Transfer values – Con Keating sees a comedy of errors!

This blog is from the pen of Con Keating


The writer at work



There has been a spate of requests for quotations of transfer values from DB schemes and much publicity given to some of the more public figures who have taken transfers. Under the surface of all this noise, there are some really interesting developments and misconceptions.

The first of these is that very few insufficiency reports are being commissioned which means that few trustees are offering deficit or funding-level related transfer valuations. In part this arises from the reported stance of the Pension’s Regulator, which might be summarised as

if you believe the employer covenant is strong, then you think stayers will have all benefits paid in full, so you shouldn’t be reducing the benefits of leavers.

Catch 22 indeed. If trustees argue for reductions, they risk requiring the sponsor to contribute more to the scheme.

This is deeply problematic as an argument – it relies on future performance of the sponsor (and scheme) rather than reflecting the reality today. It is a short step to considering schemes as stand-alone entities ….and requiring funding accordingly.

It also fails to consider the fact that the leavers are not just that; they are early leavers, no longer contributing to the risk pooling and sharing that advantages DB schemes and funds.

The valuation basis is intended to be best-estimate, but it does not consider commutation factors and the level of take-up of cash commutation. The most common commutation factor is 12, while the lifetime allowance is based upon 20, and compares starkly with quotations of 30 and 40. This is potentially a very substantial adjustment – the quotation would fall to 33 from 40 under the maximum, but not uncommon, 25% take-up rate.

Finally, the discount rate to be applied, again to satisfy the Pensions Regulator, is the expected return on assets held by the scheme. This means that schemes which have de-risked and now hold mainly gilts will apply far lower discount rates than those which where equities are prominent. This is a complete nonsense. There is no liability whose value is determined by the manner in which it is funded. The nonsense here is that the value of identical benefits may be wildly different.

In many other articles, we have indicated that the correct discount rate for liability valuation is that rate determined by the contract itself. This has the property that it is time consistent – it will value fairly both past and future performance under the terms promised and contracted. It is not dependent in any way on the level or type of funding. It also has the added advantage that other interested parties, such as spouses, cannot revisit a valuation when markets have moved unfavourably.


Note from the Pension Plowman

I read this blog but could not fully get how the grant of the contract worked. I’ve now got a further little blog which explains. Rather than force you to link- I am attaching this explanation below.

How to figure out the contractual grant (Con Keating)

For as long as I can remember, various UK Government Ministries have been at pains to point out that the assets in a local authority pension fund are the property of the sponsor entity, not the members of the scheme. This has been a cause of much misplaced consternation among trustees and union officials. As insolvency is not an issue for such bodies, the role of the pension fund is clearly to offset or entirely defease the future payment costs of pensions awarded.

Pension liability valuation, the accumulated liability of the sponsor and the value to an employee depends solely on the terms of the contract under which the pensions were awarded. Other articles have introduced the concept of the contractual investment accrual rate; this is illustrated below in the simplest possible case, a single contribution for one year of service, together the associated projected pension cash flows. In this illustration, the pension includes a 50% surviving spouse’s benefit.


Just focus on the red line – the rest is irrelevant


The contractual investment accrual rate is the rate required for a contribution of £16 to equal the projected pension payments (1.5% of final salary); in this case, it happens to have a value of 5.19%. The detail here is not material; the point of this illustration is to show that the evolution of the liability valuation is fully defined over its entire lifetime. In order to be solvent, say, at the end of the member’s 64th year, the fund needs to have assets valued at maximum a little under £42, the value of the cumulative award at that time. The cumulative award line shows the value of this pension liability at all points over its entire lifetime.

A scheme is just the aggregation of many such individual contracts in any year and over time. There is no need to invoke any external factor to value a pension promise; the contract(s) fully defines it. This is a “going concern” valuation; it is “true and fair”.

Should the investment portfolio not generate returns at these levels, the scheme will have recourse to the sponsor authority. Whether this should be at the time of the deficit appearing or at the time of pensions payment is debatable, and largely, when the sponsor cannot experience insolvency, a matter of local authority preference.

Private sector, corporate schemes differ in that they may experience insolvency. This has led to a raft of misguided regulation and practice. The cumulative contractual award valuation defines the amount that the sponsor should deliver in discharge of its obligation at that point in time. It is entirely reasonable that the fund should serve to secure this value, given the importance of pensions to the overall personal wellbeing of members.

Whether this sum is sufficient to buy similar benefits to those originally promised is an entirely separate question, the answer to which depends upon conditions in financial markets at that time and particularly upon the expected returns from those markets. However, given that the collective risk-pooling and risk-sharing that occurs in defined benefit schemes, it is to be expected that a short-fall may occur with inferior benefits resulting. Nonetheless, this position is common to other creditors; the contractual value is the equitable value in insolvency or more widely in any liquidation.

However, in the wake of Maxwell, the emphasis has been shifted from discharge of the sum due at some time to performance of the original promise; the scheme has stepped into the sponsor’s shoes. Clearly, with performance by the sponsor employer impossible, as it has become insolvent and been liquidated, this now falls upon the scheme. The purpose of the fund has changed from offset of the sponsor’s costs to provision of the pensions by the scheme and fund. It means that the accounting and regulation are treating the pension promise as if it was procured from some other institution, and that brings with it the question of cost of these alternate arrangements. It also brings with it exposures to new risk factors which drive some of these costs.

This debate over the longevity of the sponsor entity is a recognition of this issue. For any institution, which is effectively perpetual in nature, such as USS, it is clear that the basis of valuation should be the contractual one. By equal part, it is also clear that the basis for a ‘going-concern’ corporate sponsor should be this. With funding at this level at all times, the member is a secured creditor. Given the possibility of sponsor failure, it is not unreasonable to require that full-funding to this level be maintained at all times; that the sponsor “top-up” a fund should the investment returns prove lower than required to ensure this minimum level of funding.

In fact, if fully funded to this level, the liability has been effectively defeased and no liability or corresponding assets should appear on sponsor balance sheets. The profit and loss account would show only top-up contributions made to maintain full funding at this level.

It is entirely unreasonable to force the sponsor beyond this point. The nature of the scheme may change post sponsor insolvency; it is now closed to both new members and future accrual. However, this does not invalidate the original terms of award; the liabilities are unchanged.  The contributions made and received by it remain historical facts.

Closing a scheme to new members makes the cost of provision of new pensions higher as the active scheme membership ages. Contribution income is reduced to that of the actives only, and cessation of future accrual eliminates this entirely. This brings closer in time, the point at which assets need to be realised in markets in order to pay pensions; it induces earlier market-price path dependency. Post insolvency, the scheme is entirely dependent upon its investment income, and the management process is path-dependent.

The quite separate question is whether the scheme has sufficient assets and a sufficient expectation of returns from those assets to discharge those liabilities. It is trivial to calculate the rate of return required from those assets necessary to achieve that full and timely discharge objective. Assessment of the likelihood of achieving that rate is more difficult, but it depends principally upon the portfolio already held and only marginally upon the gyrations of market prices and yields.

Of course, even if the scheme is fully-funded, and the expected returns are estimated to be sufficient, the scheme faces uncertainty and requires extra capital provisions in respect of this. This is costly. This is necessary to cope with adverse developments at some level of uncertainty, but it also leaves a problem of stranded assets for those paths which experienced favourable developments. These assets are rightly the property of former creditors or shareholders.

From the perspective of the Pension Protection Fund, for a section 75 valuation, buy-out by an insurance company, it may be justifiable to define the claim amount in insolvency in this manner, but this valuation is far from equitable to other stakeholders. We should not forget that this buy-out valuation is based upon market prices and yields, or rather, the reduced set of these securities eligible as investments to life companies, as well as their costs of capital and profit margins. To attempt to fund a scheme to this level when the sponsor is a going concern is simply to add unnecessary expense to the cost of provision.

However, none of these considerations justify the use of market yields as an ongoing input into valuation of the liabilities of scheme. For an annuity insurer, market prices are relevant for all liabilities as these market prices determine the investments available to be made by the insurance company at the time of liability acquisition and premium receipt. But they may be of very limited consequence subsequently. Take the instance of an insurance company which dedicates its investment portfolio by matching the projected ultimate cash flows of pension payments with gilt strips: this insurer is only exposed to market prices to the extent that its projections prove inaccurate. For a DB scheme, the liabilities are already held; there is no transfer.

There really is no case for using market prices and yields when valuing pension liabilities, and with that, absolutely no case for hedging the discount rates used in current accounting and valuation practices.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to Transfer values – Con Keating sees a comedy of errors!

  1. henry tapper says:

    “the correct discount rate for liability valuation is that rate determined by the contract itself”.

    Is there an argument for schemes to have and to publish this rate? I have never seen one though I can see it could be calculated easily enough, providing there was a universally accepted methodology for doing so.

  2. henry tapper says:

    Thanks Con, I have an argument from you which explains how the contractual grant is calculated, I am attaching it to your blog to help people like me who don’t get it first time around!

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