Con Keating, head of research at Brighton Rock Group
It may be a triumph of hope over experience, but it appears that risk-sharing may be back on the regulatory agenda in the UK now that the election is out of the way. Unfortunately, all too much of this debate has been shrouded in the mumbo-jumbo of actuarial science and financial economics. This article hopes to shed some light on that debate, including the terms used.
Much can be learned from the differences between UK scheme design and that adopted in other countries. Defined benefit (DB) schemes are complex, but highly efficient collective risk-sharing arrangements; they pool a number of important risks associated retirement income, such as idiosyncratic mortality and investment liquidation values. An explanation of terms such as risk-neutrality is necessary to take the discussion further: I attempt this in the box.
The sponsor underwrites the risks of a DB scheme, placing the scheme member in a fundamental position of risk-neutrality; members are indifferent to variations of the value of the scheme or funds provided the sponsor is solvent and able to fulfil its underwriting role. This implies that the sponsor employer must be risk-seeking, but that is not unusual - only by assuming risk can a company prosper and earn profits. This, in turn, implies that the relevant valuation accounting model is not risk adjusted in any way in this ‘going-concern’ situation. It is a straightforward technical best estimate of liabilities.
The sole risk faced by the scheme member is that the sponsor employer will become insolvent - a ‘double-whammy’ for the member who faces both unemployment and the possibility of a reduced pension. This suggests that the relevant accounting valuation standard should then reflect the likelihood of sponsor insolvency and its consequence for the scheme and any fund. The role of pension funding is precisely as a mitigant of the consequence of sponsor insolvency. Prior to insolvency it is redundant security. Like all collateral security, it distances the scheme member from the employer - which is not a desirable state of affairs.
Many of the arguments around funding are specious. If the scheme is unfunded, it really isn’t - the liability is part of the capitalisation of the sponsor employer. This is also true in the public sector, and there the circularity of a government borrowing in order to fund a scheme, only to have that scheme then make investments in government securities, is obvious. It is also a classic illustration of ‘wrong way’ risk. If the government cannot pay its pensioners then it also cannot service its debt obligations. And if the funds are invested by the scheme in private sector obligations such as equities, the scheme is acquiring private sector risk. This would be perverse risk-seeking behaviour at best. In fact, the post-World War Two recovery of Germany was in large part financed by the unfunded pension schemes of the Mittelstand.
It is not unlikely that one unintended consequence of the new and punitive UK tax treatment of higher paid employees’ pensions will be the emergence of unfunded UK schemes - EFRBS. From a corporate governance standpoint, this would be welcome development; as saving and investment in their employer firm this would go far towards resolution of the principal-agent conflict of management. The argument that funding helps to develop capital markets is true but this, in reality, is only a debate about the distribution of capital availability within the economy. More importantly, most productivity growth, which of course admits increasing standards of living, is driven by smaller enterprises - and these do not have ready access to capital markets.
Diversification arguments are also much weaker than is generally recognised. In the face of aggregate systemic shocks, such as that to the liquidity stock in the recent crisis, diversification is of no help - all capital asset values suffer. However, due to their longevity and the relative smoothness of their cashflows over time, DB pension funds are uniquely positioned to bear such systemic risks by riding out the storm.
There is one real conundrum for corporate finance associated with sponsor insolvency. Post-insolvency the scheme stands alone and faces the vicissitudes of life until all pensions have been discharged; in order to do this it requires funding not at the 100% of liabilities level but at a level such that it can bear these risks - a buffer.
It then requires capitalisation at a level similar to an insurance company or a bulk annuity ‘buy-out’ quotation, about 140% of liabilities, to achieve orderly and complete run-off of liabilities. If a scheme is funded to levels above 100% of the best technical estimate of liabilities, some important questions arise. For example, the question of whose property these assets are: clearly, in equity they belong to the other creditors of the insolvent firm and that, in turn, gives rise to questions as to the timing of availability of these funds to them. This problem can be fully and efficiently resolved using pension indemnity assurance, but for current purposes, this aspect serves an entry into questions of risk-sharing more generally.
If a sponsor finds that the level of cost and risk it faces now exceeds that which it was originally comfortable bearing, the rational solution is to arrive at some new risk-sharing equilibrium; in this, members would take some part of the risk exposure. The situation is, in essence, one where the best gives way to the good. The Dutch approach in which inflation indexation of members’ pensions is discretionary rather than mandatory is a prime example. When funding falls below 130% of liabilities, indexation may be restricted, and may be reinstated if funding subsequently exceeds this level - the scheme maintains a capital buffer. The scheme is effectively operating along the lines of the traditional ‘with-profits’ pension policy that was so prominent in UK insurance - and is now so disliked by the UK”s Financial Services Authority.
The implicit optionality in these risk-sharing arrangements has value and this should be reflected in the liability valuation and accounting, but currently isn’t under international standards. The optimal distribution of risk between member and sponsor is complex, trading off the risk-aversion of the member with the limited risk-tolerance of the sponsor employer.
Unfortunately, far too much of this debate has focused on the discount rate and pursuit of the best proxy for the ‘risk-free’ rate of financial theory. It seems that many believe there is some ‘correct’ rate, when the reality is that there are a myriad - each reflecting the risk tolerances of members or employer sponsors. Perhaps the greatest irony is that these questions only came to the fore in the UK as an unintended consequence of another regulatory intervention - the regulations which overrode the principle of impartiality in UK trust law and gave priority to pensioners-in-payment over other members in scheme wind-up.