are not fooled by simple accounting devices, and it is argued that UK company share prices would increase substantially if pension funds were to be run according to prudent market value-based principles.
The accounting standards bodies, both in the UK and internationally, have rejected out of hand traditional methodologies (in favour of market value-based approaches) at significant cost to the actuarial profession’s reputation. It is too early to determine whether these accounting bodies will be able to carry the day and introduce reform.

Investment banks
The leading investment banks are often now taking an interest in pension fund matters. Just as in continental Europe, where life company ALM strategy is increasingly being developed with the banks, the possibility that banks will encourage the adoption of modern techniques should not be dismissed. Disclosure of the pension scheme funding position, and the degree of off-balance sheet risk being undertaken by many companies through their pension fund, may encourage investment analysts to begin to ask more questions.

Regulators and government
The dividend yield and equity return-based method of discounting pension liabilities for MFR purposes appealed to pension and investment actuaries because it promoted continued investment in equities (by hiding volatility). However, the ACT credit was removed in 1997 and assessed asset values of equities were cut by 20% at a stroke, necessitating basis revisions to make schemes continue to appear solvent. However, it is highly unlikely that the regulators and government will believe in the supposed link between equities and pension liabilities a second time. Difficult political questions arise. Once it is generally recognised that members’ pensions may not be met in full, issues such as who was to blame may emerge. Actuaries, the government, and the regulators would quite probably prefer any pensions scandal to emerge later rather than sooner. Possibly the profession’s recent moves acknowledging the scale of the deficiencies, and moves to minimise reported numbers by arguing for use of corporate bond-based rather than gilt yield-based liability benchmarks indicates recognition of the need for careful positioning.

How should individual actuaries react to the market value trend? Disclosure of market value information would highlight the widespread insolvency of UK pension funds. The current strategy seems to be either to ignore the existence of modern finance, or to create confusion, for example by setting up ‘straw men’ in discussions with clients. An old-style valuation balance sheet, using off-market values for both assets and liabilities, is represented as ‘market consistent’ by multiplying both sides by the ratio of the market value to discounted cashflow value of the assets. However, there may be a commercial benefit to taking a more enlightened position:
– Much of the current workload is driven by regulatory changes, and is unlikely to be threatened by a U-turn in methodology. Realistically, any political response to difficulties faced by companies and members as a result of poor actuarial advice is likely to increase rather than decrease the amount of regulation.
– Disclosure may well become a reality so what advantage is to be gained by continued opposition?
– The financial economists are not likely to step aside.
– We contend that there is a link between companies that follow sound financial principles and business success. Today’s giants may provide plenty of fee income today, but who will be the top companies of tomorrow?
– A generous approach to the profession will cost little and earn respect in the long term. A first step would be to review the relevance and overhaul much of the later parts of the current education syllabus.
The younger actuary will need to weigh up the likelihood that the profession will be able to stand aside from developments in the outside world, the cost of retraining, and the risk to her or his career from openly supporting use of market values. Against this is the benefit of participating in the intellectually rewarding area of providing such advice. Will there be a demand for off-market advice in ten years’ time?
At this stage it may be that resistance to market value principles among most senior UK investment and pension actuaries is so great that they will not make the switch. On the other hand, one of the big three consulting firms is already taking account of financial economics in giving its advice, and competition from new entrants will also encourage change. It will be interesting to observe behaviour over the next decade.