Mark-to-Market, 24th November mallowstreet.com debate

A fantastic debate was held last night with the motion:

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

My piece from the debate is reproduced below:

“I was sitting in Subway at the weekend thinking about what I might say today, staring at my “foot long” sandwich – yes I know I’d be better off with the 6 incher. It made think how bizarre the world would be if instead of having a universal measure for a foot we all put our own foot on the counter and demanded the sandwich was re-measured as 10 inches, 11 inches or 13 inches as appropriate. The length of that same sandwich would then be different depending on the last person to enter the shop and their view on what a “foot” constitutes.

But this is the bizarre world we live in when it comes to pension scheme liabilities. We regularly change our tape measure and value liabilities based on the opinion of the last person that day’s preference for bonds.

How can this be classed as a “true and fair” way of measuring liabilities. Just as the measured length of an unchanged sandwich varies in this fantasy world, the expected cost of paying pension benefits as and when they fall due could be unchanged in the real world but the value disclosed dramatically different. It also means that at measurement dates just a few days apart, large differences can result in balance sheets making 2 companies difficult to compare.

As well as the overarching principle of accounts being true and fair, there are 2 other accounting principles that mark to market valuation does not follow: “continuity” and “consistency”.

Continuity relates to accounting on the assumption that a business is ongoing. For this reason, assets do not have to be valued at “disposable” value. Yet this is exactly the basis on which marking to market works. I watched an entertaining debate on mark-to-market and regulatory capital on you-tube a few weeks ago and one comment stood out: “how much would your house be worth if you had to sell it in the next 10 minutes?”. This is what mark-to-market does for you.

The reason for this principle of continuity is clear. It avoids almost immediate losses being realised when a capital investment is made in assets that are valuable and profit making to the company, but have limited resale value in the “market”.

Consistency is another important principle. It is quite clear that a company’s balance sheet does not give its market value so why apply this inconsistent approach to the pension scheme? It is also worth mentioning at this point that accounting was never designed to give a company valuation and has never stated that as its intention.

As Simon has already stated there is no market for occupational pensions and nor would it be desirable to have one. We have specific legislation in the form of Section 91 of the Pensions Act to guard against this.

However, if we were to accept that marking to market was the right approach, and to be clear I don’t, then what would such a market look like? There is much evidence to suggest that it would have little to do with government or AA rated bond yields.
We can get some idea on the average member of the public’s preference for cash now over cash later by looking at loan and credit card rates. Looking a bit closer to home there are 2 areas where there is clear evidence that pensions are not valued in line with current views of mark-to-market rates.

The first is by looking at potential opt-outs. Recent research by the Department for Work & Pensions, Hymans Robertson and the Office for National Statistics, revealed that 62% of those in the public sector earning less than £25,000 a year were unwilling to make pension contributions of more than 6% and that widespread opt-outs are likely. The key point here is that by opting-out if contributions are increased members are saying they value 6% of immediate cash salary equivalent to 20% of salary worth of pension benefits. And this is based on a 3.5% real discount rate that I have no doubt those opposing the motion tonight would like to see significantly reduced! By my calculations this means the implied member discount rate is nearer 10% above inflation!

The other area to look at is enhanced transfer value exercises. Looking at the substantial difference in take-up rates for exercises where the enhancement is given in pension or cash again shows the reduced value members place on pension compared with cash.

Now both of these examples reflect a significant mistrust and misunderstanding in occupational pensions and only apply to a proportion of the membership. A market, if one existed may actually improve this, but I still believe that it provides some clear evidence that pension benefits are not valued by members in line with traditional mark to market theory. It also highlights why a market is SO undesirable as information asymmetries would be rife.

In addition to the obvious reasons for this e.g. the need for cash now, living for today not tomorrow, concerns of dying before retirement etc. a key reason for the increase in discount rate is the risk of default. Despite how those on the other side may protest, pensions are still not guaranteed, and they certainly weren’t setup to be guaranteed. Employers can still default on their obligation. When talking about guarantees, RPI to CPI also adds an extra dimension to the debate. In the future it is unlikely that the pensions industry will ever be able to persuade members that accrued rights cannot be reduced.

I therefore suggest that it is difficult to take seriously the views of those opposing the motion when they can’t even apply their own approach correctly!

The effective discount rate at which members value their pension benefits is important. Unless this rate is lower than the rate underlying the cost to the sponsoring company, the pension scheme has no value to the company and it may as well pay additional salary instead. This combined with the volatility driven by mark-to-market leads to another great undesirable behavioural change, in addition to those already mentioned by Simon, the end of defined benefit pensions.

Taking a more holistic view. What mark-to-market is doing is stopping companies taking on, pooling and smoothing risk and instead forcing every ill-equipped individual to take on the risk themselves – this is wrong!”

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