What’s this? Now the even the pension trustees have gone all theoretical on market prices.
From the Marathon Club, comprised of trustees and senior executives representing pension schemes with £179bn of assets, and which has submitted a proposal to the International Accounting Standards Board recommending changes to the way pensions are accounted for:
The IASB’s announcement of 14 July of a review of mark-to-market accounting of financial assets and liabilities is welcome. However, the exposure draft (ED/2009/7) issued with the announcement is limited in scope to rectifying accounting problems in the banking sector. The Marathon Club is principally concerned with the insidious effects of mark-to-market accounting on pension funds, although the issues we raise apply more generally.
The exposure draft appears to make no change to the position in IAS 39 which equates the “fair value” of listed equities with current market value, whatever the market conditions. Should we assume therefore that the IASB retains faith in the efficient market hypothesis, despite the clear evidence against it? Does the IASB admit the existence of Benjamin Graham’s intelligent investor looking for long term value, or does the IASB’s world only consist of “strategic investors” and traders? And where in this world do pension funds belong?
Recall that under current accounting rules, specifically IAS 19, companies calculate their pensions liabilities using a discount rate based on high quality corporate bond yields (usually AA), while valuing their assets according to market prices. Both of those tend to be volatile, or at least they have a tendency to move. When corporate yields are high, pension liabilities tend to fall and vice versa; and when market prices fall, the value of the pension fund’s assets’ tends to fall, and vice versa. In fact, according to some estimates, a 1.7 per cent increase in the AA-corporate bond yield will depreciate a pension scheme’s liabilities by as much as 40 per cent. That, however, is troublesome in the eyes of the Marathon Club, since it tends to lead to things like this:
That is a chart of ‘funding’ at the 200 biggest UK private sector schemes. The combination of valuing the fund’s assets at market value, combined with swings in corporate bond yields, means the funding status of pension funds has been yo-yo-ing for some time now. Indeed, up until recently, relatively high corporate bond yields associated with the credit crunch meant pension funds experienced a little of what you could only call ironic relief on liabilities (corporates were judged to be riskier in 2008 but their pensions were deemed to be safer) even as the value of their assets fell.
However, there is already a degree of variation in terms of calculating the discount rate. Pension trustees, for instance, tend to take a ‘glass-half-empty’ point of view and use gilt yields as a starting point for the rate. Since the Bank of England began QEasing, lower gilt yields have also meant greater liabilities for pension funds under gilt rates, which meant you had something of a gap between the liabilities accounted for and funding requirements calculated by trustees.
What’s more, different European regulators already allow a degree of flexibility in calculating the discount rate. In the Netherlands for example, the central bank uses the more onerous measure of interest-rate swap yields to value liabilities. In Germany they’re moving towards using a rolling average of corporate bond yields, which seems to be what the Marathon Club is now advocating:
The Club encourages the accounting profession to look for an alternative approach to making a valuation of pension fund assets and liabilities for the purposes of company reporting, which reflects their long term nature and purpose on a going concern basis. A possible approach for liabilities would be to apply a discount based on a rolling average of corporate bond yields, similar to what is being proposed in Germany. It might also be appropriate, depending on the maturity and complexity of the fund, to apply different discount rates to different tranches of liabilities.
The point — according to the Marathon trustees — is to eliminate the ‘short-termism’ of current pension accounting rules and replace it with something a little more long-term. Intriguingly, the Marathon proposal comes as both the the decline in gilt and corporate yields may be causing a few difficulties for company accounts and trustees: