The pragmatists fight back

Editor's letter

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Is valuation an objective or subjective exercise? In the dynamic social construct that is a pension scheme, measuring liabilities is a loaded question.

Much of the history of science comes down to measuring sticks: once the meaning of something like mass or temperature is agreed upon, then the properties of objects can be investigated. We view mass or temperature as objective qualities, and the laws of physics that mathematically connect them as embodying eternal truth.

In social science, objective truth is harder to come by, but the political principle of fairness is so widely held that it has something of an objective quality. And fairness requires objective measuring sticks, whether in assessing the performance of hospitals, or for the balance sheets of companies that raise capital from investors.

There is a strong philosophical tradition behind objective measurement, stemming from the view that beliefs must be capable of being proved true or false. But there is an alternative tradition, associated with the American philosopher William James. Called pragmatism, this school of thought rejects the use of objective measuring sticks to assess truth or falsity. Instead, ideas should be assessed on the basis of usefulness. If the answer given by a measuring stick is not useful, then the measuring stick should be changed.

In the world of pensions, the objective viewpoint is epitomised by the shift towards market-consistent valuation methods, and increased disclosure of hitherto unreported parameters such as scheme life expectancy. But the pragmatist perspective is also alive and well. Consider the British pension actuary quoted in this issue who says that the method of valuing a scheme should be dependent on its funding status. What this means is that if the sponsor is sufficiently strong, the interest rate and inflation risks that emerge from market-consistent discounting can be ignored.

It isn't hard to see where the actuary is coming from. The introduction of market-consistent valuation seems far from useful when it exposes large funding gaps and mismatch risks, requiring extensive (and sometimes expensive) risk management.

On the other hand, objective measuring sticks like market-consistent valuation seem both fair and simple, compared with what can be highly subjective and complex assessments of sponsor credit risk.

There is also a question of motives. Market-consistent valuation can cast doubt on the funding status of a sponsor. Accepting that strong funding status makes market-consistent valuation irrelevant appears like a suspiciously convenient form of circular reasoning.

The whiff of sophistry is much in evidence in the US, the birthplace of pragmatism. The new US Pension Protection Act gives pension funds seven years to clear their deficits, except for airlines whose lobbying has gained them an extra ten years. That's very useful for the airlines, but also blatantly unfair.

Such conflicts between objective fairness and subjective pragmatism are a hallmark of pension regulation. In the UK, objectivity seems to reside at the Pension Protection Fund, whose risk-based levy raises fairness above other considerations. A mild form of pragmatism appears to have a home at the Pensions Regulator, summed up by the phrase 'scheme-specific funding'. This philosophical characterisation maybe something of a caricature, but it helps explain why corporate sponsors have grown to like the Regulator and dislike the PPF.

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