How should scheme liabilities be measured?

The Universities Superannuation Scheme has been at the centre of this discussion for some years now. As the UK’s biggest occupational fund, over the years some observers have argued that it has fallen victim to inaccurate valuation methods.

Some of these experts have questioned use of a discount rate to value the current cost of USS’s future obligations, along with the employment of the mark to market measure of asset values.

The use of unrealistic rates of return on assets, as a rate at which to discount the future liabilities, encourages really perverse behaviour by management

Norma Cohen, PhD candidate at Queen Mary University of London

Mark to market accounting records the value of an asset that reflects its current market level. Pension schemes are required to value their assets on this basis.

Regulation has forced scheme closure

Speaking at a lively debate on scheme funding hosted by the Centre for the Study of Financial Innovation, Jon Spain, an actuary for 28 years at the Government Actuary’s Department, said that the current system is too narrow in its scope.

Demographic differences between members matter, he said, arguing that the current discounting process is unable to inform the mark to market basis for valuation.

“There are many future uncertainties, and one number cannot possibly be shown to have all of those numbers shown properly within that one number,” he said, describing the results produced by discount rates as “fake news”.

Dennis Leech, emeritus professor of economics at the University of Warwick, argued that existing regulation is “not fit for purpose” and has facilitated the closure of defined benefit schemes.

There are currently under 6,000 DB schemes in the UK, compared to 7,800 in 2005.

Leech objected in particular to what he viewed as a regulatory focus on asset values and capital values.

“As a system for regulating pensions it’s not transparent,” he said, adding that “capital values are the wrong instrument” for measuring assets and liabilities.

“The idea that individuals have a lifetime utility function covering the whole of their working life, and their retirement, is something which is hard in my view to sustain, empirically in the real world,” he said.

Some actuaries are to blame

In the view of John Ralfe, an independent pensions consultant, the rejection of the market valuation of assets is a view whose scope extends far beyond the topic of pensions.

“If you don’t believe in the market value of assets, then we’re not having a conversation about pensions,” he told the debate. “We’re having a much, much more profound conversation about the nature of financial markets.”

Ralfe instead accused actuaries of manipulating the values of assets and liabilities. Brandishing a giant pencil, he quoted an actuary, who he said had confided in him that “the secret to defined benefit pensions is the actuaries’ magic pencil”.

He said: “The actuaries’ magic pencil can make assets bigger than they are, and liabilities smaller than they are,” adding that most actuaries “have broken their actuarial pencils”.

Actuaries do indeed vary in their opinions of scheme funding levels. As of June 30, JLT Employee Benefits measured the funding position of all UK private sector DB schemes at 98 per cent, on an accounting basis.

First Actuarial, meanwhile, estimated the aggregate funding ratio of the same schemes at 131 per cent on June 30, using its in-house methodology.

Unrealistic measures encourage bad management

Earlier this year, lecturers at 65 universities went on strike in response to a proposal by employer association Universities UK to close the DB scheme for academics and replace it with a defined contribution arrangement.

In March, UUK and the University and College Union agreed to explore risk-sharing alternatives from 2020, with a particular focus on a collective DC arrangement. The proposals were rejected by the UCU membership.

Norma Cohen, former Financial Times journalist and PhD candidate at Queen Mary University of London, told the CSFI that she was “shocked that all these years after employers began to close their supposedly fully-funded pension schemes… that we should still, today, be having the debate about how to value pensions”.

Cohen observed that DB surpluses encouraged some companies to delve into their schemes and offer employees early retirement, moving them off the company payroll.

“The benefits… flowed through to the P&L, the bottom line, and guess what, the executives got bonuses,” she said.

“The use of unrealistic rates of return on assets, as a rate at which to discount the future liabilities, encourages really perverse behaviour by management,” she added.

“Aside of the fact that it risks leaving the pension scheme wildly underfunded in a moment of crisis.”