Nullius in verba, Rodney

On a brisk October
morning in 2002, under powder blue autumnal skies and with a chill in the air, I
stepped out into a West End street, drew the collar of my coat up around my ears
and walked through St James’s Park up towards Pall Mall. The leaves on the trees
were a stunning pastiche of variegated mustard yellow, burnt orange and rust and
teal. I suppose I should have been lost in wonder, but I wasn’t. I had a lot on
my mind.


A few minutes earlier,
I had finished a meeting with the Finance Director of a FTSE 50 company with a
large pension scheme grappling with a significant funding deficit. As a matter
of fact, I had attended an earlier meeting with the same Finance Director three
weeks before that, at which I had outlined the shape and size of a financial
meteorite which, I informed him, would probably throw up a cloud of dust and ash
that would blight the rest of his time in office.


My message was simple
and had three points. First, the ground rules are about to
change. There is shortly coming a day when the
present
value of your pension scheme’s liabilities will be
calculated and unceremoniously dumped onto your corporate balance sheet. Second,
the volatility that this will introduce will dwarf all your current problems and
cause a prolonged corporate
headache, the like of which you cannot now fathom.
Third, this issue (rather than poorly performing equities) will be the central
cause of all your difficulties from now on.


I then offered him my
humble services and said my then employer, Merrill Lynch, would be grateful for
the opportunity to look more carefully at the issue and to propose a solution in
the form of a hedge. I went further and suggested that failing to hedge would be
akin to foregoing home insurance in the belief that your house could never catch
fire.


I have to say he did
take me seriously at that initial meeting. It was the first time anyone had put
any numbers around the size of the potential problem and, if even half true and
not merely the product of an investment banker’s over-stimulated imagination, he
realized he needed to look closer. He promised to speak to his investment
consultant and see if he agreed.


This second meeting
was by way of follow up. It quickly became apparent that his interest had waned.
The FD had spoken to various corporate and scheme advisers who were unanimous in
their advice that the type of action I proposed was not
necessary.


They had advanced
three principal arguments:


First, marking to
market of pension liabilities was a misconceived accounting device and it would
be a mistake to take major strategic decisions based upon “a new and arbitrary”
accounting
rule. Something about the accounting tail wagging
the investment dog.


Second, the only point
at which the predicted meteorite would materialise would be in an environment of
prolonged, extremely low real yields, namely, yields significantly lower than
then prevailed. Real yields were at 2.20% and “just would not and could not
fall below 2% for any sustained period of time”. The “problem” as I had
articulated it simply did not exist.


Third, a badly beaten
up equity market was the principal problem that had to be addressed. In the
aftermath of 9/11, markets had collapsed and it seemed obvious that all
restorative effort needed to be applied there.


In a nutshell then,
the FD informed me with some regret, despite his best efforts he simply could
not garner support from any quarter. No one bought it. He suggested I focused my
efforts instead on devising equity downside protection strategies and bid me
farewell.


And so it was, that as
I stepped out into the bustle of Victoria Street, SW1, the monumental scale of
the issue dawned on me and I realized that this was going to be one huge
mountain.


In the following
months, I wrote articles, made presentations
and had literally hundreds of meetings which followed a similar pattern; initial
interest in the concept of hedging volatile pension liabilities, followed by
evaporating enthusiasm. I was like Old Man Noah, predicting torrential rain in a
dry, hot desert.


Then in late 2003,
after extensive deliberations between sponsor and Trustee, Friends Provident
Pension Scheme decided there was merit in the idea and hedged all of their
liabilities against a falling real yield. By coincidence,
they executed the hedge on the very day that real yields began their precarious
and prolonged descent from
2.20% to absolute zero and below.


As the real yield
collapsed, UK PLC’s defined benefit pension liabilities soared. The Friends
Provident hedge – which rose dramatically in value – was a runaway success and
the Liability Driven Investment (“LDI”) market rapidly developed over the next
few years to become a core part of pensions risk management.


But – and it’s a big
“but” – the main objection has never gone away. Many people are still firmly of
the view that it is utter folly to force pension funds to mark their long
term liabilities to market and madder still to then plonk them onto the
corporate balance sheet and behave as though they represent some kind of debt
“payable today”.


Even those who accept
that if liabilities are to be discounted then a meaningful / market
discount rate should be used, still often regard the whole thing as a somewhat
flawed exercise given that the liabilities don’t actually all have to be paid
today.


Listen to
Lord
Hutton during Q&A at the NAPF on 7 October
2010:


“Discounting is a
topic that seems to generate views of almost religious fervour within the
pensions community. I tend to eschew any sort of idealogical approach to this. I
don’t think there’s an appropriate discount rate. I don’t think there’s an ideal
benchmark – bonds, gilts, whatever, or social funding preference rate. You will
see from my report I have made some comments about whether, for example, the 1%
[discount rate] that’s factored in for cataclysmic events is really appropriate
in the context of pension provision and I’ve suggested it probably
isn’t.


And I think if you
look at the spread of 3.5% above RPI as a notional rate of return for
investment, that’s pretty generous and that’s why I’ve said I think it’s at the
high end of what could be useful. Now of course that has very significant
implications. Some people get very excited about the increase in the valuation
of liabilities. I think that’s an issue but I wouldn’t sort of sweat over that
at night. It’s not keeping me awake.


I don’t think an
event’s going to happen where we have to pay out on Day 1 all the accrued
liabilities across the public sector. I don’t think that’s likely to be how a
cataclysmic event materialises in this context. And neither do we ignore
spending care on the elderly or education or housing or anything like that
because if we did we would all probably panic and leave the room immediately and
go and lie down somewhere.”


So there you have it.
Lord Hutton is not a fan of discounting liabilities per se. It’s really
not something to sweat about.


However, Lord Hutton
acknowledges that using a meaningful discount rate does matter when it
comes to calculating pension contributions. He went on:


“So I think we’ve
got to be level headed about it. What I do think, however, is an issue about the
discount rate is measuring the contributions. We’ve kept contributions low
because the discount rate has been too high and now we’ve got a
problem.


I’ve said to the
government “You should look at the discount rate because it’s too high and
you’ve got to think about the implications for contributions and so
on.”


I believe I am
right and I have set out the argument very clearly in the report. I’m not trying
to torture the data until it confesses. A lot of people think it’s all jiggery
pokery or smoke and mirrors. It’s technical but it’s really fundamental and I’m
not doing anyone any favours in the long term or even the short term if I try to
pretend that this part of the estate is in good order. It’s
not.”


To sum up, his
Lordship’s view is that discounting is important for calculating contributions
but not for working out the present value of the liability.


Well, as his Lordship
says, the business of discounting pension liabilities provokes normally sanguine
individuals to levels of quasi-religious intensity. In fact, I have rarely come
across a philosophical problem that has more clearly divided right thinking and
intelligent people across this industry.


There are of course
many types of “problem”. One type is the “Is there a God?” kind. You
can be super intelligent and yet be an avowed atheist:


“A man’s ethical
behaviour should be based effectually on sympathy, education, and social ties;
no religious basis is necessary. Man would indeed be in a poor way if he had to
be restrained by fear of punishment and hope of reward after death.”
Albert
Einstein


Then again, you can be
extraordinarily brilliant and still be an ardent believer.


“A man can no more
diminish God’s glory by refusing to worship Him than a lunatic can put out the
sun by scribbling the word, ‘darkness’ on the walls of his cell.” C. S.
Lewis


Intelligence, then,
has no bearing on whether or not you believe – it’s a matter of
faith.


The second is the
“Why (in the absence of friction) does a heavy object fall at the same speed
as a light object?” type. That’s the sort of question which, given enough
thought, deliberation and reason by sufficiently smart people, can eventually be
answered. Up until Galileo, (and Newton shortly after), it was all a bit of a
mystery (Aristotle got it completely wrong). Then in 1667, Sir Isaac Newton
published his Principia
Mathematica describing the action of gravity and the penny dropped. It
remains one of the most influential books of all time and was undoubtedly the
product of much reasoned debate together with the weighing of corroborated
evidence by the great minds of the day.


The third problem is
of the “Should I vote right or left?” variety. Those of either
persuasion will argue until they are blue (or red) in the face that theirs is
the enlightened path. The other is an affront to humanity. It appears one can be
highly intelligent, (except perhaps in the case of George
Dubya or Mrs.
Palin) and sit on either side of the political
line.


The issue of
discounting pension liabilities, to my mind, falls squarely into the
third category. As in political leaning, there appears to be simply no universally accepted
“correct” answer and I am constantly taken aback by the strength of views on
both sides of the divide. If you want a sense of how sophisticated, protracted,
intricate (and punchy) the argument can get, read Con Keating’s mallowstreet
blog: “The nostrums of modern
financial theory”.


I have just been asked to participate in yet another debate on this topic:

Here’s the
motion:


“This house believes
that mark-to-market accounting is inappropriate for pension liabilities and
should be abolished.”

As Delboy would undoubtedly
say, “Nullius in verba, Rodney, Nullius in verba!”