Questions related to valuing liabilities (2)

[Adithyan]

Hi!

Kindly help me with these questions as they hinder my understanding.

Thanks in advance for your time and efforts.


What is the difference between these two points?

In page 7 of the chapter
The liabilities are valued using a discount rate calculated as the weighted
average of the individual discount rates based on the proportions
invested in each asset class.

The discount rate could be determined using the distribution of the actual
investment portfolio or the scheme’s strategic benchmark (if the current
asset allocation is not representative of the scheme’s usual investment
strategy).

What does distribution of actual investment portfolio mean?

In pg 9 of the chapter
When setting the discount rate, the credit risk element should be stripped out of the
corporate bond yield, reducing the discount rate to 4.5% pa. However, the allowance
for marketability risk will often be included in the discount rate, if marketability is not
an issue for the provider, ie the assets are intended to be held rather than sold with the
income from the assets being used to meet future liability cashflows. A discount rate of
4.5% pa might therefore be used.

The question I have here is only if marketability risk is there, then it needs to be allowed for in the discount rate by increasing it by a value corresponding to the market risk. Why is that they allow for it if it is not an issue?

 

[Helen Evans]

On page 7, the "distribution of actual investment portfolio" just means the assets actually held. So for example if the fund is invested 40% in bonds and 60% in equity then that is the split that would be used.

The point on page 9 is rather subtle! Using the figures in the example, we have a risk-free bond with a 4% pa expected yield and the corporate bond with a 5.5% pa expected yield (consisting of the 4% risk free and a 1% default risk allowance and a 0.5% allowance for marketability risk). Note these allowances for default and marketability risk are driven by the average investor in the market, ie the additional return that average investors demand to compensate them for the risks posed by the asset compared with a risk-free asset.

If an investor were to use this 5.5% rate as the discount rate it would place a lower value on the liabilities than if the liabilities were valued using the 4% rate of the risk-free bond. We can then consider whether this is reasonable, this will depend upon the investor and in particular the extent to which the investor is worried about each element of risk.

For example, let's consider an ongoing pension scheme:
- the pension scheme would be concerned about the bond defaulting as it would lose the money needed to make regular payments to pensioners. The scheme can't therefore include the 1% allowance for default risk in the discount rate, ie the additional return of 1% is there to reflect a risk that is of concern to the scheme
- the pension scheme may not though be worried about marketability risk. As an ongoing scheme it may have no need to sell the bonds, so the 0.5% allowance for marketability risk which is additional return required by the average investor in the market as compensation for the difficulty in trading the bond is pure reward for our pension scheme. In other words it is return which is not there to compensate for a risk faced by the scheme. This 0.5% marketability risk allowance can therefore be included in the discount rate (ie use a discount rate of 4.5%) and used to provide a lower value of liabilities than if a discount rate based on a government bond had instead been used.

As I say it is rather subtle, but I hope this helps.