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Review of Minimum Funding Requirement

Danny Wilding introduces Barnett Waddingham's position in the great MFR debate.

The deadline for responses on the new MFR proposals to the DSS is the end of January 2001. Here is a preview of Barnett Waddingham's response. We are currently waiting for other members of the ACA to finish their own internal consultation in order that we can present a united front to the DSS as far as possible.

First, we are not convinced that a short term test like the MFR is in any way helpful to employers trying to finance benefits over the long term. Moreover, it does not result in more secure pensions for a lot of employees because it drives employers into less secure defined contribution schemes.

Our preferred solution is that the MFR should be renamed as the Standardised Actuarial Funding Measure (SAFM). The word "actuarial" is included so as to emphasise the fact that this is not a "solvency" measure. The steps we propose to reflect this standard in the funding policy set by pension scheme sponsors would be:

1. Funding defined benefit pension scheme liabilities should be the responsibility of the trustees;

2. SAFM (formerly MFR) would in future apply only to member transfers, and the debt on the employer;

3. There would be no formal obligation to fund according to the SAFM;

4. Trustees would have a written Statement of Funding Principles (SoFP) in the context of the SAFM, and the SoFP would be made available to pension scheme members (just as the Statement of Investment Principles is).

5. The SoFP should include a Schedule of Contributions agreed between the employer and the trustees;

6. The Scheme Actuary would advise trustees on the pace of funding and the trustees funding policy. In doing so the Scheme Actuary would be obliged to have regard to the fact that SAFM applies to both transfers and debt on the employer calculations;

7. There should be disclosure in the trustees' report and accounts of the scheme's SAFM position (available to members on request), allowing for guaranteed (but not discretionary) pension increases and revaluation. Schemes in deficit should show the cover for different benefit priorities.

Secondly, as regards the calculations for the SAFM, we believe the basis of the test has been wrongly set. We are trained as actuaries to ensure that the client "asks the right question". In this case the client (the DSS) asked the wrong question. The test that they asked for was one that would be as strong as the current test. What should have been asked for was a test that was as strong in 1997 as the current test was then - not now (when by common consent it is broken).

  • It is right that the new MFR basis should be based on bond yields (both gilts and non-gilts) with an explicit allowance made for equity outperformance above the bond yield.
  • The proposed equity outperformance allowance of 2% per annum is too conservative when compared to historical statistics. Historical market data suggests that throughout the second half of the 20th century equities outperformed gilts over medium and longer term periods (over 5 or 10 years). The level of outperformance was +2% 9 times out of 10, +3% 3 times out of 4 and +4% half the time. We would expect the MFR test to be derived from a 50:50 test, ie equity outperformance of around 4% over gilts, or perhaps 3½% over bonds after making some allowance for investment-grade non-gilt bonds.
  • The proposed reduction in the equity return of 1% per annum to allow for investment expenses (or personal pension expenses) is excessive (especially for funds managed passively). The test itself assumes passive investment and so the expense margin should reflect that. If trustees choose active managers and pay more then they must expect to beat passive funds net of fees. Even in respect of active management an expense reduction of only 0.5% per annum would therefore be more appropriate (possibly reduced further for larger schemes).
  • It is not appropriate to make no allowance for equity outperformance in the calculation of MFR liabilities for pensioners. Calculation of liabilities relating to payments more than, say, 7 years beyond the valuation date should be permitted to allow for equity outperformance. (In the interests of calculation simplicity scheme actuaries could perhaps have the option of disregarding this relief in practice.)
  • We agree that allowance should be made for improvements in life expectancy. We would recommend use of the "92 series" of mortality tables published by the Continuous Mortality Investigation Bureau (CMIB), projected to calendar year 2001. This would not make any allowance for additional future mortality improvements, but we believe this would be appropriate for SAFM purposes. Moreover the legislation should allow the Actuarial Profession to review the SAFM mortality basis from time to time in the light of future mortality reports.
  • We also welcome the proposal to remove the requirement for Annual Funding Certificates and also hope that this simplification is extended to remove the unnecessary timing adjustments which are currently required when completing the Schedule of Contributions.
  • We believe the "short term" interim adjustments are inappropriate. If there will be a delay in implementing long term changes (we would hope not) then a better "short term fix" would be simply to cap the current equity market value adjustment (MVA) with a maximum of the index-linked gilt MVA, rather than change the dividend growth assumption.

APPENDIX

The Statement of Funding Principles (SoFP) could include:

  • A general description of the funding strategy including reference to balance of cost and ownership of surplus;
  • A description of the involvement of the Scheme Actuary and the balance of power between the trustees and employer(s) in determining funding;
  • The Schedule of Contributions agreed with the employer(s);
  • The policy for funding discretionary pension increases;
  • The trustees agreed policy with the employer as regards the employer paying (or not) for benefit improvements for individual members;
  • The policy for other discretionary practices such as ill-health pensions;
  • The funding rate that applies to new entrants;
  • The funding policy with respect to re-instatements and transfers in and out on an individual or bulk basis;
  • The frequency of actuarial reviews of funding strategy and any other circumstances in which funding strategy would be reviewed;
  • A brief description of the actuarial method adopted at the previous valuation and a statement from the Scheme Actuary as to its suitability;
  • A statement as to whether the funding strategy allows for the possibility of winding-up;
  • A statement of any inter-dependence between funding strategy and investment strategy;
  • A statement of the trustees' insurance strategy.

The SoFP should be reviewed (but not necessarily changed) at least annually. It should be referred to in the trustees' annual report and made available to members on request.

Danny Wilding, December 2000.