DISCUSSION PAPER PI-0104
UK Pension Fund Management: How is Asset Allocation
Influenced by the Valuation of Liabilities?
A single valuation basis (using market values) now dominates the valuation
of pension scheme assets and has replaced the previously dominant actuarial
and accounting bases.
The same cannot be said for pension scheme liabilities. There are three different
valuation bases for liabilities currently in use: a statutory basis (specified in the
1986 Finance Act), an actuarial basis (the Minimum Funding Requirement, specified
in the 1995 Pensions Act) and an accounting basis (specified in Financial Reporting
Standard 17). Since each of these uses different underlying assumptions, the
three bases are not consistent with each other and produce substantially different
measures of pension scheme liabilities. None of these measures corresponds to
an economic valuation. Moves should be made to develop a single valuation
basis for pension liabilities.
A key difference relates to the discount rate used to calculate the present
future pension payments. The Accounting Standards Board's new FRS17 and the
recent MFR Review conducted by the Faculty and Institute of Actuaries have both
proposed a bond-based discount rate. Anecdotal evidence suggests that this is
pushing pension fund asset allocations towards bonds in an attempt to reduce
short-term volatility mismatch between assets and liabilities. Moves should be
made to ensure that the valuation basis for pension liabilities does not
distort pension fund asset allocations.
As a consequence, asset allocations are being pulled away from the asset
most suitable for the long-term asset allocation of pension funds, namely equities
and property. This raises the long-term cost to the sponsor of delivering defined
benefit pensions, further encouraging the switch to defined contribution schemes.
Various insurance-based mechanisms have recently been proposed in the event
of scheme insolvency, namely a central discontinuance fund and mutual or
commercial insurance. Experience from the US suggests that moral hazard risks are
such that commercial insurance might provide the best chance of reflecting accurately the insolvency risk associated with a scheme's particular funding stance should the MFR be replaced.