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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: The going rate

Trustees and employers are faced with a number of different valuation approaches when dealing with scheme funding and corporate accounting. To help them discern what any one valuation method is telling them and to get a handle on the method’s dynamics, I direct their attention to the derivation of the discount rate.

A solvency valuation tells you what it would cost to provide the benefits by purchase of deferred and immediate annuities on the valuation date. A valuation that discounts the liabilities using gilt yields tells you how much you need in gilts to pay the benefits and a company accounting valuation tells you how much you would need in AA-rated corporate bonds.

Typical company accounting assumptions are not meaningful for valuing real liabilities, there being no significant market in index-linked corporate bonds. The model provides for real liabilities with fixed-income assets, which is an odd and mismatched thing to do. It would be better to set assumptions that discounted fixed liabilities at the AA bond yield and discounted real liabilities at an index-linked gilt yield.

These approaches all use external reference points. In each case, the trustees have a choice: whether to invest in the manner implied by the choice of discount rate, which would stabilise the balance sheet, or to invest in some other way. If the discount rate is gilt-yield driven, then investing in gilts stabilises the balance sheet. To the extent that the assets are in non-gilts there will be volatility in the balance sheet. This is especially so in times of economic crisis, when the ‘flight to quality’ tends to mean that gilts are the only asset class that holds up in value, while most other asset classes go down.

A valuation that discounts the liabilities at a gilt yield + 1.5%, say, gives the trustees a problem. The liabilities move in proportion to changes in the yield on gilts, and investment in gilts will stabilise the balance sheet, but the return on the assets will fall 1.5% p.a. short of that required. Non-gilt investment is required to stand a chance of producing the return built into the model, but then you have a volatile balance sheet. It’s a lose-lose situation.

As well as valuations that show the trustees what a scheme costs if they were to invest in something else, whether annuities, gilts or AA-rated bonds, I think it is very helpful to have a valuation that shows the trustees what funding a scheme would require if they carry on investing as they are. I suggest it is the second most helpful valuation they can have after the solvency valuation.

To keep things simple, let’s consider a scheme that has terminated benefit accrual, which is all too realistic these days. On the one hand, we have the income from the scheme’s assets and, on the other, outgo on the scheme’s liabilities, including expenses and PPF levies. The employer’s liability is to make up the difference, if any, between the asset income and the liability outgo. A realistic model of this situation needs to project the income expected on the scheme’s actual assets.

It is conventional to summarise the asset income cash flow and liability outgo cash flow into a balance sheet. If the assets are to be shown at their market value, we need to find the rate of return that discounts the asset income cash flows and gives their market value as the answer — that is, the internal rate of return. For equities, we need to project dividends and possible future dividend growth. For property, there is rental income and possible future rental growth. For bonds, there are coupon and redemption payments. It isn’t true that ‘discounted income’ valuations are dead. Finding the rate of return that discounts the income on the assets and gets their market value as the answer is simply the correct way of deriving the prospective return.

Now we are able to value the asset and liability cash flows consistently. The same RPI assumption can be used to project RPI-related liability outgo and asset income. We can discount the liability cash flows with the internal rate of return on the assets for a fully realistic, best estimate balance sheet. Or for Statutory Funding Objective (SFO) purposes, which require a prudent discount rate, a margin can be taken against the best estimate return to obtain a prudent discount rate for valuing the liabilities. Here we have a transparent, objective approach to setting SFO technical provisions. For this article, I will not explore the debate as to whether the word ‘prudent’ really does mean making an estimate biased to the expensive side of best estimate.

One big advantage of this method is its balance sheet stability. If there is a deficit on this method, it needs funding. The size of the deficit is not the product of mismatched assets and liability calculations. In contrast, a scheme that was 100 percent funded in April 2007 when valued on a gilt yield + 1.5% basis might very well be less than 60 percent funded two years later, if the large majority of the assets are in non-gilts. Which of these results is the reliable one? Neither. The instability of the method means you can’t tell whether you were being kidded by the 100 percent result or are being unnecessarily worried by the 60 percent result.

Another big advantage of carrying out a valuation assuming continuation of the actual investment strategy is that it helps avoid some errors of judgment. For example, an equity return pre-retirement and bond return post-retirement is often used as a prudent approach, and it normally is, but not by as much as you think if the scheme already has more bond assets than it has pensioner liabilities. For a second example, an AA corporate bond discount rate is not prudent if the scheme is mostly invested in bonds with an expected return, after an allowance for expenses and defaults, that is less than the AA bond index. Unfortunately, these are real and not fictional examples.

The Pensions Act 2004 requires the discount rate for technical provisions to be set prudently, by reference to either the expected return on the assets or the yield on high-quality bonds. The internal rate of return is, by definition, the expected return on the assets and taking a margin against it is a transparent way to obtain a prudent return for SFO purposes. Using a high-quality bond yield is simple but, to be robust, a check still needs to be made that the yield adopted is less than the internal rate of return on the assets. What about a ‘gilt yield + 1.5%’ discount rate? It is not a ‘yield on high-quality bonds’.

In the recent past, a gilt yield + 1.5% represented a sub-investment grade return. Besides, if you wanted to use an investment grade corporate bond yield, the sensible way to do it is to take a corporate bond yield and adjust it down for defaults and expenses, not to add something to a gilt yield. Neither is a gilt yield + 1.5% in any meaningful sense an estimate of the prospective expected return on the assets. Its suitability in law for setting technical provisions is marginal at best.

The consultation paper from the Board for Actuarial Standards on the pensions technical actuarial standard proposes that, ‘Assumptions... should be based on evidence... In many cases, assumptions should reflect the state of the world at the effective date.’ The ‘gilt yield + 1.5%’ method contains data about the state of the world at the effective date drawn only from the gilt market, which contains very little information about the return to be expected on the non-gilt assets that the method is modelling.

To conclude, a valuation might assess the cost of a scheme assuming that annuities are bought or that the assets are reinvested in gilts or corporate bonds. Second only to a solvency valuation, I suggest that it is very useful to have a valuation in which the discount rate is derived from the internal rate of return on the assets, which may be set up as either a best estimate or prudent basis. Such a valuation on a best estimate basis sets an important boundary at the opposite end of the funding spectrum to solvency. On a prudent basis, it provides a stable approach to scheme funding and contribution planning with transparent margins.

I close with an appeal to the profession to stop using the gilt yield + x% method of setting the discount rate for a valuation. To tell trustees that their scheme is 100 percent funded and then say it is 60 percent funded a short while later, using a method represented as reflecting the actual assets of the scheme, risks bringing the profession into disrepute. It is time to move away from this method which has no sound rationale and instead use methods that have a real-world interpretation, fit better with the Pensions Act 2004 and provide a firm basis for advice.


Derek Benstead is a scheme actuary. The opinions expressed in this article are his own and not those of his employer, First Actuarial