He explains: “There is a naturally occurring rate within a pension contract, you set and pay a contribution and you promise someone a set of benefits for which you have a set of projected values. The contribution made and the projected benefits define an accrual rate; this is the rate of return contracted within the pension promised – that is the rate at which the contribution has to grow in order to deliver the benefits promised, it’s fixed over the life of that promise. It does not change unless you revise your benefit assumptions.”
So that fixed rate, according to Keating, is independent of current market prices or rates. Furthermore, it is time consistent which means if you are doing a valuation in between receiving the contribution and making the benefit payments it doesn’t matter whether you do it by accrual from bottom-up or by discounting from top-down, using that rate you will get the same value.
He adds: “If you are using market consistent rates or investment return rates that does not happen.”
He continues: “When scheme funding is measured relative to the valuation calculated using this method, you know where you are; if you are tracking to meet the promise as made. Deficits and surpluses now have meaning. The investment strategy becomes a simple case of achieving a known rate of return. But most importantly, hedging of the market-derived discount rate is no longer a relevant consideration.”
Sadly for Keating and the other cynics, it seems that the gilts-plus model is not going to disappear just yet. While an increasing number of schemes are moving away from this to an asset-based or inflation-plus measure to discount their liabilities, either way, mark-to-market valuations look here to stay.
As Wright says: “The job of the trustees is to pay 100% benefits and I think the gilts-plus model does have to stay. For it to go away they would have to change the structure of legislation and the benefit promise to members and I don’t know which politician would like to do that.”
