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How asset allocation is influenced by the valuation of liabilities

In February 2001, there were three valuation bases for pension liabilities in the UK: statutory, MFR and FRS17. This report by David Blake of the Pensions Institute argues that a single valuation basis for pension liabilities should be developed in a way that ensures pension funds are not discouraged from investing in private equity.

How should we value the assets and liabilities of a defined benefit pension fund? Its assets are liquid and subject to market value fluctuations, while its liabilities are less liquid and potentially less volatile. How can we ensure that there are always sufficient cash flows from the assets to meet the promised pension payments when they fall due? And how can we deliver pensions at the lowest economic cost to the sponsor? These questions are currently being asked by actuaries, accountants and economists.

Few people would now justify valuing assets on anything other than a market basis. Yet there are currently three official valuation bases for pension liabilities in the UK: statutory, MFR and FRS17. Even more significantly, the discount rates that actuaries and accountants currently use or propose are based on bond yields. Therefore, they push pension fund asset allocations towards bonds in an attempt to lower the short-term volatility mismatch between assets and liabilities, at the cost of lower long-term portfolio returns. The current valuation structure is unfavourable to investment in private equity because, by its very nature, it is a long-term, illiquid investment. Efforts should be made, says the report, to ensure that the valuation basis for pension liabilities does not pressure pension fund asset allocations away from private equity and other alternative assets - this could be detrimental to portfolio returns.

Click here to view the full PDF report

David Blake is a professor of financial economics at Birkbeck College, University of London and director of the Pensions Institute. He holds an MSc and PhD from the London School of Economics. Areas of research include pension economics, policy, pension fund investment management and performance. He is the author of numerous books and articles on pensions and pension fund management. dblake@econ.bbk.ac.uk

Established in 1996, The Pensions Institute is the first and only UK academic research centre focused entirely on pensions research. It undertakes and organises high quality research into all fields relating to pensions.