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.

Further adjustments to the discount rate might be made depending on the

trustees’ views of the financial position of the sponsoring company itself ie,

the strength of the employer’s covenant and so its ability to make ongoing

contributions into the scheme.

Add on to this your cash flow model that determines your view of the scheme

outgoings. This contains at least three very subjective judgements: (i) How much

will employees’ salaries increase up to the point where the last member

retires? (ii) How much will prices increase by the time the last member dies?

(iii) How long will members live once they’ve collected the gold watch? (Think

about this: how many people in 1929 would have accurately predicted today’s

prices and salaries? The point here is that 80 years is about the lifespan

remaining to the youngest member of most schemes, given continuous mortality

creep: life expectancy is already increasing by 12 minutes an hour.)

There are other, more refined assumptions that you need to fiddle with, such

as the percentage of people in the scheme that are going to be married when they

retire, since the scheme will have to pay out 50% of the benefit to the

surviving spouse if the member dies first, which adds a further set of

calculations and liabilities.

It’s up to the trustees to decide on the whole range of assumptions that will

be used to value their scheme and work out the deficit or surplus. But as

Farrant says, “The trustees are required to take advice from their actuary and

reach agreement or at least consult with the employer on the assumptions to

be used.” The assumptions have to be prudent, though that doesn’t mean they

eliminate all risks from the calculations. What it does mean is that “the

trustees need to ensure they are more likely to overestimate rather than

underestimate the liabilities.”

**Accounting valuation**

The accounting valuation is dictated by accounting standard setters who get a

nervous tick just thinking about allowing FDs as much leeway to play with as

trustees have. So the accounting valuation which binds FDs but not scheme

trustees tries to be much more stringent in constraining the assumptions to be

made about the discount rate, even if it can’t do a great deal about mortality

assumptions except to urge FDs to err on the side of prudence.

Not surprisingly, the mortality assumptions of the FTSE-100 as a collective,

lag mortality statistics by an appreciable amount, and FDs will argue

vociferously against using “impossibly long-tailed” mortality assumptions since

the impact of even six additional months’ worth of longevity on their scheme

liabilities is severe. It takes much pushing and prodding by scheme actuaries

and company auditors to bump them further along the track.

Back to the discount rate and the accounting calculation, rather than allow

FDs to second-guess market returns over 35 years or more since they would all

plumb for in excess of 10%, deflating the present value of liabilities the UK

accounting standard FRS17 and the international standard IAS19 specify the rate

as that equivalent to AA-rated investment grade corporate bonds. This is

normally a well-behaved figure that tends not to wander much above 0.5% to 0.75%

above government bonds.

Unfortunately for prudence, now, with most financial stocks being AA-rated

investment grade corporate bonds, and with no one wanting to buy those debts,

the yields have gone through the roof (see page 9). Happy days for FDs, tough

times for auditors who are having some difficult conversations trying to rein

their clients back to the path of prudence. Just to put this in context, Fleming

points out that an increase of 1.7% in the AA-corporate bond yield would

depreciate a scheme’s liabilities by as much as 30% to 40%.

Will this change? The UK Accounting Standards Board issued a discussion paper

last year in which it floated two ideas that would have opposite effects on the

accounting valuation.

As far as the discount rate is concerned, the paper suggested that perhaps

there was no reason to discount liabilities by anything other than a rate that

reflects the time value of money for example, the risk-free rate on gilts, not

corporate bonds.

The discussion paper also suggests it would be better not to provide for

future (discretionary) salary increases, but instead to calculate the liability

each year based on current salary levels. “The liability to pay benefits that is

recognised should be based on the benefits that the employer is presently

committed to provide,” the paper argues.

**Buyout valuation**

Of all the figures, the buyout rate is the most prudent and the most serious

figure, since it is the one that the scheme buyout providers strike in order to

buy a scheme’s liabilities. In other words, it is the only one of the three

where the market is actually determining the value to be put on a scheme’s

liabilities. The only reason for a provider to do this is that it will generate

value for their shareholders, so the sum reached has to be both prudent and

profitable.

At the same time, providers are in a competitive market, so the quotes they

give for scheme liabilities have to be competitive with one another. That said,

the full buyout price for scheme liabilities remains too expensive for most FDs

and most companies to contemplate. The provider will usually tweak the AA-bond

rate downwards and will be very prudent on mortality assumptions.

Included under this buyout heading is the statutory Pensions Act 1995,

section 75 liability, which is triggered if there is a corporate transaction

that amounts to the employer walking away from the pension scheme. The law says

that they can only do this by, in effect, transferring the whole scheme to an

insurance company, which is where the buyout value comes in.

The Pension Protection Fund also uses a buyout-based calculation to determine

the levy that pension schemes have to pay to the PPF. The actual PPF deficit

figure will differ from the buyout calculation to some extent, however, because,

as Farrant points out, the PPF only provides cover for a restricted amount of

benefits.

**Differences**

According to Fleming, the best rule of thumb for evaluating the three methods,

one against the other, is that if a scheme valuation is calculated at £100m by

the accounting standard’s approach, it will be somewhere between £80m and £120m

on the actuarial valuation, and between £110m and £150m on the buyout valuation.

Between 2005 and 2007, FTSE-100 pension schemes’ deficits were very similar

on a funding basis and an accounting basis. Since mid-2007, however, the

funding deficit figure has been tracking sharply downwards towards the much more

negative buyout deficit level. “This has given companies and trustees a

headache,” says Farrant.

“Companies are currently looking at a more healthy funding position in their

company accounts, while trustees are finding their schemes have much larger

deficits and are asking companies to increase their cash contribution.”

Clikc

**here**

for more on Financial Director’s final salary schemes.

Tags