Valuation DB Pensions

1. ValuationDB Pensions Con Keating TUC conference, London, 2013 con.keating@brightonrockgroup.co.uk

2. Valuation is a Dark ArtComparison of Current and Possible Methods

3. An accurate and unbiased approachThe method • Start with the primary fair value condition • present value of contributions must equal the present value of the promised pensions • This defines the internal growth rate (IGR) of a scheme • This is the weighted average cost of capital for a sponsor employer or equivalently the weighted rate of return on contributions to pensioners. • In order to compare apples with apples: • Project Liability Expense Cash-Flows • Project Asset Income Cash-Flows • Compare these at the Internal Growth Rate integral to the awards. • This produces accurately accurate, stable and unbiased results • The reported liabilities are accurate and the scheme funding ratio correct

4. Cash Flow Projections • Asset cash flows – Bonds contractual and Equities constant real income.

5. Solve for IGR under Pv(C) = Pv(P) Estimating the IGR

6. Valuation Illustrative Scheme

7. Contributions • Contributions are amortised as pensions are paid and members die.

8. Conclusions • The proposed method is precise and accurate. • It is a fair value approach. • It outperforms all existing and many possible methods • It is decision and prediction useful. • It varies only with variation in pension and contribution factors. • It carries with it incentives for DB scheme provision . • And long-term investment. • Current figures overstate the deficit • If there is a deficit, there are multiple ways of filling it, of which higher contributions is only one. • It is right to be concerned that pension finances are sound • but it is also right to be sensible. • And if time permits...

9. How long?Price and Information • The minimum length of time to distinguish price signal from noise • If we assume normality in return, we can estimate these times: • Only with high return, low volatility strategies are market prices informative. Everywhere else, we are working with noise.

10. Convergence • Market prices are driven by fear and greed - Anomalies abound • Volatility is extremely high. • Prices drive returns – Beebower, Brinson. • Market returns are negatively correlated with GDP growth out to about five years • This violates Arrow Debreu fixed point efficient resource allocation equilibria. • But as we move to long holding periods, income dominates and volatility declines. • Long term returns are positively correlated with GDP growth • In other words, short term market price moves converge to the long-term fundamentals and allocative efficiency • But not if we use them as indicators for short-term management actions • Such as special contributions and management techniques like LDI which are hedging regulatory and accounting nonsenses.

11. Expected ReturnsCorporate Bonds • Suppose we have tow zero coupon bonds outstanding both have the same maturity, but they were issued with different terms and conditions • The bond-holder claims in insolvency differ – the issue terms matter