According to Professional Pensions, the Accounting Standards Board is standing by its plans to move to risk-free rates when valuing pensions for accounting purposes. Moving from the current approach (which uses AA-rated corporate bond yields) to a risk-free approach (which uses Gilt or perhaps swap yields) would cause pension deficits in firms’ accounts to rise sharply.
On one level, this is of only secondary importance. All that is being calculated is the figure that goes in the accounts. Whilst for some firms this will have an impact on dividends, loan covenants and so on, it should have little direct economic effect on most firms. However, it sends a signal to the market about the size of pension schemes and their deficits, and might also herald a further tightening pension regulation. So is a move to risk-free rates right?
In principle, it must be. What you are trying to value is the obligation a firm has to make future payments, and its obligation is unconditional – only insolvency really frees it from its commitments. But what does “risk free” mean? Gilts are certainly as good as risk-free – the probability of default is negligible. However, the fact that Gilts are so incredibly liquid means that they are more expensive than other highly-rated bonds. Some of the difference in yield relates to the additional security of Gilts, but some is a liquidity premium – and pension schemes do not need this liquidity.
This became an issue in the credit crisis when credit spreads increased causing pension scheme liabilities to fall. Was it right that the obligation to pay benefits fell when credit risk increased? To the extent that the rise in yields reflected a rise in the risk of default, it was not. However, assuming that some of the increase was a reflection of reduced liquidity, then this implied that you were able to buy secure and fairly liquid assets to pay your benefits more cheaply than you could before – in other words, your liability had reduced.
This suggests that a rate somewhere above Gilt yields but below AA-rated corporates is appropriate, but the difficult question is at which end of the scale – in other words, what is the liquidity premium? There are few AAA-rated bonds other than Gilts around, so a subjective approach is needed, and none of the approaches seem wholly satisfactory. Unfortunately for pension schemes, this means that a liquidity premium of zero must be assumed, but this is by no means certain. If nothing else, greater clarity around the definition of a risk-free rate is needed to ensure that pension schemes are funded sufficiently, but not excessively.