This week I was asked this question by a civil servant (not directly involved with pensions).
Ignorant question:
What in regulation or law would prevent a DB pension scheme being valued based on the actual assets as opposed to the risk-free rate?
My short answer was
“nothing”.
A rather better answer came from my good friend Derek Benstead.
Not only is the answer “nothing”, the law explicitly mentions it as an option.
It’s in http://www.legislation.gov.uk/uksi/2005/3377/pdfs/uksi_20053377_300914_en.pdf
Regulation 5(4)(b)(i)
(4) The principles to be followed under paragraph (3) are–
(a) the economic and actuarial assumptions must be chosen prudently, taking
account, if applicable, of an appropriate margin for adverse deviation;
(b) the rates of interest used to discount future payments of benefits must be
chosen prudently, taking into account either or both–
(i) the yield on assets held by the scheme to fund future benefits and the
anticipated future investment returns, and
(ii) the market redemption yields on government or other high-quality bonds;
Well, my very civil , civil servant half- jokingly responded
So it is actuarial caution/convention?
Which is a really interesting observation because he/she’s right, the actuarial profession have allowed themselves to be overly cautious and allow that caution to become their convention.
I picked up on yesterday this with the man who has been conducting the review of defined benefits at the PLSA – Ashok Gupta.
He agreed that actuarial advisers, especially those offering investment advice have been overly cautious and allowed the conventions that have developed around the artifice of Liability Driven Investment to obscure the proper purpose of running a pension scheme. If you want to read any of Con Keating’s brilliant series of blogs on here – just pop “Con” in the search box, these blogs will explain why we have got to the pickle we are in today.
Not to labour the point, if you throw away the actuarial caution/convention, this is how the deficit position of UK Plc’s defined benefit/surplus position looks.
But you may want to look at things in a less abstract way and return to my friend’s question to think of the answer in a technical way….
So – for the technically minded
Technical help
When you work in an actuarial practice, help on these matters is never far away, but I wasn’t expecting such a detailed response from our technical team.
There are a number of different ways of measuring the liabilities of a defined benefit pension scheme, depending on the purpose of the valuation.
I have summarised the key purposes, the requirements as set out in legislation and made some other comments, which I hope will be helpful. In all cases, the market value of assets at the valuation date is used.
| Purpose of valuation | Legislation requirements | Comments |
| Company Accounts UK GAAP
IFRS
|
Calculate a set of future benefit cashflows using best estimate assumptions.
Then discount those cashflows back to valuation date using yields on high quality corporate bonds. Requirements set out in Accounting standards issued by FRC (UK accounts) and IASB (International Accounting Standards) |
Discount rate usually reflects the yield on AA rated corporate bonds of a term appropriate to the liabilities.
A reduction in corporate bond yields, will result in lower discount rates and higher defined benefit obligation. This measure does not take into account the expected return on the assets held by the Scheme. For schemes that hold growth assets, this measure will overstate the liabilities of the pension scheme. Over time, this will gradually be corrected so that the resulting cost of running the scheme over the history of the scheme will reflect the cost of providing the benefits. However, the issue at the current time is that the increase in the deficits over one year, on a notional measure, may restrict the director’s ability to declare a dividend. |
| Scheme Funding | Trustees are required to set technical provisions (liabilities) at a prudent level.
Pensions Act 2004, Part 3 Scheme funding and SI 2005/3377 sets out requirements. The key requirements relating to assumptions used to value the technical provisions are in regulation 5, SI 2005/3377, and repeated below: (4) The principles to be followed under paragraph (3) are— (a) the economic and actuarial assumptions must be chosen prudently, taking account, if applicable, of an appropriate margin for adverse deviation; (b) the rates of interest used to discount future payments of benefits must be chosen prudently, taking into account either or both— (i) the yield on assets held by the scheme to fund future benefits and the anticipated future investment returns, and (ii) the market redemption yields on government or other high-quality bonds; (c) the mortality tables used and the demographic assumptions made must be based on prudent principles, having regard to the main characteristics of the members as a group and expected changes in the risks to the scheme, and (d) any change from the method or assumptions used on the last occasion on which the scheme’s technical provisions were calculated must be justified by a change of legal, demographic or economic circumstances. |
Legislation does allow trustees to adopt a discount rate that reflects a prudent estimate for the expected return on the assets held.
The level of prudence will depend on what the appropriate margin for adverse deviation is. Discount rates may be presented as a gilt yield + x%. In the past, the gilt + approach was encouraged by The Pensions Regulator, but in recent years, the Regulator has moved away from this stance. |
| Buyout solvency | An actuary’s estimate of the cost of buying out all benefits earned to date, with an insurer.
This measure is quoted in actuarial valuations to demonstrate the position if the employer decided to (or forced to due to insolvency wind up) the pension scheme at the valuation date. (Known as section 75 debt) |
This measure will give the highest liability, reflecting the low risk investments held by insurers (gilts, bonds, swaps, etc), margins required for prudence, return on shareholder capital used to back business and expenses. |
I’m pleased to see your colleagues used the term “buyout solvency”, Henry.
I feel the “solvency” word has been taken
in vain by many actuaries and even some non-actuaries (Mr Ralfe comes to mind).
“It really means the ability of a business to meet its long-term financial obligations. Solvency is essential to staying in business as it asserts an ability to continue operations into the foreseeable future. … A business that is insolvent must often enter bankruptcy.”
Going concern.
Thanks George
Thank you. Interesting .
Very busy at Pru but it’s better – different type of stress
But it’s tiring and no life in effect
Glad you found it interesting
When things settle down, beer
Rgds
Keith
Sent from my iPad