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ValuationDB Pensions

Con KeatingTUC conference, London, 2013

con.keating@brightonrockgroup.co.uk

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Valuation is a Dark ArtComparison of Current and Possible Methods

Assets Liabilities Surplus %

Illustrative Scheme

132,017,010

117,735,917

14,218,094 112%

Pensions Act

186,030,788 182,433,905

3,596,884 102%

Accounting

186,030,788 222,631,806

36,601,018 84%

Gilt

341,353,967 222,631,806

118,722,161 153%

Asset Implied

186,030,788 153,468,329

32,562,459 121%

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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

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

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91-100,000,000

-80,000,000

-60,000,000

-40,000,000

-20,000,000

0

20,000,000

40,000,000

60,000,000

-20,000,000

0

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

Income and Expense

Cash Deficit / Surplus Total Income Total Expense

Cash

-Flo

w S

urpl

us /

Defi

cit

Inco

me

and

Expe

nse

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Estimating the IGR

1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 2020 2026 2032 2038 2044 2050 2056 2062 2068 2074 2080 2086 2092 20980

20000

40000

60000

80000

100000

120000

140000

0

5000

10000

15000

20000

25000

IGR (7.68% )

Amortised Contributions Liabilities Accreted Contribution Sum Present Values

Solve for IGR under Pv(C) = Pv(P)

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Valuation Illustrative Scheme

92898683807774716865625956535047444138353229262320171411 8 5 2 1 4 7 101316192225283134374043464952555861646770737679828588910

50000

100000

150000

200000

250000

300000

350000

400000

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

100000

Asset and Liability Cash-Flow Valuationat IGR

Amortised Contributions Present Value Asset (Market Price)

Liabilities (RHS) Asset Cash Flows (RHS) Discounted Liabilities

Sum Present Values Discounted Asset Cashflow Sum Present Value Asset Cash Flow

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

1964 & prio

r1966

19681970

19721974

19761978

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

Contribution Amortisation

Proportion of Contribution Proportion of Total Cash Contributions

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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...

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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.

0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1Average Return

0.1

1

10

100

1000

Volatility 0.05

Volatility 0.07

Volatility 0.09

Volatility 0.11

Volatility 0.13

Volatility 0.15

Volatility 0.17

Volatility 0.19

Minimum Time to Distinguish

Year

s (L

og)

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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.

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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

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 150

20

40

60

80

100

120

Seatbelts and Brakes

Funding 0.1 0.05 Valuation dateRoA B RoA Fifteen Ten