[Skip to content]

Sign up for our daily newsletter
The Actuary The magazine of the Institute & Faculty of Actuaries
.

Pensions: Prudent assumptions

Since the new scheme funding regime came into force, trustees, following the advice of scheme actuaries, are obliged to use ‘prudent’ assumptions to assess the extent to which the scheme meets its funding objective. Regulatory prescription appears to rest largely on the current measurement of technical provisions, rather than on the long-term nature of the liabilities. In turn, this has led to much effort spent considering which assumptions are prudent, even though this might detract from the trustees’ objective for the valuation, which is likely to concentrate on the end result.

The Pensions Regulator (TPR) explains in its Code of Practice on Funding Defined Benefits that it interprets prudence as taking a margin on the cautious side of best estimate — this in itself is imprecise, but perhaps the subject of a different article. Although the Code of Practice has some force in clarifying legislation, it is not the same as legislation. Do trustees have to adopt TPR’s definition of prudence, or can they take a broader view?

The dictionary definition of prudence includes exercising caution and avoiding risks, but also extends to ‘the exercise of sound judgment in practical affairs’. Sound judgment can be interpreted as forming a decision after having taken all the relevant information into account. The decision needs to be considered, but not necessarily cautious. Could there be circumstances in which it would be prudent not to err on the side of caution?

Trustees set their funding assumptions after considering the nature of the scheme’s liabilities, their investment strategy, the employer covenant and data on the demographic and other experience of the scheme. In developing their approach, they will receive advice from their scheme actuary regarding the economic value of the liabilities and the volatility implicit in their asset portfolio, including any dependencies on the employer. TPR’s guidance suggests that, no matter what this information implies, technical provisions must be calculated using a basis that is stronger than a best-estimate basis (although elsewhere, the Code of Practice states that trustees are not obliged to eliminate all risk that the technical provisions will not be sufficient to pay the benefits).

To take an extreme example, if a scheme is 100% invested in gilts, the ‘best estimate’ discount rate would be the gilt yield. A literal interpretation of paragraph 85 of the Code of Practice would require technical provisions to be calculated using a discount rate less than this, which could give a value in excess of the cost of buying out the benefits. This also leaves trustees with little flexibility to take into account the employer covenant or the scheme’s funding level. With a strong employer and strong funding, the scheme members are exposed to little risk. As flexibility around the pace of funding is likely to be advantageous to the employer, the trustees might consider it prudent — that is, exercising good judgment — to have a weak funding basis to calculate the technical provisions, perhaps with a secondary funding target that reflects the actual investment strategy being followed.

Very few schemes follow such a conservative investment strategy and, currently, few schemes are well funded. However, if the basic tenets underlying the regulatory regime do not apply at the extreme, then even if they apply in some cases, there must be some more realistic point at which they break down. Equities fell by 30% during 2008, wiping about £150bn from pension scheme assets and reducing the covenant of many employers, so few trustees are likely to have the luxury of debating the semantics of prudence. Yet it is precisely when models are tested to extremes that their weaknesses become apparent.

In November, TPR issued a statement advising trustees how they should operate in the current financial climate, saying that trustees should strengthen technical provisions where employers appear to be weakening. The statement published in June and TPR’s message to the Profession, published in July’s issue of The Actuary, reinforce this position, addressing the difficulties employers have by suggesting that contributions to meet new deficits could be spread over longer recovery periods. But will it always be prudent for trustees to take actions that have the effect of imposing a larger debt on the employer at a point when it is already weak?

TPR encourages trustees to treat pension scheme deficits like debt, and the new regulatory regime has engendered a more considered relationship between trustees and employers. However, deficits are not like banking or other forms of corporate debt. A stark example of the difference is that, while bankers tend to reduce the value of debt as a company becomes weak, this would rarely be appropriate for trustees. Indeed, they are constrained by TPR’s guidance to write debt up as a company weakens. Legislation restricts their flexibility to take steps that could otherwise reduce the debt, so the only safety valve for the employer is for trustees to agree to spread the debt over a longer period.

Normally it will be in the members’ best interests that their pension scheme receives immediate payment, but longerterm survival, and the chance that recovery payments will be met over the longer term, depends on the employer’s continued existence. By revaluing corporate debt upwards, the trustees potentially place extra strain on the company’s financial position, making it more difficult for it to achieve new finance or to reorganise its corporate structure, thus reinforcing the weakness. This will not be prudent for the employer, and might also be imprudent from the scheme’s perspective.

TPR’s February statement to employers advised them to prioritise pension contributions over dividend payments to shareholders. For some companies, continuing to pay dividends is evidence of its ability to survive. Cancelling a dividend payment can create loss of confidence, putting further pressures on the company’s balance sheet and, again, making refinancing and continued survival less likely. Is it necessarily prudent for trustees to pressure companies into continuing to meet recovery plan payments at the expense of ordinary dividend payments?

Trustees, with the support of their advisers, should resist any pressure to make decisions that are not in the interests of scheme members. However, pension schemes and companies have a symbiotic relationship — they need each other to survive. Without continued profitable employment, there is no pension security, and equity market values are buoyed up partly by pension scheme investment.

TPR wrote its Code of Practice in far more benign financial circumstances. The current climate, when regulators seem to agree that models that worked previously may now be faulty, could be a timely point to review it. There is a certain logic, for example, in taking a more cautious approach to funding in favourable economic times to build up margins, to then weaken the approach during economic downturns. Even where trustees have not managed to build up a margin or where any margins have been wiped off their balance sheet, the prudence of imposing extra economic burdens on an employer just as it experiences financial strain seems arguable.

The interpretation of the schemefunding regulations taken in TPR’s Code of Practice seems to point trustees and their advisers towards a narrow view of prudence, concentrating on the assumptions required to value technical provisions. A different approach, based on trustees’ general duties under trust law, would emphasise the output from the valuation process rather than just the inputs. The approach would recognise that, in some circumstances, when an employer’s covenant remains sufficiently strong, the precautionary element to prefunding might require funding to a higher target than technical provisions.

However, the approach should also retain sufficient flexibility to take into account short-term setbacks to the employer covenant and include communication to ensure that members understand the risks the trustees’ approach imposes on them. The approach might not always result in greater security but, because it considers the valuation process in the context of the trustees’ duty to manage the scheme in the best interests of its beneficiaries, the result could be more prudent than one produced under the current regime.

______________________________________________________________

What TPR says about prudence
All assumptions must be chosen prudently. We interpret prudence as taking a margin on the cautious side of a best estimate (or expected value) (Code of Practice, Funding Defined Benefits, para 85).

Deborah Cooper is a principal at Mercer