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The trm Report - May 2007 This article compares the framework of pension provision and actuarial valuation that was current in the 1930s with that of today. In highlighting parallels between these two periods this article seeks to inform our understanding of near term changes in professional practice and to be suggestive regarding the direction of potential change in the longer term.
In the 1930s sponsoring firms provided members with several types of mechanism offering assurance in order to elicit their participation in defined benefit pension funds. Firstly, sponsoring firms and pension funds adopted a surprisingly modern approach towards member participation. In Pension & Superannuation Funds, an early book on pension fund management, published in 1928, Robertson and Samuels suggest that three out of seven places on the board of trustees should be allocated to trustees representing the membership and that these trustees should be elected in an annual general meeting of members. They propose establishing a management committee reporting to the board of trustees, which would again, allocate two out of five seats to member representatives. Robertson and Samuels also discuss processes for dispute resolution between the sponsoring firm and the pension fund. Although early schemes often had up to half of the trustees representing the members, such governance mechanisms were dissolved in the 1950s . Secondly, Roberston & Samuels also not that it was customary to appoint two auditors – one appointed by the management and another by members, to audit the pension fund. Thirdly, it was considered advisable for small pension funds to contract with insurance companies to hedge longevity risk associated with defined benefit provision . Fourthly, it was common practice for sponsoring firms to provide solvency and interest guarantees . Solvency guarantees enabled the trustee board to demand that the sponsoring firm bring the pension fund to full solvency either immediately or in a series of payments. Such a guarantee, made by the sponsoring firm, was only credible when the sponsoring firm had sufficient assets to back the guarantee. In providing an interest guarantee the sponsoring firm undertook to ensure that the value of the assets of the fund, and thus the amount available to be paid to members in benefits, appreciated no less than a predetermined rate. This type of guarantee provided limited protection against the deterioration in the real value of benefits. Interest guarantees were typically provided at a rate of between three and four percent. This range reflected interest rates available on fixed income investment over much of the preceding century. Regardless of these several mechanisms providing assurance to members, unions were generally hostile to occupational pension provision in the pre-War period. The difficult negotiations between representatives of the sponsoring employer and of the membership were reflected in the proliferation of benefit structures, including average salary defined benefit and defined contribution, as well as final salary defined benefit. Pension funds invested predominantly in fixed income securities with a minor allocation to equities, reflecting the need to provide a significant degree of assurance to members. Contribution rates were determined on a tough actuarial basis that typically reflected the attainment of solvency. Assets were valued at the lower of cost or market price. The discount rate used to value the liabilities reflected the rate of return that the actuary expected to be earned on the pension fund. The task of estimating this rate of return was simplified in the case that an interest guarantee was provided by the sponsoring firm. If so, the actuary discounted the liabilities at the guaranteed rate. The rationale was that the sponsor would not guarantee a rate that is greater or lower than what it regarded as the returns earned by the pension fund. If this were not the case the sponsor would be seeking to either take money from the fund or make additional contributions to it. In the absence of an interest guarantee the discount rate used to value the liabilities was determined by reference to the yield of the fixed income securities held by the pension fund. As the price of these securities fluctuated, so did the discount rate used to value the liabilities. The assumptions used to value liabilities reflected existing financial market conditions, providing a snapshot of rates of return available at that moment in time. The actuarial valuation penalized pension funds investing in risky assets. Once the actuarial valuation, which was typically conducted on an actuarial basis reflecting the cost of bringing the pension fund to full solvency, was presented negotiations would then ensue regarding whether the sponsor would contribute sufficiently to bring the pension fund to full solvency or whether a variety of half-way measures would be adopted. The re-emergence of the four protection mechanisms The past five years have witnessed the re-emergence of an environment that in important respects resembles that which reflected pension provision in the 1930s. The promulgation of FRS17 (and IAS19), fair value pension fund accounting standards, has introduced transparency with respect to the trade-offs between the demands of shareholders and of members. Lane Clark & Peacock’s (LCP) 2006 survey notes that the aggregate reduction in shareholder equity of FTSE 100 firms, arising from the recognition of pension fund deficits on the balance sheet of sponsoring firms, is six percent. For seven companies the reduction in shareholder equity is thirty percent. Firms take steps to limit the impact to the value of shareholder’s equity by closing pension funds, increasing retirement ages and shifting to defined contribution arrangements. The NAPF 2005 survey notes that sixty percent of defined benefit schemes are closed to new members. As pension contracts are renegotiated, there is once again a proliferation in types of benefit design and a shift towards the defined contribution and average salary defined benefit structures that were common in the 1930s and 1940s. As there is divergence in benefit design there is convergence in the assumptions used to value the liabilities of pension funds. The LCP 2006 annual survey of pension accounting by FTSE 100 companies notes a narrowing in the range between the highest and lowest discount rates over the previous year, from 0.65% to 0.25%; a tenth of the 2.5% range reported in LCP’s 2000 survey, returning to the small range in discount rates that held in the 1930s. The four mechanisms that served to provide members with increased assurance in the 1930s have once again re-emerged as important features of pension fund provision. Firstly, there is greater emphasis on the role of Member Nominated Trustees. The 2004 Pensions Act mandates that at least a third of all trustees must be nominated by members, and establishes a rigorous framework for the nomination and selection of these trustees . Secondly, it becomes common practice for pension funds and sponsors to hire separate advisors, such as auditors and actuaries. Sponsors and members are advised separately on funding and investment policy as each side builds a case in anticipation of negotiation with the other. Thirdly, as there is a narrowing in the discount rates used to determine the value of liabilities, uncertainty relating to the assessment of longevity becomes more prominent. In addition to purchasing protection from insurance companies, innovative solutions develop to mitigate the risk of the decreasing mortality of the membership to the sponsor. For example, BAe Systems links the pension benefits of the membership of its pension fund to future increases in longevity, transferring some of this risk to the membership. Fourthly, there is a re-emergence of the two types of guarantees that existed in the 1930s. Contingent capital solutions provided by the sponsor to the pension fund represent a commitment under which on the bankruptcy of sponsoring firm a payment is made to the pension fund in order to cover any shortfall in solvency. These are equivalent to the solvency guarantees of the 1930s. There is also the emergence of nominal interest guarantees. The benefits of retired members are indexed to Limited Price Indexation (LPI), at inflation or five percent, whichever is lower. Under certain circumstances the pension fund may offer a cap of two and a half percent. These are equivalent to the nominal interest guarantees provided by sponsors of pension funds in the 1930s. As in the 1930s, these guarantees acquire importance with respect to the actuarial valuation. The provision of a contingent capital solution enables the recovery plan to take place over a longer period and reduces the risk based PPF levy payable by the pension fund. In the absence of such a guarantee actuarial valuation is primarily concerned with the strength of the sponsor and the risk of the investment policy. As investment policy becomes riskier, the actuarial valuation becomes more onerous. Further, actuarial valuation evolves so that it becomes common for actuaries to indicate to clients the solvency of the pension fund conducted on a buy-out basis. Actuarial practice shifts so that instead of using discretion to mediate between the two principals involved in pension fund management, actuarial practice now serves to inform the sponsor and the members regarding the risks to shareholder value or the security of members’ benefits of particular strategies for funding and setting investment policy. The purpose of this article is not to underplay the development of financial market institutions over the past seventy years, or our advances in our understanding of accounting and finance. Rather, it is to abstract away from this linear advance to focus on elements of financial market provision that change in a recursive manner. By parsing between these different aspects of historical change this article seeks to better inform our understanding of the current environment for pension provision. Unexpectedly high inflation was the catalyst for the dramatic changes in pension provision in the post-War period, and was associated of the unraveling of tight practices relating to pension fund governance. Unexpectedly high inflation in the next couple of decades could similarly be expected to be associated with changes in practice and governance that would seem to be antithetical to the framework of pension provision that is being adopted today. Yally Avrahampour
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