Introducing The Internal Growth Rate Of A Pension System

Monday, 07 April 2014

Many different ways have been proposed and used to evaluate the state of (DB) pension funds for reporting and management purposes. In "Keep Your Lid On: A Financial Analyst’s View of the Cost and Valuation of DB Pension Provision", we introduce the Internal Growth Rate (IGR) of a pension system; this is a form of amortised cost accounting presentation.

We argue that discounting liability projections at the IGR meets both reporting and management objectives. Moreover, when discounting at a single rate is used, as it usually is for the sake of clarity and comparability, then the IGR is the only rate satisfying these requirements.

The many alternatives in use (“risk-free” rate, gilts, corporate bond yield, expected asset return, …) lead to over or under estimates, bias, and volatility in liability valuations. The main reason for this is that they are exogenous to the system and do not reflect scheme arrangements and dynamics; it is actually worse in that they introduce elements that are not part of the contract, and therefore arbitrary.

The IGR avoids these arbitrary introductions by considering contributions, an element of the (DB) pension contract (system) overlooked by current arrangements. These are the inputs to the process that delivers the pensions output. The IGR enables accurate and consistent evaluation of the state of the pension system when applied to the income and expense projections.

In the simplest possible terms, the IGR is that rate of return that must be achieved by a contribution to deliver the promised pension benefit when due.

The added benefits of evaluation at the IGR include stability of reporting and elimination of spurious external effects in pension fund reporting. In this way, it will be possible to avoid unnecessary and costly interventions in scheme management, which are aimed purely at improving reporting under current (misleading) standards rather than on improving fund dynamics. Valuation at the IGR is consistent with the admitted claims values in insolvency proceedings.

The estimate of fund IGR may incorporate the entire fund design, including funding arrangements with sponsors and the use of insurance and guarantees. This is not possible using many of the currently-used methods, for example, market value based approaches. The IGR can be used to assess and compare pension system performance, and to measure the impact of management interventions such as liability driven investment and closure of schemes to new participants. It also sheds new light on the debate on the affordability of defined benefit (DB) schemes.

The valuation methods for pension funds have been highly contentious. The IGR and proposed method inform several aspects of those debates and offer resolution of them.


Related Publications

  • Keating C., Settergren, O. & Slater, A. (2013). 'Keep Your Lid On: A Financial Analyst’s View of the Cost and Valuation of DB Pension Provision'. Long Finance and EFFAS, Finance Shorts. Feb Issue. Available Online.
  • Keating, C. (2011). 'Don't Stop Believing: The State and Future of UK Occupational Pensions'. Long Finance, Finance Shorts. Nov Issue, Available Online.
  • Keating, C. (2010). "Don’t Stop Thinking About Tomorrow: The Future of Pensions". Long Finance, Finance Shorts. Nov Issue, Available Online.