Only an actuary or an accountant could think that pension liabilities are at all like fixed interest bonds, not subject to the whims of price and wage inflation. Yet Germany is about to make the same mistake that the US, Britain, and Holland have already made, of thinking that bonds are the natural asset class for pensions.
Germany is to adopt a new accounting standard: E-DRS 19. Like the Dutch and Anglo Saxon predecessors, this wrongly assumes away inflation risk.
The actuaries somehow convinced themselves, and the accountants in turn, that equities do not move up with inflation. Only they could so stupidly – or should I say intelligently – believe that equity markets would be blind to price moves in the long run. If you really believe that, you should become a socialist; capitalism wouldn’t work.
The German move will apply to book reserves as well as to normally funded schemes, magnifying the problem. Contrary to common belief, the German book reserve system is not really unfunded; rather it is the equivalent of investing the whole pension plan in non-voting shares of the sponsoring company. This may not be diversified, but it is funded, and entirely in equity. The new accounting standard will encourage a move to funding in bonds over time.
Meanwhile there is talk in the UK that the new MFR – the government minimum funding requirement – will repeat the fundamental error of the old MFR and of FRS17 of being 100% bond based.
If you could buy something that genuinely matched pension liabilities – a complicated mix of wage, price and nominal commitments – all these standards would wrongly show balance sheet volatility. Thus they wrongly push funds away from natural homes such as equities.
The actuaries and accountants have somehow also convinced themselves that their work is irrelevant, oh that that were so. These standards do affect actual investment policy. No finance director can ignore volatility in his balance sheet as published. No fund can ignore the risk of apparent underfunding, however badly measured.
This would be a problem even if there were no equity risk premium. But as there probably is in the long run, albeit smaller than commonly believed over the past couple of decades, the result will also be to increase funding requirements. In some cases it will even push firms into bankruptcy, hardly what the workers want.
Yet I fear that I am fighting for a lost cause; this dark monster is not going away.