Measure for measure – three ways to measure pension deficits

Why have one way of calculating a pension deficit when you can have three? Each of the methods stems from a completely different perspective. The deficit is in the eye of the beholder: there is no “right” view as to how big it really is. Where you stand determines what you see.
The three methods are:
• The funding valuation or actuarial calculation of the fund’s value, which must be carried out every three years, with the actuaries being commissioned by the trustees;
• The accounting calculation, as set out by FRS17 and IAS19, and which lies in the hands of the finance director of the company sponsoring the scheme (and of course the company’s auditors); and
• The full buyout or section 75 calculation (the two are different beasts, but amount to the same thing, as we will see). This last is in the hands of the pension buyout providers.

Already we see three completely different communities of people: independent actuaries and pension trustees; finance directors and auditors; and insurance or capital markets companies. Each of the three communities has a subtly different starting point and end goal, so the fact that the three calculations throw up wildly different figures for the fund value (be it surplus or deficit) should be no surprise to anyone.

Funding valuation
“Scheme valuations look at the cash flowing into the scheme from member contributions throughout the life of the scheme and from asset valuations, and they look at outflows in terms payments to retired members to try to place a single value on all those future cash flows,” explains Donald Fleming, head of pensions at KPMG.

But, he adds, “if you are trying to compare the three calculations on the basis of which is more subjective, the funding valuation has the greatest leeway for subjectivity on key assumptions such as the scheme discount rate, average longevity of the membership and the inflation rate over the life of the scheme.” Not a good start ­ especially given that it is this calculation that determines the amount of cash to be paid by the employer into the scheme.

While all the assumptions made in carrying out the actuarial calculation of fund value will have an impact, the assumption that dwarfs all the rest, in terms of its ability to push and pull the final figure about, is the discount rate.

The yield on long-term gilts is the usual starting point, though the yield on high-quality corporate bonds has also been used. Sarah Farrant, a consulting director and actuary with Deloitte Total Reward and Benefits, says the discount rate used to calculate the liabilities may be adjusted according to the expected returns from the investment strategy adopted for the assets. “In this way, they can allow for expected higher returns that are hoped to be achieved on the more risky assets held by the scheme (such as equities or property).”

She adds that the shape of the yield curve has an impact, too, depending on the maturity of the pension scheme. A scheme whose members are mostly pensioners or near to retirement age will use a shorter-dated gilt yield than a scheme whose members are mostly young. At present, that would mean using a lower discount rate in the former example than in the latter.