1. Valuation DB Pensions Con Keating TUC conference, London, 2013 con.keating@brightonrockgroup.co.uk 1

2. Valuation is a Dark Art Comparison of Current and Possible Methods 2 AssetsLiabilitiesSurplus% Illustrative Scheme 132,017,010 117,735,91714,218,094112% Pensions Act 186,030,788 182,433,905 3,596,884102% Accounting 186,030,788 222,631,806 36,601,01884% Gilt 341,353,967 222,631,806 118,722,161153% Asset Implied 186,030,788 153,468,329 32,562,459121%

3. An accurate and unbiased approach The method Start with the primary fair value condition present value of contributions must equal the present value of the promised pensions This defines the internal growth rate (IGR) of a scheme This is the weighted average cost of capital for a sponsor employer or equivalently the weighted rate of return on contributions to pensioners. In order to compare apples with apples: – Project Liability Expense Cash-Flows – Project Asset Income Cash-Flows – Compare these at the Internal Growth Rate integral to the awards. This produces accurately accurate, stable and unbiased results The reported liabilities are accurate and the scheme funding ratio correct 3

4. Cash Flow Projections Asset cash flows – Bonds contractual and Equities constant real income. 4

5. Estimating the IGR 5 Solve for IGR under Pv(C) = Pv(P)

6. Valuation Illustrative Scheme 6

7. Contributions Contributions are amortised as pensions are paid and members die. 7

8. Conclusions The proposed method is precise and accurate. It is a fair value approach. It outperforms all existing and many possible methods It is decision and prediction useful. It varies only with variation in pension and contribution factors. It carries with it incentives for DB scheme provision. And long-term investment. Current figures overstate the deficit If there is a deficit, there are multiple ways of filling it, of which higher contributions is only one. It is right to be concerned that pension finances are sound but it is also right to be sensible. And if time permits... 8

9. How long? Price and Information The minimum length of time to distinguish price signal from noise If we assume normality in return, we can estimate these times: Only with high return, low volatility strategies are market prices informative. Everywhere else, we are working with noise. 9

10. Convergence Market prices are driven by fear and greed - Anomalies abound Volatility is extremely high. Prices drive returns – Beebower, Brinson. Market returns are negatively correlated with GDP growth out to about five years This violates Arrow Debreu fixed point efficient resource allocation equilibria. But as we move to long holding periods, income dominates and volatility declines. Long term returns are positively correlated with GDP growth In other words, short term market price moves converge to the long-term fundamentals and allocative efficiency But not if we use them as indicators for short-term management actions Such as special contributions and management techniques like LDI which are hedging regulatory and accounting nonsenses. 10

11. Expected Returns Corporate Bonds Suppose we have tow zero coupon bonds outstanding both have the same maturity, but they were issued with different terms and conditions The bond-holder claims in insolvency differ – the issue terms matter 11