The market value of assets reflects both the company’s well-being and the emotional state of market participants. Stock market bubbles and other quick changes are usually the result of changes in investor temperament. For example, Toronto stock market returns have varied significantly since the beginning of the decade. In 2000, the rate of return was 7.4%. It dropped to -12.6% in 2001, hit a high of 26.7% in 2003 and then fell to 9.8% in 2007. More recently, the Canadian dollar went from US$1.02 to US$1.0852 and back to US$1.015 within 17 business days.
A favourite allegory of Benjamin Graham (the father of value investing) is that of Mr. Market, an obliging fellow who turns up every day at the stockholder’s door offering to buy or sell shares at a different price. The investor is free to agree with his quoted price and trade with him or to ignore him completely. Mr. Market doesn’t mind this and will be back the following day to quote another price. The point is that the investor should not view Mr. Market’s whims as determining the value of the shares. The investor will be better off concentrating on the real-life performance of the companies and receiving dividends, rather than focusing on Mr. Market’s often-irrational behaviour.
Accounting Trends
There are three new trends in accounting rules relating to point-in-time values of assets and liabilities: one, using current long-term bond rates to discount liabilities; two, using the market value of assets; and three, recognizing gains and losses immediately rather than amortizing them.
The old rules allowed for inordinate smoothing, resulting in companies recording large pension income in the same year that their pension funds dropped precipitously. There was a major disconnect between pension expense and reality.
Nevertheless, the impact of the new rules is extreme volatility in pension expense. It is common for long-term bond rates to change by 0.25% in a single month. If assets are invested 40% in bonds (and assuming that the liabilities exceeded assets by 10% at the beginning of the month), the impact is a 30% change in unfunded liability that must be recognized immediately.
David Dodge, former governor of the Bank of Canada, recently said, “[The use of accounting rules] is becoming increasingly important to pension plan sponsors because international accounting standard setters are examining a move to unsmoothed, so-called ‘fair-value’ methods.” He goes on to emphasize that these accounting rules “are intended to replace rules that smooth changes in asset and liability values with rules that focus on values at a point in time. But it is not at all clear how useful or relevant it is to determine point-in-time values of assets and liabilities in a DB plan. For plans as a whole, what we are interested in is not today’s values, but expected values far into the future.”
Here’s an example. On Black Monday (Oct. 19, 1987), the Dow Jones fell by 22%. Overall, the Dow Jones gained 2% in 1987. Yet accountants would say that the market values at the end of the previous Friday and at the end of Black Monday were both appropriate for valuation purposes.
Dodge concludes, “If this review results in changes to accounting standards, it could make sponsor balance sheets and income statements much more volatile. So sponsors will have an increased incentive to hold assets with low volatility. This incentive may make pensions more expensive because sponsors would be less likely to take on assets with higher expected returns. Put another way, plan sponsors could be given the incentive to become overly risk-averse, meaning an increase in the cost of providing for future liabilities.” Perhaps the pendulum has swung too far.
Stephen Donald is a consulting actuary with Buck Consultants, an ACS Company. steve.donald@buckconsultants.com
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