Understanding Your Actuary
A TUC guide for trustees and negotiators
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The Actuary 3
Actuarial Valuations 7
Valuation Principles and the 11
Ongoing Valuation
Other Valuations 25
Forthcoming Changes 31
Appendix 1 - Summarising 37
Your Actuarial Valuation Report
Appendix 2 - Glossary of Pensions 41
Terms
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Introduction
The background to this guide
The recent nightmare stories of bankrupt employers with similarly bankrupt pension schemes have stressed how important it is for pension scheme trustees and negotiators to understand the financial position of their pension schemes. To do this, they are reliant upon the advice and reports given by the scheme actuary. But actuarial valuation reports can be daunting documents. The lack of sufficient time for debate means that even trustees who have access to the scheme actuary, can find they never really understand the information they are given.
Perhaps the most important aspects of advice given by the actuaries are the funding recommendations given when they conduct an actuarial valuation of the scheme. This guide therefore concentrates on these actuarial valuations.
This guide aims to give trustees and negotiators a basic understanding of actuarial valuation reports. After reading the guide, trustees should be able to enter into a meaningful discussion with the scheme actuary and negotiators should be equipped to raise appropriate questions through the employer or the trustees.
This guide has been produced at a time when actuarial practice is changing - partly as a response to new legislation and partly due to debate within the actuarial profession. It should be read with the caveat that the information may be rendered incorrect by changing legal and professional requirements.
The guide is not intended to replace actuarial advice and nothing in it should be viewed as advice to specific trustees.
The Actuary
Actuaries advise pension schemes about the financial aspects of the scheme. The advice can be directed at the trustees of the scheme or the employer. The actuary’s advice is based on their knowledge of the legal and statutory requirements. But actuaries also use modeling techniques to assess the financial health of a scheme.
At its simplest level, consider a scheme with one member where the employer promises to pay a pension of half that employee’s salary from the member’s 65th birthday. The actuary can then advise how much needs to be saved to cover that promise. To do this, they need to use statistics about mortality (the probability of death) and assumptions about the rates of interest any money saved will earn and the rate at which the employee’s salary will increase. So the actuary is using statistical and economic techniques to model the financial position. This guide considers all these issues in later sections.
The Pensions Act 1995 clarified the role of the actuary. Now every scheme must have a 'scheme actuary' appointed by (and responsible to) the trustees.
The scheme actuary is given certain roles by legislation. The scheme actuary will:
- perform the actuarial valuation of the scheme
- perform the required checks on the minimum funding requirement and the schedule of contributions
- calculate the transfer values payable to members who leave the scheme
- check that the scheme benefits are sufficient to allow the scheme to contract out, and
- prepare the various certificates required by law (detailed below).
In addition, an actuary (who may or may not be the scheme actuary) may assist the trustees (and/or employer) by providing advice on:
- the investment strategy (perhaps in drawing up the Statement of Investment Principles or advising more generally on the way in which the assets and liabilities can be 'matched')
- the benefit structure (including the terms on which members can exercise options in the scheme eg the commutation rate)
- insuring the benefits with an insurance company
- choosing other advisors (the investment manager, the administrators etc)
- the Additional Voluntary Contributions scheme
- the way in which Inland Revenue maximum benefits impact on the scheme
- sales and purchases and scheme mergers
- special projects (eg a review of the benefit structure)
- miscellaneous points (eg communications).
The terms on which an actuary is engaged will be set out in a letter of appointment. The letter will need to tackle issues such as where the actuary’s responsibility begins and ends (especially if a scheme uses more than one actuary) and the way in which any conflicts of interest would be managed. The terms must allow the actuary to report to OPRA.
Conflicts of interest have always been a thorny problem for scheme actuaries. There is an argument that the employer and trustees should always have separate advice. However, this would significantly increase the costs and is perhaps not realistic except for the largest schemes.
The Institute of Actuaries have recently issued a copy of a legal opinion they have commissioned on the subject. This suggests that actuaries need to be more careful about managing conflicts of interest and that they should resign (as scheme actuary) if the employer gives them information they cannot disclose to the trustees. This seems to threaten the primacy so far given to the scheme actuary’s duty to the trustees over any duty to the employer.
It is important that trustees have confidence in the scheme actuary and trustees should ensure that they have a frank discussion with the actuary on these issues. They should insist that the actuary approaches trustees early if any conflicts arise. Being open about conflicts and seeking to resolve them with the parties is critical.
The Pensions Act 1995 introduced a legal requirement for scheme actuaries to report to OPRA (colloquially known as whistle blowing) if there are relevant breaches of the law.
Actuaries who are not scheme actuaries may also report to OPRA. Although these other actuaries have no legal duty to report, the professional guidance, which has been issued by the professional bodies, makes it clear that they have a professional duty to report.
OPRA, in their transition to The Pensions Regulator, are now advising actuaries to operate on a traffic light system, only reporting events which can be classified as red lights. Actuaries will continue to monitor schemes by keeping a record of unreported breaches.
Certificates the Scheme Actuary Must Supply
|
What? |
When? |
|
Acceptance of Appointment |
Within 1 month of appointment |
|
Actuarial Valuation Report |
At least every 3 years |
|
Minimum Funding Requirement Calculation |
At least every 3 years |
|
Annual Certificate of Schedule of Contributions |
Annually (if <100%) |
|
Actuarial Statement for Trustee Report & Accounts |
After each valuation |
|
Surplus Statement |
After each valuation |
|
Reference Scheme Test (if contracted out) |
When required |
|
Cash Equivalent and Transfer Value Certificate |
Current at all times |
|
Change in Accrued Rights without Members’ Consent |
When required |
|
Bulk Transfers without Members’ Consent |
When Required |
|
Debt on the Employer |
When required |
|
Statement of Resignation or Removal |
When required |
Actuarial Valuations
It is helpful first to understand why actuarial valuations are needed. Most pension schemes are "funded". This means that assets are put aside now to pay the benefits when they become due.
The funding of pension schemes is generally accepted as a good idea for the following reasons:
a) Security
Pension scheme members will have greater security if the money to pay their pensions is put aside as they earn the pension. If employees relied on their employer paying the pensions as they fall due out of the company income then available, they could find that when they get to pension age, the employer does not have the money available. The need to ensure this security is the main reason why the concept of funding pension schemes has gained such support in the UK.
b) Cash Flow
From the point of view of a company's management, it is better to pay for pensions as they arise and in a way that involves relatively stable rates of contribution. If pensions were simply paid out of company income when they become due, the company could end up having to pay out a lot in pensions (and particularly lump sums) one year and a little amount the next year. This could produce cash flow problems.
c) Accounting Principles
It is an accepted accounting principle that money should be reserved as soon as a liability arises. For example if a company buys a new machine, it may not have to pay for it for say 6 months. However the money to pay the expected invoice should be put on one side as soon as the machine is delivered. Similarly with pensions, the money to pay a pension should be put aside as soon as the service giving rise to the pension is worked by the employee.
d) Contracting Out
Historically, if a company ran a scheme which was contracted out of the State Earnings Related Pension Scheme (SERPS) - now replaced by the State Second pension (S2P), it was required by law to meet certain minimum levels of funding.
e) Tax Relief
The fact that assets which are set aside in an approved pension scheme build up free of most taxation on income and capital gains means that it may be cheaper to provide for pensions by setting aside assets in this way. (This is only true if a company can make more money by tax free investment in the stock market than by taxed productive activity)
f) The Minimum Funding Requirement
The Pensions Act 1995 requires schemes to be funded at a certain minimum level. The minimum funding requirement (or MFR) will be explained later in this guide.
g) The Pensions Protection Fund
Under the Pensions Protection Fund, the levy will in future be assessed on the basis of the funding level of the scheme. The lower the scheme is funded (on some industry standard basis), the higher the levy the scheme will pay.
Note however, that not all pension schemes are funded. One obvious exception is the State pension scheme where benefits are paid on a pay-as-you-go basis out of the current taxes. Some public sector schemes (NHS, Armed Forces) also operate on an unfunded basis). Schemes with significant deficits can be viewed as operating on a part funded, part pay-as-you-go basis.
Why do we need actuarial valuations?
The fact that schemes are generally funded is one reason why valuations are needed. If it is decided that some money should be put away now to cover future pensions, then the question of how much to reserve inevitably arises. Pension schemes (even unfunded ones) are also valued so that managers can have some idea of how much the pension is worth as part of the pay package.
Most pension schemes are valued every three years (which fulfils the legal requirements) although some have mini valuations each year or as a result of changes to the scheme. Recent volatility in the markets and funding problems have meant many schemes now have valuations more frequently than they once did.
Valuations may be done for a number of reasons. The purpose for which a valuation is done will determine the method and basis used and therefore the result produced. A good analogy is with the valuation put on your house - you (or an estate agent) would place one price on it assuming that you had as long as you needed to sell it but quite another price if you had to sell it in one week, and yet another value if you were insuring the property. In terms of the valuation of a pension scheme, it is obviously never possible to say how much an employer needs to put away now in order to pay pensions to his employees. This will depend on what happens to the workforce, how long pensioners live for, how much the benefits will be and what level of investment returns will be achieved. The attitude taken to these questions should be decided by the actuary after discussions with his/her client and will be reflected in the funding method and funding basis used (these terms are explained later).
A valuation report will usually include a number of different valuations - each answering different questions and so each giving different results. It is important to differentiate between the different valuations and understand what each result means.
The different types of valuation are:
- The "Ongoing" Valuation
- The "ICTA 1988" Valuation
- The "Discontinuance" Valuation
- The "MFR" Valuation
- The Valuation for the Company Accounts
- The 'GN11' valuation for assessing transfer values
A new valuation will start appearing soon which is done for the purposes of determining the levy which will be paid to the Pensions Protection Fund.
Valuation Principles and the Ongoing Valuation
Past and Future Service Valuations
The ongoing valuation is based on the assumption that the scheme will continue in existence for the long term future. It has two purposes:
i) to work out whether the assets held by the scheme on the valuation date are sufficient to pay the existing pension entitlements (or liabilities) - this is generally called the past service valuation, and
ii) to determine how much needs to be paid into the scheme to cover the benefits which build up in the future - this is called the future service valuation.
It is important to recognise these as two separate exercises. Unfortunately, they are sometimes confused. There is a great tendency to simply concentrate on the amount the employer needs to pay in the short term. But this is often a composite rate dependent on both the past and future service valuations. If the past service valuation shows that the assets are greater than the liabilities, a "surplus" exists and the future service contribution rate may be adjusted, allowing a reduction in contributions or a "contributions holiday". Similarly if the past service valuation shows that the liabilities exceed the assets, a "deficit" exists and the future contribution rate may be increased.
The first important step is to separate the results of the past and future service valuations. If the scheme has a past service surplus and the company is taking a contribution holiday, this does not mean that the cost of the benefits building up after the valuation is nothing. The cost may be something like 14% of salary but that cost is being paid out of the past service surplus. Similarly, if there is a past service deficit and the employer is paying 25% in contributions, then the cost of the benefits building up is still 14% - the additional 11% is the money being paid in to make up the shortfall.
The methods and bases used for valuations are discussed later. However it is worth saying here that the "ongoing" valuation is normally done on the basis which the actuary considers to be a realistic though perhaps slightly cautious view.
On the liabilities side, it is clearly never possible to say with certainty, how much is needed now to pay a proportion of final salary as a pension to an individual. This depends most obviously on how long the person will live for. It also depends crucially on the assumptions made about salary increases, investment returns and inflation. These are all areas in which the actuary will use his/her judgment, guided by the instructions given by the trustees.
In the past, actuaries also used judgement in placing a value on the assets. Often the asset value they used would be based on their view of the stream of income the assets would produce. These methods were called discounted income methods. Nowadays almost all actuaries have switched to market related valuations.
With a market related valuation approach, assets are valued at their market value - usually the actual value on the day of the valuation. (Occasionally, a smoothed market value would be used). It is important to maintain consistency between the value placed on the assets and the value placed on the liabilities. It is not therefore legitimate to compare the market value of the assets with the long term value placed on the liabilities by the actuary. Instead the actuary must express the liabilities in 'the same currency'.
This can be done by valuing the liabilities using the assumptions implicit in the market value placed on the assets.
For example, if market values are such that:
Market yield on 20 year gilts 5%
Market yield on index linked gilts 2%
Then, the long term inflation rate implied by the market is 3%. This is because the market will price these two kinds of gilts consistently. Since index linked gilts pay a return of the current yield plus whatever inflation is, the market must expect 3% inflation so that the two securities will give the same yield. If the two securities gave different yields, then the market would sell the expensive one and buy the cheap one to equalise yields.
The actuary could therefore use an inflation rate for valuing liabilities of 3% per annum and an investment return assumption which uses a risk free rate of return of 5% as a starting point. The basis can then be built up around this in ways discussed later. Using assumptions set in this way means that the actuary can produce a market related value of the liabilities which is directly comparable with the market value of the assets.
Using consistent approaches to the valuation of assets and liabilities is meant to make the result less sensitive to market movements. For example if interest rates rise, this would be expected to decrease both the assets and liabilities. If the effect on assets and liabilities is the same, the valuation result would not change. In other words, if the market is 'wrong' about interest rates, then the assets and liabilities would be 'wrong' to the same extent. In reality, since the value of the assets (and in particular equity type assets) will depend on issues other than interest rates, this mirroring of movements of assets and liabilities is unlikely to happen.
There are a variety of different "funding methods" used by actuaries. What the funding method does is to set the speed at which contributions are paid into a scheme. Different methods are useful in different circumstances and there is nothing wrong with any one method. However, it is important to be able to understand the effect of using different funding methods.
To explain the principles, think about an employer who promises to pay an employee a lump sum of £100 in 10 years time. For the moment, ignore complications like interest, the possibility of death and so on. There are a number of ways in which this amount could be funded. Some examples are:
a) the employer could put away £100 now. This is called capital funding
b) the employer could put away nothing now and simply pay the £100 at the end of the ten year period. This would be pay as you go funding
c) the employer could put away £10 in each of the ten years
d) the employer could put away £5.50 in the first year, £6.50 in the second year, £7.50 in the third year and so on, making a final payment of £14.50 in the final year.
These last two examples are more akin to the way in which most pension schemes are funded. Note how the different funding methods do not affect the eventual cost of the benefits - this is always £100 - the difference is how quickly the amount is reserved.
From the point of view of trustees, the more the employer puts away now the better. This means that members are less reliant on their employer's future profits and action and so have a greater security for their benefits. Employers may wish to put off provision into the future. However, once employers have accepted the need to make advance provision, there are other factors which become important. It is often claimed for example that they are keen to be able to predict future costs and so may prefer funding methods which give a contribution rate which will be stable as a percentage of employees’ salary.
The main funding method in use today is the projected unit credit method. The only other method which enjoys popular use is the attained age method.
The main difference between these two methods is the way in which they allow for future changes in the workforce.
In estimating the future contribution rate, the actuary needs to make some assumption about what will happen to the workforce in the future. To understand this, you simply need to appreciate that you need to put away more now to provide the same amount of pension for an older person than you do for a younger person. This is because the money will build up investment returns for a shorter period.
If you assume that the workforce will remain roughly the same, (which would happen if people retiring are replaced by young people joining the scheme), then the average contribution rate appropriate for people now will remain the same for the long term future. If you assume that the average age of the scheme will rise, (if there are no new entrants replacing those retiring), then the average contribution rate which is appropriate now, will not be sufficient over the long term as the costs will rise with the average age of the workforce.
The projected unit credit method calculates the contribution rate as the rate appropriate for current active members over the year following the date of the valuation. It could be argued that this is not an appropriate method for schemes which do not expect a flow of new entrants. This is because the rate will rise over the future as the average age of the scheme rises. The contribution rate set by the projected unit method could therefore be misleading - it means the employer is putting away less now in the expectation of putting away more in the future.
The attained age method allows for the ageing of the workforce by setting the contribution rate at the average level appropriate over the future working life of the active membership. This is perhaps better for schemes which will not have a flow of new entrants as the contribution rate is expected to stay at the same level. (If an unexpected flow of new entrants turns up in the future, the contribution rate will then fall).
The valuation basis is the term given to the assumptions which underlie the actuary's calculations. In placing a value on the scheme's liabilities, the actuary is trying to answer the question "how much do we need to have "in the bank" now in order to pay out all the benefits which have been promised?' To answer this question, the actuary needs to make assumptions about how many people will die before retirement, how long people who have retired will live for, how much salaries will increase between now and when each member retires and so on. All the assumptions needed are collectively termed the valuation basis.
In order to understand the importance of the basis, it is useful to look at the mechanics of how the fund is valued. The actuary will look at the members of a scheme and estimate what will happen to them in the future - so a certain number will die in service; others will live to retirement. These estimates are combined with assumptions about what level of benefits will be paid (which depends on future salary levels for example) and with discount factors which allow for the interest earned on any money set aside to produce estimates of the cost of the benefits.
The basis of valuation can be considered in two main parts - these are the economic assumptions and the demographic assumptions.
Assumptions will be needed about:
- the rate of inflation
- the rate of pay inflation
- the rate of pension increases (if this is not inflation)
- the return which will be available on investments
In setting an appropriate economic basis, the actuary is obviously making a large number of assumptions and it would be surprising if the assumptions made all turned out to be correct. Note the use of the term assumptions rather than estimate. The actuary is not trying to predict the future. The aim is simply to put forward a sensible framework on which to fund the scheme. In fact the assumptions made are always incorrect - this is why surpluses and deficits appear in schemes. However this is not to say that the valuation is meaningless. In considering the economic basis, the following points should be remembered:
a) the relationship between the assumptions is more important than the assumptions themselves. So, if an inflation rate of 3%, a salary inflation rate of 5% and an investment return of 7% are assumed, the results would be much the same as if an inflation rate of 2%, salary inflation of 4% and investment returns of 6% were assumed. The difference between different aspects of the basis tends to be more stable than the individual items so estimates can be made more easily.
b) in assessing these relationships, the actuary is looking to the long term future. Of course salary inflation is unlikely to exceed price inflation by 2% in any one particular year. (In fact with the growing number of 2 and 3 year wage deals, we often know in advance it will be wrong!) But considering a large number of future years, it is much easier to set an assumption for the annual average.
c) for market value based valuations, the actuary’s assumptions are driven by the market. If the market’s view of any element (eg inflation or interest rates) changes, then both the market value of the assets and the assumption used would change. To the extent that these change to a similar extent, the valuation result would be similar.
Some of the assumptions will depend on the specific scheme. For example, the assumption about pension increases will depend on the Trust Deed and Rules and the assumption about salary inflation may be influenced by the industry in which the company operates.
One of the key assumptions is the rate of return the scheme will achieve on investments. It is standard practice now for actuaries to assume a low risk return (based on bond or gilt yields) for liabilities in retirement but a higher return before retirement. This reflects the fact that trustees will tend to hold bond or gilt investments to match their pensioner liabilities but to invest in riskier investment classes (largely equities) for non pensioners. The higher rate of return before retirement is determined by assuming a return at a certain premium over risk free rates. For example if risk fee gilts yield 5% at the valuation date, the actuary might assume an equity outperformance of 2% and so assume 7% rates of return before retirement.
The demographic basis covers assumptions about what will happen to members of the scheme.
Assumptions are needed about:
- Mortality: both for those in service and those who have retired
- Withdrawals: the proportion of members who will leave before retirement
- Retirements: the proportion of members retiring at each age - in normal or ill health
- Family Statistics: the proportion of members who will leave a partner to whom a benefit is paid and the relative age of that partner
- Promotional salary increases: the pattern of salary increases by age.
Note the assumption about promotional salary increases. The economic assumptions include an assumption about the general level of salary increases which will apply over the long term future. This refers to the general salary increase which applies across the board and is often negotiated by the trade union. In addition, individuals may receive salary increases which are particular to them - as a result of a promotion or progression through the scale. Actuaries will often make an additional assumption about these individual salary increases - particularly for clerical staff.
Actuarial reports differ in the amount of information they give on the demographic assumptions - some set out the assumptions in detail where others simply point out any differences on the assumptions made at the previous valuation. Whilst the demographic assumptions are important, they are usually overshadowed by the economic assumptions made.
In assessing the demographic assumptions made, trustees should think about whether any changes made are justified and what effect they will have on the valuation result. Changes in the demographic assumptions are sometimes required because of a change in the scheme itself or because of wider changes at the level of society. For example, if a scheme changes its rules to allow early retirement on better terms, then the actuary might expect more people to take early retirement and therefore increase the number of early retirements assumed in the valuation basis. The effect this will have on the valuation result will depend on how good the new and old terms for early retirement are. The effect should be discussed in the valuation report.
Another example of a change in the demographic assumptions is for the actuary to assume people will live for longer in retirement. This is quite a common change for actuaries to make as better living standards lead to increasing longevity. The result will be to increase the value of the scheme's liabilities and so decrease the surplus. (if people live longer, they will receive more pension and so the employer needs to put away more now). An important question for the trustees to raise is the extent to which the mortality assumed allows for mortality to continue to improve in the future.
|
Basis A |
Basis B | |
|
Inflation |
3% pa |
3% pa |
|
Pay Increases |
4.5% pa |
4% pa |
|
Pension Increases |
2.5% pa |
2% pa |
|
Return on Investments: | ||
|
Before Retirement |
6.5% pa |
8% pa |
|
After Retirement |
5% pa |
5.5% pa |
|
Mortality |
PA92 c 2020 |
PA92 c 2010 |
|
Withdrawals |
None |
10% pa to age 45 |
|
Retirement |
50% at age 60, 10% per year between 60 and 64 Remainder at 65 |
All at 65 |
|
Family Statistics |
90% 'married' 'Wives' 3 years younger than 'husbands' |
90% 'married' 'Wives' 3 years younger than 'husbands' |
|
Promotional Increases |
0.5% pa |
None |
Here basis A is significantly stronger than basis B. Moving from basis A to basis B would significantly reduce any deficit (or increase any surplus) in the scheme.
The bases have been set at a time when the market rates of return at the valuation date are:
Gilts: 5% pa
Index linked gilts: 2% pa
Bonds: 5.5% pa
Considering each element individually:
Inflation
Both bases start from the market implied inflation rate of 3%.
Pay Increases
Basis A assumes that pay inflation in the long term will exceed price inflation by 1.5% pa. This is supported by economic data which tends to show pay inflation exceeding price inflation by around 1% to 2% per annum over the long term.
Basis B assumes a lower real rate of salary increases. This may be justified if the industry concerned does expect salary increases to be below the average rate over the long term.
Pension Increases
An assumption of pension increases below inflation is justified if for example, the scheme gives increases in line with inflation up to a maximum of 5% per annum. If long term inflation is expected at 3% per annum, then it will be above 5% in some years so the average increase will be less than inflation. Basis A assumes an average rate of just less than inflation whereas there is a larger gap in basis B - implying that inflation will be more volatile in the future around the same 3% average.
Return on Investments
At the time of the valuation, risk free investments were yielding 5% per annum. Basis A assumes that before retirement, the trustees’ investments will exceed this risk free return by 1.5% per annum. This is a relatively prudent assumption by current standards. It may be used if the trustees have a low level of equity investment or if they simply do not wish to allow in advance for the extra returns they may generate from equities in the future.
Basis B has a higher equity risk premium of 3%. Using this basis means the trustees are allowing in advance for significant possible future outperformance from equity investments. The higher this assumption, the lower the value which will be placed on the liabilities.
On the return after retirement, basis A simply uses the current risk free rate of return. Basis B allows for an outperformance over risk free rates and could be justified if the trustees had invested a proportion of their assets in say corporate bonds to match pensioner liabilities. Again the higher the rate of return assumed, the lower the value placed on the liabilities.
Mortality
Both bases use a standard table of mortality based on experience in the years 1990 to 1994. However, basis A projects forward future anticipated mortality improvements to the year 2020 whilst basis B allows for improvements only to the year 2010. Since better mortality increases the liabilities, basis A is again stronger.
Most schemes will use a standard mortality table as they are often not large enough to generate statistically reliable data from their own experience. However the actuary will usually test the scheme’s actual experience against the standard to indicate whether the table is suitable.
Withdrawals
Members leaving a scheme early generate surplus in the scheme - as they lose a benefit based on their projected final salary and gain a less valuable benefit based on their salary at leaving. Since basis B allows in advance for this surplus, it is less strong than basis A. (This is not to say that allowing in advance for withdrawals is wrong. In an industry with high staff turnover, not allowing for these expected withdrawals could tend to over fund the scheme.
Retirement
These alternative assumptions could well be found in a scheme where the normal retirement age was 65 but employees were allowed to retire on an unreduced benefit at any age from 60 onwards. Basis A assumes half of employees will go at age 60, with a small proportion of the remainder going at each age between 60 and 64 and the remainder at 65. Since people retiring early is more costly for the scheme, this is a stronger basis than basis B which assumes all members stay to age 65. It is important to consider whether the assumption made is realistic compared to the scheme’s actual experience.
Family Statistics
Both bases have the same assumption that 90% of members will have a partner. It is usual for the assumptions to be based on percentages 'married' although in some schemes which pay partners pensions, this will really mean the percentage with a partner to whom a pension is paid. A standard percentage is 80% to 90%. The assumption that female partners will be three years younger than the male is again fairly standard.
Promotional Increases
Basis A is again stronger as it includes an additional allowance for promotional increases. Again, the actual experience of the scheme should be a guide here.
The two examples shown are polarised with basis A stronger in all respects than basis B. In reality, comparing bases is much more difficult as they will be stronger n some respects and weaker in others.
We have already looked at how the funding method and basis can have a significant effect on the valuation result. In fact, it is not really possible to understand a valuation result without looking at the funding method and valuation basis used.
Because the funding method and valuation basis have such an important effect on the valuation result, the actuary will discuss them with the client (that is the scheme trustees) before doing the valuation.
It is important to be aware of exactly what a valuation result means. You could justifiably argue that any surplus revealed is the difference between the actuary's "guesstimate" of what the assets are worth and his/her "guesstimate" of what the liabilities are worth. In other words, the surplus will only really exist if all the actuary's assumptions are correct - which will clearly never be the case.
This is why it is not correct to view the surplus as "money to spend". In fact, part of any surplus should always be retained in the scheme to protect it against the possibility that the actuary's assumptions are too optimistic. If the actuary has used very optimistic assumptions, then a larger part of the surplus should be retained than if the actuary has used very cautious assumptions. Again this leads us to the point that the valuation result is only meaningful if the funding method and valuation basis are considered.
In the example bases discussed above, the valuation results may look something like this:
Basis A Basis B
Assets £100m £100m
Liabilities £140m £70m
Deficit £40m Surplus £30m
In other words, it would be possible to change the assumptions from those in basis A to those in basis B and turn a £40m deficit into a £30m surplus.
It is important to understand however that changing the valuation assumptions does not change the actual position of the scheme. It simply means that the scheme is allowing more in advance for future benign conditions - most notably here of high investment returns and low salary increases.
This is why it is important for trustees to interrogate the assumptions made by the actuary so they can assess whether these are reasonable.
Other Valuations
This is an additional valuation which is produced to show whether the fund could meet its liabilities if it were to be discontinued immediately. This valuation is sometimes called the "wind-up", "termination" or 'solvency' valuation.
When a scheme winds up, it can broadly do one of two things:
i) it can "buy out" the benefits with an insurance company. Here, the pension scheme sells all its assets and uses the cash to pay premiums to the insurance company. The insurance company then issues individual policies to the pension scheme members and eventually pays their benefits.
ii) it can continue as a closed scheme. Here, the scheme continues but no new benefits build up and no further employer contributions are paid. The scheme eventually pays the benefits to the pensioners as they become due. [Note that traditionally it was thought that this option is only available to larger schemes - probably those around £200 million and above. But given that many employers cannot afford to wind schemes up, it is now accepted that much smaller schemes can run on a closed basis].
The wind up valuation then is a comparison of the market value of the scheme's assets with the cost of providing the benefits either through a buy out with an insurance company or through the scheme operating as a closed scheme. Almost all schemes are currently insolvent on a wind up basis. Briefly, this is because interest rates are relatively low, so it is very expensive to provide the benefits through an insurance policy or a closed fund. When this high cost is compared with the market value of a scheme’s assets (and bearing in mind that the value of the assets may be reduced if they have to be sold quickly), a substantial deficit is often the result.
If the employer sponsoring the scheme is solvent when the scheme is wound up, legislation currently requires them to meet the full cost of buying out the benefits. But if the employer is not solvent (or if the pension scheme deficit makes them insolvent), members are reliant on the assets already in the scheme (or on the Pensions Protection Fund when it is introduced).
Whilst it is important to check whether the scheme could meet its liabilities in the event of its being wound up, the discontinuance valuation does not provide the trustees with much information beyond this. This is not to say that the discontinuance valuation is unimportant - indeed there is a view that the discontinuance position is the most important measure.
If a scheme is going to continue for the long term future, its short term discontinuance deficit may be only of theoretical importance. But if the scheme is run by an employer whose financial position is weak, then the discontinuance position of the scheme will be of greater importance. The real problem is that if a scheme has a deficit on a discontinuance basis and it becomes clear that the company is in financial difficulties, it is then "too late" to do anything about this. The company will at that point be least able to afford to put extra cash into the scheme to make it solvent on a discontinuance basis. This is why it is important to be aware of the discontinuance position of the scheme. The ability and willingness of an employer to stand behind the pension scheme is often called the 'employer covenant'. So the discontinuance position needs to be considered in conjunction with the employer covenant.
This valuation is sometimes called the surplus valuation or the Surplus Regulations valuation.
In the 1980s, the government were concerned that companies were building up large amounts of surplus in their pension schemes as a method of avoiding paying tax. They therefore introduced legislation which required schemes to take action if they had a surplus considered to be excessive. The legislation requires schemes which have surplus of more than 5% of the liabilities to either pay some tax or to dispose of the surplus by making benefit improvements, by allowing contributions reductions or holidays or by paying part of the surplus to the employer (any such payment being subject to tax).
Although the ICTA 1988 valuation assumes that the scheme will continue for the long term future, it is a special type of "ongoing" valuation. It is conducted on a basis laid down by the Government Actuary which was at the time very cautious - that is it overestimated the value of the liabilities and underestimated the value of the assets. It was not uncommon for schemes to have a surplus of up to 100% of the liabilities on the ongoing valuation basis, yet to have a surplus of less than 5% of the liabilities on the surplus basis. More recently, with changes in actuarial methods, as well as changes in mortality and investment conditions, some schemes have been experiencing problems with the ICTA 1988 valuation. This particularly affects schemes where the bulk of the members are deferred members - in some cases, these schemes have found that they can be overfunded on the ICTA 1988 basis but actually in deficit.
The ICTA 1988 valuation is produced effectively for the Inland Revenue and provides little information to the trustees beyond establishing whether action needs to be taken to satisfy the Inland Revenue. If a surplus of more than the allowed 5% remains in the fund, then the Inland Revenue can tax the fund on the proportion of the fund which is in excess of the 5% allowed. To date, very few schemes have taken up this option. Whilst it may seem to trustees that it is better to keep the 'excess' surplus in the fund, scheme administrators, advisors and most trustees have taken the view that it is better not to invite the Inland Revenue to start taxing a portion of the fund.
Under the simplification of pension tax rules in April 2006, this particular requirement will be phased out.
The Minimum Funding Requirement valuation
The minimum funding requirement (MFR) valuation is essentially a special type of discontinuance valuation.
MFR was introduced by the Pension Act 1995 and stipulated for the first time, a requirement that schemes be funded at a certain minimum level.
MFR was always a compromise solution. The minimum funding level it introduced was meant to be sufficient to allow the scheme to:
- meet the expenses of winding up
- meet the pensioner liabilities by matching investments in gilts, and
- pay a transfer value to active members which gave them a reasonable expectation of producing the same investments by investing in equities.
A scheme which met MFR was by no means solvent. For smaller schemes which would have to buy out the benefits, the cost of buying out the pensioners was significantly above the MFR reserve for these individuals. Since the priority orders meant that these members had to be catered for first in a wind up, this left assets for the non pensioners well below the MFR requirement for them. Even the full MFR would be significantly less than the amount required to buy out the benefits for the non pensioners so the reduced amount came nowhere near. This is why we have seen the horror stories of people close to retirement receiving a fraction of the benefits they were promised.
All these are criticisms of MFR as it was originally introduced. A further problem is that the changes in the shape of the UK investment market have made the theory underlying the MFR unworkable. When MFR was introduced, equities were in general valued by actuaries on the basis of the income they produced. This discounted income approach to valuing equities was widely adopted and worked well when dividends represented a significant part of the value of an equity share. However, the move away from dividends - partly for tax reasons, partly due to European and American influences, has meant that dividends are no longer a useful guide to the value of a share. The underlying methodology behind MFR which is based on this discounted income approach therefore no longer works. In recognition of this, there have been a couple of pragmatic changes in the MFR basis but it has been very difficult to make MFR work without simply starting all over again.
In terms of where we are now, MFR continues to be the legal minimum level at which a scheme can be funded. The time constraints on reaching 100% MFR funding also continue (3 years to reach 90%, ten years to reach 100%).
Whilst trustees obviously need to make sure they comply with these requirements, the usefulness of MFR beyond this is limited. Funding a scheme at only the MFR level would mean very weak funding and could probably only be justified if the trustees were absolutely confident in the covenant of the employer sponsoring the scheme.
MFR is due to be phased out and replaced with the new Statutory Funding Objective (SFO). The exact timings for this changeover are not yet known.
Valuations for the company accounts
Companies and other organisations which have to produce accounts giving a 'true and fair' view of their financial position are also required to produce pension scheme valuation figures to be shown in the employer’s Report and Accounts. They are designed to allow investors to look at a business's income and assets taking into account the pension scheme. The two aims of this are to ensure income is not distorted by contribution holidays or deficit contributions, and to ensure that the balance sheet takes into account any surplus or deficit in the pension scheme. There is currently a lot of debate about the way in which these figures are presented with a new standard FRS17 now being introduced. Under FRS17, the cost of the benefits is likely to be much higher than the MFR or ongoing funding costs. FRS17 also requires companies to place pension scheme surpluses or deficits on the company balance sheet. It is currently being cited as a reason why companies are closing final salary schemes. There are also similar figures produced in accordance with international accounting standards. International companies may use the American standard, called FAS87.
These figures are not very helpful for pension scheme trustees although they will help in giving an indication of how important the pension scheme is to the company’s finances.
Example Valuation Results for Comparison
The above explanations should make it clear that the results of the different valuations discussed can be very different. The valuations are attempts to answer different questions - and these different questions will have different answers. It would be possible for one scheme to have the following different valuation results on the different bases:
Ongoing ICTA 1988 Discontinuance
Valuation Valuation Valuation
£m £m £m
Value of Assets 30 25 30
Value of Liabilities 33 25 45
Surplus (Deficit) (3) - (15)
Funding Level 91% 100% 67%
This perhaps explains why it is important to be careful when using words such as surplus or deficit - this one scheme has a deficit of £3m on an ongoing basis, NIL on the ICTA 1988 basis and a deficit of £15m on a discontinuance basis. The valuations are done on the same day and cover the same members.
The earlier explanations should make clear why the results are so different. Just to recap, the ongoing valuation is a comparison of the long term worth of the assets held by the scheme and the benefits already promised by the scheme, assessed on a realistic, perhaps slightly conservative, view of what might happen in the future. This result indicates whether the fund is solvent assuming it continues for the long term and assuming that the actuary’s assumptions turn out to be reasonable. The ICTA 1988 valuation is a similar comparison but assessed on a prudent basis - one which perhaps underestimates the value of the assets and overestimates the value of the liabilities. This result tells you whether the scheme has an "excessive surplus" according to the Inland Revenue. The discontinuance valuation is a comparison of the market value of the assets with the cost of buying out the liabilities (or providing them on a closed fund basis). This tells you whether the scheme would be solvent if the scheme were to wind up in the short term.
Forthcoming Changes
The statutory funding objective
In their response to the Myners’ Review, the government announced its intention to replace MFR with a scheme specific funding requirement. This has been developed into the Statutory Funding Objective (SFO).
In addition to the problems of MFR, the SFO has been motivated by the requirement on the government to enact the European Union Directive on the activities and supervision of institutions for occupational retirement provision (the IORP Directive). Lots of the technical phrases in the new legislation ('technical provisions') have been lifted directly from the directive.
There had been some nervousness about the directive in pensions circles. The directive says for example that a:
's cheme must have at all times sufficient and appropriate assets to cover its technical provisions'.
If this had been interpreted as meaning schemes must always be fully funded on a buy out basis, it would have caused massive problems for UK companies. However, the UK legislation makes it clear that the trustees and the employers can decide how the technical provisions should be calculated (after taking actuarial advice).
Under the new legislation, the trustees will have to set their own funding objective. They will need to take actuarial advice to do this and will need to agree the objective with the employer.
In theory, most trustees would want to set a funding objective which aimed to make sure the scheme was fully funded on a buy out basis. However, it is unlikely that most employers would agree to this.
Trustees are likely to find themselves in a position where they seek a compromise solution with the employer.
It could be argued that the most transparent approach would be for the trustees to agree a Statutory Funding Objective set at say 75% of buy out costs. However, it is more likely that trustees will set rather more opaque standards - for example aiming to fund the benefits based on returns on current gilt yields and allowing for equity out performance of 2% pa on assets backing the liabilities for members in the period before receipt of a pension.
A major problem with the new basis is that trustees are put in the position of having to negotiate with the employer. They are generally in a very weak negotiating position since they have little practical power. They could threaten to wind the scheme up (if the Trust Deed and Rules allows them to - this would force the full buy out debt on the employer), consider writing to all members or simply dig their heels in. But given that many trustee boards are currently having to work hard to retain the support of the employer for the final salary scheme, they would need to be very brave to take such action.
The trustees need to set out their Statutory Funding Objective in a document which must be available to members called the Statement of Funding Principles.
This also needs to explain how any deficits measured against the Statutory Funding Objective will be met.
The legislation proposes that schemes will have to either:
- have an annual valuation to assess their position against the SFO, or
- have triennial valuations with an annual actuarial report - basically a rough check on the position.
- If the valuation discloses a deficit against the SFO, the trustees need to agree a recovery plan with the employer and lodge a copy with the regulator.
This will form the basis of the new schedule of contributions which will presumably be used by the scheme auditor as at present.
If the trustees and the employer cannot agree a suitable schedule of contributions, then:
- the trustees can reduce future service benefits
- the trustees can report to the regulator who can impose a contribution rate or reduce future benefits
Although it had been suggested at one point, the legislation does not introduce a power for the trustees to wind up scheme (although many Trust Deeds give this power to the trustees anyway).
As an example, assume the trustees of a sixtieths scheme have asked the employer to contribute:
16% to cover the future service benefits, and
14% to make up the past service deficit.
The employer says he is unable to make contributions at 30% but could pay 20%. Of this 20%, 14% would be used to meet the past service deficit. This leaves 6% plus 4% from the members - a total of 10% to pay for future service benefits. The benefits building up actually cost 20% (the 16% from the employer plus 4% from the members).
So one solution would be for the scheme benefits to be halved for future service - that is to move from 1/60th to 1/120th. (This would cause difficulties if the scheme were contracted out but ignore this complication). This might be something the trustees would have to consider if the employer were only able to pay the 20%.
Valuations in connection with the pensions protection fund
The Pensions Bill will introduce a Pensions Protection Fund intended to provide some security for members whose employers are insolvent and their scheme wound up in a position of deficit.
Despite the impression being given by the government and the media, the PPF will not protect all the scheme benefits. It will cover what are known as the Protected Liabilities which are:
- the cost of securing the benefits which would be paid by the PPF
- the expenses of winding up the scheme, and
- the non member liabilities (adviser fees for example).
The benefits covered by the PPF are different for those over and under normal retirement age.
For those over normal retirement age (including younger retirees who retired in ill health but not excluding those who retired early for other reasons), the benefits covered are:
- 100% of the current level of benefit
- with a 50% spouses’ pension
- but with pension increases only:
- at RPI with a maximum of 2.5% per annum
- on pensions accrued after April 1997.
So a pensioner who retired before 1997 - or whose service was all before 1997, would under the PPF lose all their future pension increases. Since future pension increases can account for 30% of the value of the pension, the usual claim that pensioners are 100% covered is very misleading.
For those under normal retiring age (including those who have taken early retirement), the benefits covered are:
- 90% of the benefit but with a maximum pension per annum of £25,000
- with a 50% spouses pension, and
- pension increases limited as above to RPI maximum 2.5% per annum on benefits accrued after 1997 only.
For members under normal retirement age, another important factor is the rate at which pensions will be revalued prior to retirement. The position on this is not yet entirely clear, but it seems likely that revaluation will be at the rate of RPI maximum 5% per annum on all pensions. Some members who are already deferred members of schemes will currently be receiving 8.5% pa revaluation on the GMP portion of their benefit to the reduction to RPI maximum 5% could mean a significant cut in benefits. If this is coupled with the points raised above on pension increases and the limits to 90% of the benefit and £25,000 pa maximum, it is clear that the common assertion that such members are 90% covered is again misleading.
The PPF will be funded by the assets transferred from schemes making a claim together with the proceeds from a levy on employers with defined benefit schemes. Obviously the size of the levy will depend on the deficit in the PPF and is therefore unknown.
Initially the levy will be a fixed charge per member but the intention is to introduce a risk based levy dependent on the risk of the scheme making a claim. The risk will obviously be higher for poorly funded schemes. But since only the schemes of insolvent employers can make a claim, the levy should also vary according to the financial strength of the employer. In addition, the investment strategy followed by the scheme trustees will also increase the risk so this is likely to be an additional factor. A levy based on all three factors would however be administratively complex and we may therefore end up with a levy based only on the funding level of the scheme.
The funding level used for levy purposes would have to be assessed on a consistent basis for all schemes and would have to be based on the benefits covered by the PPF only. This is why the PPF is likely to mean yet another valuation is required in the triennial review.
Appendix 1
Pro Forma - Summarising Your Actuarial Valuation Report
Name of Scheme: ………………………………………
Date of Valuation: ………………………………………
Valuations included in report:
(This is to help you differentiate between the different valuations included in the report. It simply asks you to say on which page of the report, you can find the results of the different valuations)
"Ongoing" Valuation - page .....................
"ICTA88" Valuation - page .....................
"Discontinuance" Valuation - page .....................
"MFR" Valuation - page .....................
Any other Valuations - page ……………..
Questions 1-5 relate to the "ongoing" valuation:
1. What valuation method is used? Projected Unit
Attained Age
2. What economic assumptions were made in the valuation basis?
|
% per annum | |
|
Inflation | |
|
Pay Increases | |
|
Pension Increases | |
|
Return on Investments in service in retirement |
3. What demographic assumptions were made?
(Note - there may not be much information in your report. If you cannot find answers, or the answers do not mean anything to you, raise these questions with your actuary).
|
Mortality | |
|
Withdrawals | |
|
Retirement | |
|
Family Statistics | |
|
Promotional Pay Increases |
4. What was the ongoing valuation result?
Past Service
Value of Assets ..............................
Value of Total Liabilities ..............................
Surplus/Deficit ..............................
Funding Level (= Assets/Liabilities) ………………..%
Future Service
Employer's Contribution Required ..........................%
Note: this is the contribution needed from the employer to meet the cost of benefits building up from now on - before any adjustments for surplus or deficit.
Use Of Surplus/Funding Of Deficit.
How is the deficit to be made up? (OR How is the surplus to be used?)
5. Does the scheme have more than 5% surplus on the ICTA88 basis?
6. What does the discontinuance valuation reveal?
7. What does the MFR valuation tell you?
Appendix 2
Glossary of Pensions Terms
AVC Additional voluntary contribution are extra payments that scheme member can make an to enhance their pensions. They are usually on a defined contribution basis, separate from the final salary benefits.
Commutation Rate Many final salary schemes allow members to sacrifice, or ‘commute’, a part of their annual pension in return for a tax free cash lump sum when they retire. The commutation rate is the amount of cash lump sum provided for each £1 of pension given up.
Contract Out The use of a pension scheme which meets certain conditions to provide benefits (GMPs, protected rights or section 9(2B) rights) in place of the State second pension, formerly SERPS (State Earnings Related Pension Scheme).
Contribution Holiday If there is a significant surplus in a scheme, the trustees may grant members, the sponsoring employer, or both a break from having to pay into the pension scheme.
Deferred Benefits Benefits payable on retirement or earlier death to an individual ceasing to be an active member of an occupational pension scheme.
Early Retirement The retirement of a member (either voluntarily or through ill health) with immediate retirement benefit before normal pension date. (The benefit may be reduced because of early payment.)
Final Pensionable Earnings Pensionable salary at, or close to a member’s retirement or leaving, by reference to which benefits are calculated in a final salary scheme.
Final Salary Scheme A defined benefit scheme where the benefit is calculated by reference to the final pensionable earnings of the member, usually also based on pensionable service.
Funding Level The relationship at a specified date between the actuarial value of assets and the actuarial liability. Normally expressed as a percentage.
Index Linking A systemwhereby pensions in payment and/or deferred benefits are automatically increased at regular intervals by reference to a specified index of prices or earnings. Typically public sector schemes offer increases fully in line with the Retail Price Index, whereas private sector schemes usually limit increases to a specific level.
Member Contribution The amount that a pension scheme expects its members to pay into it, usually expressed as a percentage of salary. Also known as ‘employee contribution’.
Normal Pension Age Commonly the age at which a member of a pension scheme normally becomes entitled to receive their retirement benefits. The statutory definition can be interpreted as the earliest age at which a member has a right to take benefits without reduction.
Occupational Pension Scheme A scheme organised by an employer or on behalf of a group of employers to provide pensions and/or other benefits for or in respect of one or more employees on leaving service or on death or retirement.
OPRA Occupational Pensions Regulatory Authority. Established by the Pensions Act 1995, OPRA supervises a range of legal requirements to protect occupational pensions, acting against carelessness or negligence which could endanger scheme benefits.
Pensionable Salary The earnings on which benefits and/or contributions are calculated under the scheme rules.
Pensionable Service The period of service which is taken into account in calculating benefits.
Personal Pension Scheme A scheme approved by the Inland Revenue under Chapter IV which is not an occupational pension scheme.
Reference Scheme Test Since 1997 the Inland Revenue has required that schemes which contract out of the State second pension offer benefits greater than those provided by a hypothetical ‘reference scheme’.
Schedule of Contributions A document outlining thelevel of contributions that the sponsoring employer is to pay into the scheme. The actuary must certify this annually if the scheme is less than 100% funded.
Sponsoring Employer Also known as the ‘Principal Employer’. Commonly used in scheme documentation for the particular participating employer in which is vested special powers or duties in relation to such matters as the appointment of the trustees, amendments and winding up. Usually this will be the employer which established the scheme or its successor in business.
Statement of Investment Principles Legislation requires that trustees draw up a statement outlining the broad investment principles governing the investment policy of the pension fund.
Transfer Payment A payment made from a pension scheme to another pension scheme (or to purchase a buy out policy), in lieu of benefits which have accrued to the member or members concerned, to enable the receiving arrangement to provide alternative benefits.
Trustee An individual or company appointed to carry out the purposes of a trust in accordance with the provisions of the trust instrument (ie a trust deed or other document) and general principles of trust law.
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telephone 020 7636 4030
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