There has been growing discontent among the sponsors and trustees of defined benefit (DB) pension schemes over scheme valuation regulations and practices. This is evidenced by the calls for smoothing from the NAPF, CBI and Association of Member Nominated Trustees, and, indeed, by the DWP’s call for evidence on the subject of asset and liability smoothing and the Pension Regulator’s responsibilities. There is an ongoing debate about the use and relevance of market prices and yields in scheme valuations, as these form no part of the pension contract between employer and employee. Different ways are used and several have been proposed to evaluate the state of pension funds for reporting and management purposes. None is satisfactory.
Long Finance is pleased to publish a ground-breaking paper by Con Keating, et al., on a better method for calculating fund discount rates. The paper introduces a method, the Internal Growth Rate (IGR), which is accurate, stable and entirely consistent with fair value accounting, though it does not rely on market prices or yields. The authors show that discounting using IGR meets reporting objectives. The many alternatives in current use (risk free rate, Gilts, expected asset return, …) are shown to lead to over or under estimates, bias and volatility. The IGR avoids over or under estimates by considering an element of the system overlooked in current arrangements, contributions. Contributions are primary inputs for the process that delivers the output, pensions. The IGR enables accurate and consistent evaluation of the state of the pension system when applied to the income and expense projections.
Added benefits of IGR include stability of reporting and elimination of spurious external effects in pension fund reporting. With IGR, it is possible to avoid unnecessary and costly interventions in scheme management. Current (misleading) standards are aimed at improved reporting of problems rather than on improving fund dynamics.
IGR calculations incorporate the entire fund design, including funding arrangements with sponsors and the use of insurance and guarantees. The IGR may be used to assess and compare pension scheme performance, and to measure the impact of management interventions such as liability driven investment and closure of schemes to new participants. IGR sheds new light the debate on the affordability of DB schemes. Professor Michael Mainelli of Long Finance, said, “We are delighted to publish our third report on pensions reform. The authors show that the biggest obstacle to bringing back our most effective retirement savings vehicles, DB schemes, is our lack of intellectual rigour in valuing them over the long term. This report raises serious questions about regulation and valuation for actuaries and accountants.”
IGR provides the correct incentives for both funded DB scheme provision and long-term socially useful investment. The many criticisms of current standards have lacked a coherent description of a simple, viable and accurate substitute; this is it.
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