Iain Clacher and Con Keating say there is much confusion over pension valuations and argue all the methods currently used are wrong. They say a pragmatic resolution could be to use the expected return on assets
Wilkinson and Curtiss's article - Death by discount rate: The fundamental flaws of the accounting approach to pension scheme valuation - produced a highly predictable Twitter-storm. This is unfortunate as the article of Wilkinson and Curtiss is thoughtful, balanced, well-written exposition of many of the problems arising from current accounting and valuation standards.
The tweet by John Ralfe that was the opening shot in the Twitter-storm was simple in its description of the problem:
1 A defined benefit (DB) pension promise has the same economic characteristics as as long dated secured bond.- John Ralfe (@JohnRalfe1) 30 May 2018
2 We know how to value long dated secured bonds, using AA bond rates.
3 Therefore we know how to value DB pension promises, using AA bond rates.
4 It's as simple as that.
The logic here seems to follow all dogs have four legs, this elephant has four legs, therefore...
Others, before us, have challenged the assertion of sameness between DB pensions and long-dated secured bonds, and at least one commentator made this very point on Twitter in response to the above tweet.
In fact, there are many more differences that similarities, and these begin with the proceeds of bond issuance, being deployed within the enterprise.
There is a bond lesson to be learned - from the manner in which the collateral security of a secured bond is maintained by the issue's trustees. The trustees of a conventional secured bond maintain collateral cover for the principal together with any accrued but unpaid coupons. The process of acceleration, immediate repayment on default, makes the full principal repayable. For a zero-coupon bond, the process is slightly different. The amount repayable is the original advance plus the accrued interest, to date, offered under the original terms of issuance. Market prices or discount rates do not enter the reckoning; it is all about performance due under the contract.
By contrast, under current regulations and standards, pension valuations are being used to determine the level of collateral funding that trustees should demand. This unfortunately is unrelated to the due performance of the original pension contract.
The tweet then contains a basic error. It asserts: We know how to value long-dated secured bonds, using AA bond rates. The primary valuation standard for a corporate or other bond, secured or not, is to mark it to market; this does not involve the use of AA corporate bond rates.
Marking to market is itself problematic - it can lead to such patent nonsenses as we saw during the crisis when many bank bond issues traded as junk, and their valuation in this manner threw up large unrealised gains as the bonds fell in value. This basis of valuation represents a serious challenge to the principal of good faith in business transactions.
As Wilkinson and Curtiss explain, the accounting and valuation standards bring with them a host of issues. There is little doubt that cash flow projection could provide a more accurate view of the true position of DB pension schemes, but as they correctly note these methods may be subject to abusive manipulation.
There is much confusion in the world at large over pensions valuations, but all of the methods currently employed are wrong; they are counterfactuals (see box) to the promises as made on award. However, such is the degree of damage already inflicted that a pragmatic resolution is needed, and that looks to be one using the expected return on assets, though that also may be subject to manipulation.
Iain Clacher is associate professor in accounting and finance at Leeds University Business School and Con Keating is chairman of the EFFAS Bond Commission
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