On a brisk October morning in 2002, under powder blue autumnal skies and with a chill in the air, I stepped out into a West End street, drew the collar of my coat up around my ears and walked through St James’s Park up towards Pall Mall. The leaves on the trees were a stunning pastiche of variegated mustard yellow, burnt orange and rust and teal. I suppose I should have been lost in wonder, but I wasn’t. I had a lot on my mind.
A few minutes earlier, I had finished a meeting with the Finance Director of a FTSE 50 company with a large pension scheme grappling with a significant funding deficit. As a matter of fact, I had attended an earlier meeting with the same Finance Director three weeks before that, at which I had outlined the shape and size of a financial meteorite which, I informed him, would probably throw up a cloud of dust and ash that would blight the rest of his time in office.
My message was simple and had three points. First, the ground rules are about to change. There is shortly coming a day when the present value of your pension scheme’s liabilities will be calculated and unceremoniously dumped onto your corporate balance sheet. Second, the volatility that this will introduce will dwarf all your current problems and cause a prolonged corporate headache, the like of which you cannot now fathom. Third, this issue (rather than poorly performing equities) will be the central cause of all your difficulties from now on.
I then offered him my humble services and said my then employer, Merrill Lynch, would be grateful for the opportunity to look more carefully at the issue and to propose a solution in the form of a hedge. I went further and suggested that failing to hedge would be akin to foregoing home insurance in the belief that your house could never catch fire.
I have to say he did take me seriously at that initial meeting. It was the first time anyone had put any numbers around the size of the potential problem and, if even half true and not merely the product of an investment banker’s over-stimulated imagination, he realized he needed to look closer. He promised to speak to his investment consultant and see if he agreed.
This second meeting was by way of follow up. It quickly became apparent that his interest had waned. The FD had spoken to various corporate and scheme advisers who were unanimous in their advice that the type of action I proposed was not necessary.
They had advanced three principal arguments:
First, marking to market of pension liabilities was a misconceived accounting device and it would be a mistake to take major strategic decisions based upon “a new and arbitrary” accounting rule. Something about the accounting tail wagging the investment dog.
Second, the only point at which the predicted meteorite would materialise would be in an environment of prolonged, extremely low real yields, namely, yields significantly lower than then prevailed. Real yields were at 2.20% and “just would not and could not fall below 2% for any sustained period of time”. The “problem” as I had articulated it simply did not exist.
Third, a badly beaten up equity market was the principal problem that had to be addressed. In the aftermath of 9/11, markets had collapsed and it seemed obvious that all restorative effort needed to be applied there.
In a nutshell then, the FD informed me with some regret, despite his best efforts he simply could not garner support from any quarter. No one bought it. He suggested I focused my efforts instead on devising equity downside protection strategies and bid me farewell.
And so it was, that as I stepped out into the bustle of Victoria Street, SW1, the monumental scale of the issue dawned on me and I realized that this was going to be one huge mountain.
In the following months, I wrote articles, made presentations and had literally hundreds of meetings which followed a similar pattern; initial interest in the concept of hedging volatile pension liabilities, followed by evaporating enthusiasm. I was like Old Man Noah, predicting torrential rain in a dry, hot desert.
Then in late 2003, after extensive deliberations between sponsor and Trustee, Friends Provident Pension Scheme decided there was merit in the idea and hedged all of their liabilities against a falling real yield. By coincidence, they executed the hedge on the very day that real yields began their precarious and prolonged descent from 2.20% to absolute zero and below.
As the real yield collapsed, UK PLC’s defined benefit pension liabilities soared. The Friends Provident hedge – which rose dramatically in value – was a runaway success and the Liability Driven Investment (“LDI”) market rapidly developed over the next few years to become a core part of pensions risk management.
But – and it’s a big “but” – the main objection has never gone away. Many people are still firmly of the view that it is utter folly to force pension funds to mark their long term liabilities to market and madder still to then plonk them onto the corporate balance sheet and behave as though they represent some kind of debt “payable today”.
Even those who accept that if liabilities are to be discounted then a meaningful / market discount rate should be used, still often regard the whole thing as a somewhat flawed exercise given that the liabilities don’t actually all have to be paid today.
Listen to Lord Hutton during Q&A at the NAPF on 7 October 2010:
“Discounting is a topic that seems to generate views of almost religious fervour within the pensions community. I tend to eschew any sort of idealogical approach to this. I don’t think there’s an appropriate discount rate. I don’t think there’s an ideal benchmark – bonds, gilts, whatever, or social funding preference rate. You will see from my report I have made some comments about whether, for example, the 1% [discount rate] that’s factored in for cataclysmic events is really appropriate in the context of pension provision and I’ve suggested it probably isn’t.
And I think if you look at the spread of 3.5% above RPI as a notional rate of return for investment, that’s pretty generous and that’s why I’ve said I think it’s at the high end of what could be useful. Now of course that has very significant implications. Some people get very excited about the increase in the valuation of liabilities. I think that’s an issue but I wouldn’t sort of sweat over that at night. It’s not keeping me awake.
I don’t think an event’s going to happen where we have to pay out on Day 1 all the accrued liabilities across the public sector. I don’t think that’s likely to be how a cataclysmic event materialises in this context. And neither do we ignore spending care on the elderly or education or housing or anything like that because if we did we would all probably panic and leave the room immediately and go and lie down somewhere.”
So there you have it. Lord Hutton is not a fan of discounting liabilities per se. It’s really not something to sweat about.
However, Lord Hutton acknowledges that using a meaningful discount rate does matter when it comes to calculating pension contributions. He went on:
“So I think we’ve got to be level headed about it. What I do think, however, is an issue about the discount rate is measuring the contributions. We’ve kept contributions low because the discount rate has been too high and now we’ve got a problem.
I’ve said to the government “You should look at the discount rate because it’s too high and you’ve got to think about the implications for contributions and so on.”
I believe I am right and I have set out the argument very clearly in the report. I’m not trying to torture the data until it confesses. A lot of people think it’s all jiggery pokery or smoke and mirrors. It’s technical but it’s really fundamental and I’m not doing anyone any favours in the long term or even the short term if I try to pretend that this part of the estate is in good order. It’s not.”
To sum up, his Lordship’s view is that discounting is important for calculating contributions but not for working out the present value of the liability.
Well, as his Lordship says, the business of discounting pension liabilities provokes normally sanguine individuals to levels of quasi-religious intensity. In fact, I have rarely come across a philosophical problem that has more clearly divided right thinking and intelligent people across this industry.
There are of course many types of “problem”. One type is the “Is there a God?” kind. You can be super intelligent and yet be an avowed atheist:
“A man’s ethical behaviour should be based effectually on sympathy, education, and social ties; no religious basis is necessary. Man would indeed be in a poor way if he had to be restrained by fear of punishment and hope of reward after death.” Albert Einstein
Then again, you can be extraordinarily brilliant and still be an ardent believer.
“A man can no more diminish God’s glory by refusing to worship Him than a lunatic can put out the sun by scribbling the word, ‘darkness’ on the walls of his cell.” C. S. Lewis
Intelligence, then, has no bearing on whether or not you believe – it’s a matter of faith.
The second is the “Why (in the absence of friction) does a heavy object fall at the same speed as a light object?” type. That’s the sort of question which, given enough thought, deliberation and reason by sufficiently smart people, can eventually be answered. Up until Galileo, (and Newton shortly after), it was all a bit of a mystery (Aristotle got it completely wrong). Then in 1667, Sir Isaac Newton published his Principia Mathematica describing the action of gravity and the penny dropped. It remains one of the most influential books of all time and was undoubtedly the product of much reasoned debate together with the weighing of corroborated evidence by the great minds of the day.
The third problem is of the “Should I vote right or left?” variety. Those of either persuasion will argue until they are blue (or red) in the face that theirs is the enlightened path. The other is an affront to humanity. It appears one can be highly intelligent, (except perhaps in the case of George Dubya or Mrs. Palin) and sit on either side of the political line.
The issue of discounting pension liabilities, to my mind, falls squarely into the third category. As in political leaning, there appears to be simply no universally accepted “correct” answer and I am constantly taken aback by the strength of views on both sides of the divide. If you want a sense of how sophisticated, protracted, intricate (and punchy) the argument can get, read Con Keating’s mallowstreet blog: “The nostrums of modern financial theory”.
I have just been asked to participate in yet another debate on this topic:
Here’s the motion:
“This house believes that mark-to-market accounting is inappropriate for pension liabilities and should be abolished.”
As Delboy would undoubtedly say, “Nullius in verba, Rodney, Nullius in verba!”