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Falling equity markets and pension scheme funding
Paul Houghton from our Amersham office discusses the consequences of the falling equity markets for occupational pension schemes.
As has been widely reported in the national press, equity markets have fallen significantly during 2002 and, in particular, during July. Also, share prices have shown considerable volatility on a daily basis over the last few months. Both of these characteristics of the equity markets are causing concern to many pension scheme managers.
However, it is important that these events are considered in the appropriate context with regard to the funding of final salary pension schemes. The fundamental comfort is that schemes invest for the long-term rather than the short-term, and it is the long-term performance which counts. No one knows where and when the bottom of the current fall in the market will occur but, in reality, this only affects the value of any disinvestment whilst the markets are low. The real cost issue is future long-term equity performance.
In terms of the impact of the falling markets on funding levels, most pension schemes are currently interested in three different funding measures; namely the Minimum Funding Requirement (MFR), FRS17 company accounting disclosures and ongoing pension scheme funding.
MFR funding
The MFR funding measure has come in for a lot of criticism from many commentators in recent times, but one positive feature it does have is that it retains a stable funding level during short-term market volatility. (This is because the MFR values equities by considering the value of future dividend payments and is, therefore, not affected by the market value of an equity investment if it is not sold).
The graph below illustrates how, for UK equities, the fall in market values has been substantial in 2002 but the assessed value of UK equities under the MFR has actually risen in this period (a large part of the increase was due to the change in MFR methodology in March but without this, the level would still have remained relatively stable).
The performance of any pension scheme, therefore, on the MFR funding measure will depend on how many equity investments are actually held compared to the MFR theoretical equity holding (which varies between each scheme). If the pension scheme held more equities than the MFR theoretical amount, then the MFR funding level will have fallen and vice-versa.
Roughly speaking, if the allocation of equities was, say, 10% higher than that implied by the MFR then the MFR funding level would have reduced by approximately 2% (ignoring any other influences on the pension scheme's funding) since the beginning of the year. So even schemes which hold considerably more equities than the MFR theoretical amount, will only have had a limited fall in MFR funding levels due to the fall in the equity markets.
FRS17 Company Accounting Numbers
FRS17 funding disclosures for company accounts are quite different. The method of calculating the funding level is set out in the Accounting Standard providing, by design, little flexibility.
The method is a great inconsistency for the majority of pension schemes because the liabilities have to be calculated with reference to the return available on AA-rated corporate bonds, whereas the assets are taken at market value at the accounting date - and, of course, many pension schemes have the majority of their investments in equities.
This means that the value of a pension schemes' assets and liabilities will almost always move in different directions between any two accounting dates and it is unfortunate that, in the current economic climate, the asset values have fallen in line with equity markets whereas liabilities have increased gradually over the same period in line with corporate bond prices. Therefore, the fall in the market value of equities in final salary pension schemes would be reflected directly in the funding position disclosed.
This inconsistency is a fundamental problem in the eyes of many actuaries and, as you may have seen, there was a recent announcement that full mandatory adoption of FRS17 figures in company accounts may be postponed until 2005. The position will still have to be disclosed in the notes to the accounts but not reflected in the balance sheet position. This announcement was most welcome.
Ongoing funding levels
The position for ongoing funding levels is not as clear-cut. Ongoing funding levels are assessed using an actuary's judgement of future investment returns, among other assumptions, and are by nature more subjective and will vary between pension schemes.
Nearly all pension schemes have moved in recent years to a market-related method of valuation where assets are assessed as their market value. On the face of it, therefore, a fall in the market values of equities would lead to a falling ongoing funding level for schemes. However, an actuary valuing a pension scheme will recognise that a pension scheme investment is a long-term investment and so short-term market falls do not, necessarily, affect the long-term return from the investments.
If the actuary believes that the short-term fall in equity values is simply the nature of this type of investment, and that the long-term return from equity investments will still be at the level assumed a year ago, then the assumptions used for a current valuation will reflect this and the funding level will not significantly change as a result of the fall in equity markets.
However, the actuary's view of the true equity market level may have changed following this dramatic fall and, if this is the case, the scheme's funding level may well have fallen.
Funding is an assessment for the long-term and, therefore, the ongoing funding basis should be flexible so that the funding level is not as volatile as the market values of assets themselves. However, how this recent fall in equity markets has affected your pension scheme's funding level will depend on your Scheme Actuary's view.
Paul Houghton, September 2002.