Home > News > 2004 > January 2004 > Identifying and Dealing with Pension Scheme Deficits
Identifying and Dealing with Pension Scheme Deficits
Stop Press - FRS17 Update
Many companies are now putting together their FRS17 numbers for 31 December year ends and finding that, despite much better (and positive!) equity returns in 2003, the position has not improved as much as expected. Corporate bond yields have fallen over the year, and the market's expectation of future inflation has increased (despite actual inflation levels falling slightly). Both of these trends mean that the pension scheme liabilities will have increased - somewhat offsetting the gains from favourable investment returns.
We are also noticing that auditors seem to be taking a much keener interest in the FRS17 assumptions being used this year. Ultimately the assumptions are the responsibility of the company but, in a number of cases, we are helping our clients justify their assumptions by talking directly to the auditors.
Identifying and Dealing with Pension Scheme Deficits
Many employers are currently coming to terms with a deficit in their pension scheme and deciding how to deal with it. This process usually starts when the actuary produces the results of the latest actuarial valuation, within which the deficit is presented as the difference between the market value of the assets and the (market-consistent) value of the liabilities as in the following table:
As the value of the liabilities is only an estimate, based on a number of actuarial assumptions, the deficit itself is also only an estimate. The assumptions that have to be made in a valuation include future price inflation, salary growth and longevity, but one of the most important, and subjective, assumptions is the allowance for future investment returns.
The purpose of this note is to highlight that a greater degree of clarity can be brought to the presentation of valuation results. Perhaps in future, valuation results could be presented in such a way that the trustees and the employer can identify any subjective allowance for future investment returns in excess of the risk free returns available on gilts.
To facilitate this the actuary would initially value the liabilities on the basis of gilt yields alone. A comparison of the market value of the assets with the value of the liabilities using gilt yields would provide the trustees and the employer with an indication of the additional funding which would be required by the pension scheme in order to provide benefits for all members of the scheme without taking investment risk.
Whilst the pension scheme is ongoing, the trustees and the employer may feel it is reasonable to expect the additional funding to make up this deficit to come from one or both of the following sources:
- Expected long-term out-performance, compared to gilts, of the actual investments held by the scheme's.
- Deficit contributions from the sponsoring employer (in addition to contributions due for future benefit accrual).
A key issue for the trustees and the employer is therefore to decide on the balance between cash from the sponsoring employer (for which the likelihood of payment is dependent on the covenant of the employer, which is perhaps greatest in the short term) and expected investment performance from the actual assets held by the scheme (which is uncertain in the short term but arguably more predictable over the longer term).
Using the example shown above, we would suggest that a more informative presentation of the valuation results might be as follows:
In some cases the presentation of results in this format could identify a cautious approach to the valuation calculations which was hidden in the original presentation. Whilst the Scheme Actuary's primary responsibility is to the trustees, we suggest that employers would be interested in this information presented in a more transparent format. We see a number of other advantages of this alternative presentation of valuation results:
- We think that this presentation provides a clearer explanation of how the scheme is being funded and the extent to which the scheme is relying on a combination of investment out-performance and additional contributions from the employer.
- The value of liabilities using gilt yields is a useful starting point when considering the potential cost of purchasing annuities, since the insurance companies providing annuities invest mainly in gilts and similar bonds. The Actuarial Profession has announced that, in the future, the estimated cost of securing benefits on winding up the pension scheme should be disclosed in valuation reports and possibly revealed to members as well.
- The value of liabilities using gilt yields is useful when reviewing risk within the investment strategy. This enables risks to be assessed, and quantified, in the context of the pension scheme liabilities. In the future, strategic investment decisions could focus on asset classes that deliver out-performance relative to gilts. This also addresses the issue raised by Sir Paul Myners when he suggested that a pension scheme's investment strategy should be expressed in terms related to its liabilities.
- We have always believed that funding strategy and investment strategy are inextricably linked. The approach described in this note would help to align future investment strategy and future funding strategy. In due course we envisage a time when the existing Statement of Investment Principles and the proposed Statement of Funding Principles (which is expected to be introduced once the MFR is finally abolished) will cross-reference each other and possibly become a single document.
If you would like to discuss this note please contact any of our offices.
Barnett Waddingham, January 2004.