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Mark-to-market blues

Lucy Prebble’s musical Enron, about the troubled energy company of the same name, famously features a song routine on mark-to-market accounting. Marking pension liabilities to market is a complex issue, fraught not only with market and technical considerations but now, increasingly, with political ones.

While over-generous assumptions mask future problems, a discount rate that is too ‘prudent’ can be extremely uncomfortable for all, diverting corporate profits away from shareholders and future investment, and increasing member contributions while lowering pensions, in the case of the Netherlands.

The Netherlands introduced a discount rate based on the euro swap curve in 2008 with the introduction of the new FTK. While based on coherent and prudent assumptions, this method of valuing pension liabilities suffered from two problems. First, ultra-low rates from late 2008 magnified pension liabilities beyond the reasonable assumptions of future interest rates.

Second, the same regulation, coupled with the changing demographic of Dutch pension funds, led them to buy the very swap instruments for hedging purposes that they were measuring their liabilities against. The sheer volume of Dutch pension assets meant there was a predictable herd effect, lowering the swap rate still further and increasing liabilities commensurately.

Pressure to reform the discount rate has led to the introduction of a new rate, based on the ultimate forward rate (UFR) of Solvency II, which works out at close to the old 4% fixed rate from before 2008. This pressure was partly political in nature as many Dutch funds face benefit cuts, although the UFR itself won’t stave off the cuts.

Denmark followed the Netherlands in a similar discount-rate reform in 2012, and Sweden introduced a floor to its rate. Now the UK’s finance minister has announced a smoothing of the rate for pension funds undergoing a triennial valuation in 2013, which led to a sell-off in long-end Gilts at the beginning of December.

Any discount rate is a tool for the estimation of the current value of liabilities. While it must reflect prudent economic assumptions, it is not infallible. The underlying problem in the UK is that benefit rules are far too rigid, leading to an all-or-nothing situation where the liabilities must be met in full, including limited price-inflation increases for pensioners, or the sponsor must go bankrupt for the liabilities to be passed to the Pension Protection Fund.

And it is by no means prudent to assume that low interest rates will not persist, perpetuating the difficulty of achieving adequate risk-adjusted returns to meet the liabilities. Real returns pay pensions after all, not assumptions.

The optimistic discount rates and return assumptions of some US pension funds show that politics, economic reality and discount rates sometimes make for a very uneasy combination.

This story first appeared in the January issue of IPE magazine.

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