Con Keating;- how we should value large DB schemes



There are a number of issues which get confused in the valuation debate.

So to clarify, the start point is that a DB pension is a fixed claim in the sense that a bond issue or debt is fixed. This means that its cost is fixed at the time of award, albeit that this “fixing” may be parametrically determined. A floating rate note is fixed (at say ¼% over Libor) and similarly DB pensions are fixed though the parameters which set the final pension payments (salary, longevity, indexation) and may allow some significant change over time. This is not a weakness; it is strength of the contract design.

To repeat, the cost of a DB promise is fixed at award, just like a bond. In the absence of changes in the parameters (subsequently experience) that determine pensions this remains unchanged until the liability is discharged. The analogy to a bond is clear. Just as with a bond, we have a solid idea what it will cost us. This is the rate of investment return promised to the scheme member; it is also the cost to the sponsor company. This is the cost underwritten by the scheme sponsor. Most importantly it determines the interim values which should be attributed to the pension promise. This would be the value of a claim in insolvency or voluntary liquidation (where possible and of course confounded by tax considerations).

Now note that members should want this rate to be high – it is the return they are promised on contributions. This is conditioned by their degree of risk aversion; a high rate which endangers the viability of the sponsor is not a good idea. The scheme member preference given the criticality of DB pensions to later life wellbeing should be for the highest certainty equivalent rate.

The rate implicitly promised is slowly moving – for the scheme overall it is the weighted average of many decades of awards. Given the history of financial markets, it should not surprise us that it lies in the range 6% – 8% for many schemes.

The role of assets is to serve as security for the accrued benefits of the scheme member. They also serve a role in defraying or defeasing the obligation the obligation underwritten by the sponsor.

The amount of security provided should be no more than the best estimate of the pension promises calculated using this rate. A balance of probabilities valuation. This is 100% funding.

This is the value of the book of business in force – the pension promises outstanding.

No-one values DB schemes in this way. Largely because legislation specifies methods to be used.

The current valuation methods are actually counterfactuals to this value. Both the gilts/bond and expected return on assets methods examine the question: what would these liabilities be worth if this rate applied. Interesting but they really do not apply. In essence, these valuations are pricing a book of business in force as if it were new business. They mislead.

Our response to the DWP DB Green Paper lists a range alternate measures that throw light on the true position of a scheme. (available here: )

There is a better and most basic calculation which may be done – that is calculation of the rate of return on assets held necessary to fully discharge the liabilities when due. The likelihood of this rate being achieved is a measure of the extent to which the scheme may have to rely upon the sponsor. FABI produces such calculations as incidentals to their indices; at negative real returns, they indicate a system in robust health.

This is the work of Con Keating,

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to Con Keating;- how we should value large DB schemes

  1. Here’s how a scheme actuary could implement Con’s approach to the valuation in a manner that satisfies current pensions regulations:

    If the scheme is 100% funded on a best estimate of the return on the assets in the scheme (where this best estimate is the weighted average of the best estimates of the internal rates of return on the various asset classes), this best estimate of the return on the assets will be equal to the rate that Con identifies. Since that latter rate is the rate of return on their contributions that members have been promised, let’s call it the ‘promised rate’.

    As Con mentions, “The likelihood of this [promised] rate being achieved is a measure of the extent to which the scheme may have to rely upon the sponsor.”

    If a scheme is 100% funded on the basis of a best estimate of the return on the assets, there is a 50% chance that this promised rate will be achieved.

    The regulations require that the discount rate “used in setting technical provisions must be chosen prudently”. We might interpret prudence as a higher than 50% likelihood that the promised rate will be achieved. How much higher than 50% this must be will depend on the strength of the covenant. Suppose that the required likelihood is 67%. Then the scheme will be fully funded on a technical provisions basis if a discount rate is set as a rate of return which it is judged that the assets in the scheme have a 67% chance of achieving.

    Have I got things right?

  2. There are also the unknown unknowns to think about! The Barclays Equity Gilt study should be compulsory reading for trustees and pensions advisers!
    Whilst I accept that weak employers should never have been allowed to set up DB pension schemes – except perhaps in such well run sensible examples as the plumbing industry ( ) – despite section 75 issues – the over regulation in terms of adding on ‘Gilt edged’ inflation linked promises has killed off most private sector schemes. It became necessary to regulate where a few employers would not offer any protection against inflation on a voluntary basis. Some of the big banks were the biggest offenders – “Shareholders and staff come first – ex-employees – no duty of care!” This attitude was partially responsible for the legislation that eventually made the pension promises unaffordable for most employers (or so they said).

    The beauty of design that worked so well in the vast majority of DB pension schemes became a huge millstone due to successive tinkering and short termism by one Government after another. Safety valves were removed and the ‘best endeavours’ approach became an unaffordable index linked guarantee.

    When asked: “Do you want a 100% chance of receiving £1,000 a year or a 99% chance of receiving £1,400 a year?” I think most would opt for the £1,400! Investing a bit more aggressively and taking a risk of insolvency might just be worth the odd mishap! But not for your whole pension!
    These days many are faced with a legacy DB pension (and a State DB Pension) typically with some DC elements from later scheme memberships. Put together they are not necessarily so bad if you have saved a reasonable amount and understand your various pension pots/schemes (roll on the dashboard!) and have some idea of what you are aiming for and how you expect to get there! The dreaded ‘journey’!

  3. Bob Compton says:

    Another excellent article from Con. This does set out with clarity why there are issues surrounding the true cost of a DB promise. It is important in any debate that the terminology is clearly defined and understood, otherwise positions become entrenched, all believing they are correct.

    Con raises the debate by clarifying the objective. Do you start from the point the promise is made or do you work from the point the benefit is paid. One is a fact the other a fact in the future, funding assumptions are the bit in between which may accelerate prefunding, or decelerate. Cost and funding are clearly not the same, but are often confused..

    For example, pay as you go public sector pension schemes pay pensions as they fall due, with no prefunding. A National Audit Office report from 2010 stated the 4 largest pension schemes had cost c £15bn in 2008/9 and predicted costs rising to c £60bn by 2059, however projected liabilities were only estimated at £575 bn, roughly half the predicted cash outflow over 50 years. Eight years on the assumptions made do not stand up to scrutiny in todays climate. Highlights that assumptions are merely that. If the government can get away with non prudent assumptions why should Companies be burdened by excessive prudence?

    A further example of how inappropriate figures can cause alarm, is the USS statement of a £17bn deficit, causing worry and concern for intelligent pensioners due to a lack of awareness of what the numbers really represent.

    The debate will no doubt rumble on.

    • Con Keating says:

      Thanks for the comments and questions. I will respond to them in another piece – probably after I have written a comment on USS for my daughters (as that is overdue) and after I have cleared some work for the day job.

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