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The Actuary The magazine of the Institute & Faculty of Actuaries

Funding valuations

A finance director recently told me how he solved
his pension problem. His accountant said the
company pension scheme was 85% funded.
The actuary said ‘the scheme is 100% funded but if we insure the pensions, then it’s 70%’. The FD put his ‘trustee hat’ on in order to ‘negotiate the contributions with himself’.
He decided not to insure the pensions because it is ‘too expensive’, not to pay extra money into the scheme because it is ‘fully funded’ and to pray the actuary never agreed with the accountant.

The lottery analogy
Saying ‘it only costs £1 to win the lottery’ is misleading. Winning the lottery requires paying £1 for the ticket, plus having an enormous amount of luck and often many years of buying losing tickets.
Likewise, counting on the equity risk premium to reduce employers’ expected pension payments is acceptable as long as the risks are clearly explained to those who bear them.
The price of a pension can be defined as the cash you need to pay today to be sure that the pension will get paid. The question is, how sure? Any pension scheme member would say ‘100% sure’, or maybe 99% if they understand zero risk is impossible. Scheme booklets, upon which members might base their expectations, are often categorical: ‘you will get a pension’ no ifs or buts.
In practice, the closest thing to being 99% sure a pension gets paid is to purchase one from an insurance company. Insurers, unlike sponsors of defined benefit schemes, are regulated by the Financial Services Authority which seeks to ensure that the insurance companies hold sufficient capital to meet their financial promises if things go wrong.
I believe that the buyout cost should be the starting point in any actuarial valuation. Then, borrowing from the latest FSA rules for insurers, risk margins should be considered to cover risks that have not been or cannot be insured, eg asset-liability mismatch, salary increases, longevity.

Contributions and investment risk
Please do not to jump to conclusions at this point. I have not said that trustees should ask sponsors to make up the deficit up to the buyout cost, or insure the pensions, or even move into bonds. Indeed, I believe matching pension liabilities with bonds is often an inefficient use of assets.
All I have said is that the liability calculation should not reflect a risky investment strategy. Otherwise, we may unduly influence trustees towards that same risky strategy.
If trustees believe in equities, let them take the risk of poor equity returns. If they prefer bonds, let them take the risk of missing out on good equity returns. But they must decide for themselves. From our point of view as actuaries, we should present the results of our calculations in such a way as enables our clients to understand the risks.
A scheme with a strong sponsor, a growing membership, and positive net cashflows may decide to invest in equities and run a large deficit (by reference to buyout). A scheme with a weak sponsor, no new entrants, and negative net cashflows may decide to invest in bonds and make up the deficit over a short period.
In my experience, sponsors are increasingly regarding the accounting basis as the most useful measure of a fund’s position, and so trustees may decide to be pragmatic and do the same for funding purposes. People are more likely to agree if they ‘sing from the same balance sheet’.
Trustees should also consider the sponsor’s financial strength. Full funding on the accounting measure is generally not enough to buy full pensions with an insurer. The reasons are that the accounting measure allows for some investment risk (AA credit risk) when discounting liabilities, and it ignores insurers’ longevity risk margins and profit margins.

The nature of risk
Helping trustees and sponsors agree the trade-off between higher sponsor contributions and more investment risk for trustees is where actuaries can prove invaluable. We are ideally placed to quantify the liabilities, the risk margins, the value of expected employer contributions, and the value of expected outperformance from risky assets.
We should adopt valuation techniques that allow our clients to understand the scale and nature of the risks that they take. The approach that I have outlined in this article seeks to do this.