Meaningless and dangerous numbers
Market price fluctuations divert attention from pension trends
by Brian Reading in London
Wed 21 Sep 2016
Following the 23 June referendum vote to leave the European Union, the estimated UK defined benefit pension fund deficit violently increased by £164bn. This has been headline news, blamed on Brexit. It scares corporate treasurers facing stiffly increased employer contributions, hitting investment and/or dividends.
This is not a new trend, but rather collateral damage stemming from quantitative easing and collapsing bond yields dating back six years. Only the severity of the recent estimated deficit increase is remarkable, exceeding that following the financial crisis. But these numbers are bogus, meaningless – and dangerous.
The government’s Pension Protection Fund put the aggregated deficit for 6,000 defined benefit funds at £295bn at the end of May. After the referendum result, the end-June estimate was £384bn. By the end of August, following the Bank of England policy interest rates cut, the deficit shot up to £459bn. There were estimated surpluses on the eve of the financial crisis and again in 2010 and 2011, with a big dip into deficit in between. Such monthly changes are ridiculous.
Pension fund positions depend on developments over 40 years hence – what happens to demography, particularly longevity, wages and inflation, interest rates, equity prices and yield, exchange rates and other factors in the long term. To re-estimate and significantly change deficits from one month to the next based on momentary market prices is absurd. Deficits are 1% based on stale data and 99% on assumptions of unchanged asset prices.
The factual inputs are funds’ valuations reports to the pension regulator, with details of assets and liabilities. Liabilities are actuarial estimates revised at intervals of up to three years. Actuaries’ estimates can take up to nine months to prepare. Valuations are based on market prices on the estimation date, including the discount rate used to calculate the present value of liabilities.
Estimation dates can fall at any time during these years. It takes a further nine months for the regulator and the PPF to analyse and extrapolate the data to produced spot estimates for positions as of March each year. Their reports are published in December, some four years after the oldest fund data. The most recent is for deficits on 31 March 2015. While 99% of reports for 2012-15 had been received by end-March, only 0.3% had 2015 valuation dates.
Aggregate end-March estimates are extrapolated from the differing reported valuation dates by applying broad equity and bond market movements to revalue assets and liabilities. The end-March estimates are benchmarks used to extrapolate the aggregate monthly numbers from January to the following December. Rules of thumb are used. A 7.5% rise in equity prices increases assets by 2.5% and a 0.3% fall in bond yields adds 1.9%, making a total of 4.4%. But a bond yield fall of 0.3% adds 5.9% to the present value of liabilities.
Deficits are differences between large asset and liability values, hence the sharp rise in deficits since the end of May. Bond yield falls added more to the present value liabilities than equity and bond prices increases add to assets. Rules of thumb take no account of changes in asset allocations, hedging and other financial instruments, or of exchange rate movements (only a third of share holdings are in UK equity).
The basic data are the product of regulatory reporting requirements not designed and totally inadequate for the use to which the data are put. Annual and monthly estimates are fiction incapable of revealing facts. Bogus deficit estimates and their volatility have a disastrous impact on corporate behaviour, the economy and markets. There is no reason why regulators and the PPF should not do in-house sums – and every reason why they should keep quiet about them instead of attracting ill-informed market and headline-seeking media attention.
Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.
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