Market-consistent valuation of pension liabilities

The European Union is currently preparing a new set of rules for the supervision of insurance companies, and is considering implementing these rules for pension funds as well. This framework is known as Solvency II. Similar to the Basle II framework for banking supervision, Solvency II is based on market-consistent valuation and risk management techniques. Market-consistent valuation means that the value of any entry in a balance sheet is determined by the price for which an asset or liability could be traded in a market transaction between two willing and knowledgeable counter-parties. Thus, a "mark-tomarket" approach should be used for assets and liabilities whenever the prices can be observed in a liquid market. In other cases, a "mark-to-model" approach must be used to value the assets or liabilities, where the valuations models should incorporate all of the relevant market information. The benefits of market valuation are clearly found in increased transparency and accountability of pension schemes. However, there is a widespread fear— typically prevalent on pension fund boards— that market valuation based on the actual term structure of interest rates leads to excessive volatility in funding ratios. If regulators then impose solvency regulations in terms of these market-based funding ratios, contribution rates may become much more volatile. For pension fund boards, this means tougher negotiations with the sponsor of the pension scheme, and more frequent bad-news messages, caused by downward spikes in the discount rate. In order to circumvent these problems, the FTK still allows pension funds to use a smoothed or fixed discount rate to determine contribution levels, even though their solvency is always determined by the prevailing term structure of interest rates. Moreover, the solvency rules are applied only to guaranteed (in practice, nominal) pension rights. The use of market-consistent valuation- and risk management techniques is not uncontroversial in the case of pension liabilities— particularly for pension liabilities with conditional indexation.