Asset price modeling
Some have noted that it might be possible to manipulate the income cashflow projections. It indeed might be, but such manipulation would show itself in failures to receive income as projected in a matter of months and revisions then be required [6]. The audit process is a simple one.
Perhaps, the most important thing to realise is that the modeling of asset prices is a hard task, in large part because they are very volatile, but by contrast, the modeling of income flows is relatively simple, since these are an order of magnitude less volatile than prices. Indeed when an appropriate time serial model is used for income projections, the curse of forward error propagation that bedevils so many asset price models can be entirely avoided. The interpretation of these valuations is simple; they are fair value estimations. The present value equality of contributions to pensions is just that, a fair value condition; in fact it is the most primitive of all fair value conditions, a precursor to such more complex constructs as arbitragefree pricing. With market prices so different, we can see that market consistency does not ensure fair value.
However, if we wish to produce figures that are market consistent we need do no more than rescale the surplus (or deficit) by the ratio of asset value at market prices to the value derived under the IGR.
Why we should wish to do this is a mystery. The 5/95 confidence intervals for the market consistent evaluation is plus or minus £74m for this illustrative scheme, while the equivalent confidence intervals is plus or minus £7m. It is clear that most of the volatility we currently observe in scheme valuations is an artifact of the manner in which we account for and value them.
Holistic balance sheets
EIOPA has been proposing that pension schemes should produce holistic balance sheets and we have seen some amazingly complex models developed to address this question. These are unnecessary. Any deficit produced under the IGR method may be directly inserted into the sponsor balance sheet, where it would displace retained earnings and equity.
Moreover, we know the cost of this liability to the sponsor employer – it is the IGR. The comparison of the sponsor’s return on capital with the IGR tells us about the sustainability of a pension situation. In fact, we can do all of the standard asset and debt service coverage evaluations of basic credit analysis.
This approach also reveals that much of the concern over rising costs in defined benefit pensions is misplaced; the product of poor accounting and vested interests. The illustrative scheme shown here would report a deficit of 17% under IAS 19, when the reality is a surplus of 12% under the proposed method, or a surplus of 17.1% if we really did want to use a market consistent approach properly.
1. “Keep your lid on: A Financial Analyst’s View of the Cost and Valuation of DB Pension Schemes” by Keating, Settergren and Slater http://www.futureofpensions. org/resources/Keep+your+lid+on-Final.pdf
2. The use of market prices may serve to inform other aspects of scheme analysis, as we will demonstrate later.
3. This is a variant of Jensen’s inequality; that E(F(x)) ≠ F(E(x)).
4. It is also not necessary to hold the contribution must equal present value relation as an absolute truth; it is sufficient simply to justify it as an analytic convenience.
5. The historic contributions received are amortised as pensions are paid and members die. The relevant contributions are those of the membership of the pension liability projections.
6. The modelling of income cash flows is a topic worthy of another entire article.
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