The counter to this volatility is extreme caution in investment policy and a reliance on low-return government bonds, both methods drive up pension plan costs, says the NAPF’s report.

“The current standards are not appropriate for the long-term nature of pensions. They allow short-term stock market volatility to perversely affect pensions and their long-term strategy by presenting large deficits which may prove inaccurate in the long run,” says NAPF chairman Lindsay Tomlinson.

United Kingdom-based NAPF follows the direction of the International Accounting Standards Board (IASB) while the United States follows the Financial Accounting Standards Board (FASB).

The two governing bodies have attempted to merge standards recently, with mark-to-market accounting being the main hot-button issue. Some notable United States companies, including Verizon, Honeywell, and AT&T, have made the switch to mark-to-market valuation of their pension plans, partially as a prediction that the FASB will adopt the IASB’s mark-to-market standards.

The survey, which covered 134 Chief Financial Officers, Chief Compliance Officers, and valuation team members, showed an increasing attention to market volatility as it relates to fair value accounting procedures.

“The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities,” said Rob Haddad, director of Evaluated Services for Interactive Data. Haddad continued, “Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing processes to examine how these procedures worked in practice.”

Among mutual funds, 36% reported that fair value is being applied every day, up from only 10% in 2004. The other 64% of funds reported using “triggers” — a process that pays attention to market movements and benchmarks — to apply fair value procedures for the fund. The strategy for triggers varied greatly in method, scope, and complexity, said the study.

A newly popular method of valuation, CAPE relies on inflation-adjusted earnings statements as well as averaging 10 years of reported earnings to account for business cycle effects. Wilcox says that CAPE provides “an overly bearish view of the stock market” and should be used with caution.

Fair value accounting, says Wilcox, showed how a change in accounting regulations had a material impact on reported earnings and is a key flaw in Shiller’s CAPE method.

When the Financial Accounting Standards Board (FASB) issued the fair value ruling in 2006 (and up through the financial crisis in 2008), investment securities and mortgage-backed securities made up a significant percentage of banks’ assets. Wilcox says, “The move toward more fair value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions” in the fourth quarter of 2008. CAPE, says Wilcox, must continue to reflect the impact of a single quarter’s massive loss even though it’s unlikely it will happen again in the next 10 years.

Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.

The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.

Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!

This had astounding effects, says Wright. “The Basel Committee on Banking Supervision has calculated that two-thirds of the losses made on derivatives during the credit crisis came not from the default of counterparties but from the deterioration in their credit quality,” he says. Standard & Poor’s believes that of all the Basel committee’s actions, this requirement has “the greatest potential implications for the behavior of financial institutions in the medium term.”

These new rules were necessary because prior regulations ignored potential mark-to-market losses, says Wright. It was the timing and complexity of FAS 157 – the 2007 mark-to-market requirement – that ultimately caused undue stress for financial institutions in the United States.

“Often the regulatory response to one crisis sets the parameters for the next, says Wright. “All those governments poised to push through new financial regulations in the coming months should examine the example of new counterparty credit risk rules…and ask themselves whether now is the best time to field-test their unproven ideas,” Wright concludes.

Mark-to-market accounting “has led to greater volatility in comprehensive income and the recognition of substantial and often volatile pension deficits in the statement of financial position,” said the study’s authors, Iain Clacher and Professor Peter Moizer. Mark-to-market has caused the decline in defined benefit plans “as corporate managers have increased the pace at which these schemes are closed to new members and to future accrual by existing members,” the authors continued.

In the United States, however, many pension plan administrators for large companies like Verizon and Honeywell have made the switch to mark-to-market for their pension plans. Analysts believe US companies have made the shift partially as a proactive move in the event that U.S. Generally Accepted Accounting Principles (GAAP) would begin to require mark-to-market in the near future. Many also point to the practice as a strategic move, allowing recession-hit pension plans to recognize losses in one year as opposed to smoothing losses over many years.

The ideal model, according to the study, would include the present value of future cash flows and cash payments by benefit plan administrators.

Bank holdings remain full of declining assets, capitalization rules remain too thin, and compensation and bonus structures are misaligned, says Ritholtz. Balance sheets are “unnecessarily opaque” due to the removal of fair value accounting in 2008-2009. He continues, “Eliminating fair value accounting via FASB 157 did not fix balance sheet problems, but instead allowed banks to hide them.”

Instead, Ritholtz proposes a full reorganization of the nation’s largest banks, most importantly shedding under-performing holdings that are now hidden by marking assets at original value.

Presently, controlled entity investments are consolidated with assets, liabilities, income, and expenses recognized on the company’s financial statements. The new proposal would simplify this reporting to one line, measured at fair value.

International auditing firm KPMG viewed the proposal as a step towards streamlining management and better gauging performance. “This could be a significant, positive change compared with the current position in IFRS,” said Tom Brown, KPMG’s UK head of investment management and funds.

The proposal may affect firms in the United States, depending on its adoption of IFRS. The proposed IFRS changes are in consultation until January 2012 – near the time at which the United States Securities and Exchange Commission would make its recommendation. Application of fair value has been a point of contention in efforts to adopt IFRS in the past.

The trouble comes in, says Ford, in an imbalance like Princeton’s, which invested 82% of its portfolio in a category called “Level 3 – Significant Unobservable Inputs.” (Level 2 shares are assets like Treasury bonds – not actively traded but easily measured. Level 1 inputs are market assets, liquid and easy to measure.)

The Financial Accounting Standards Board (FASB) defines a Level 3 asset as something illiquid with little certainty about the valuation. All assets for university portfolios must apply fair value accounting, per Ford’s research into the FASB governing rules.

The issue with this “Yale model” adopted by so many institutions is that these “unobservable” inputs could vary widely if sold today – perhaps not at the perceived market value that the endowment fund managers place on these illiquid assets. “Many jokes could be told about how the brilliant minds at Princeton use “unobservable” inputs to calculate a net endowment value of $14.4 billion while not being able to park their bicycles straight,” says Ford.

His comments relate to a discussion on the Fed’s reaction to the financial slump. Mr. Mundell said that the Federal Reserve’s decision to implement mark-to-market accounting in the midst of the subprime mortgage crisis is “one of the worst mistakes in its history.” Mark-to-market forced financial firms to cover short-term losses, a key component in the overall health of the bank. Mundell says this implementation exacerbated the problem, rather than eradicated it. The first bout of quantitative easing, which lowered the dollar against the euro, gave the economy it’s first sign of recovery, he said. But QE2, which lowered the value of the dollar and allowed the second leg of recovery to begin, was the wrong solution, he says.