Chris OBrien says actuaries should seek more relevant ways to measure the financial strength of pension schemes
Regulations in the UK require trustees of a defined benefit pension scheme to disclose information to members about the financial position of the scheme. I would suggest that the regulations as they stand are quite unsatisfactory. I am sure actuaries, with their public interest role, can help to improve them.
The regulations require trustees to disclose, in a summary funding statement (SFS) to members, the scheme's financial position on two measures. The first compares the market value of assets with liabilities assessed as the buy-out cost from an insurer. It is common for trustees to explain that the buy-out cost inflates the liabilities compared with the trustees fulfilling their obligations themselves, and that they have no intention of using a buy-out.
The relevance of the buy-out cost is therefore downplayed, and members are led to focus on the disclosure arising from the other measure in the regulations, where assets are compared with 'technical provisions'.
Variations on a theme
The main problem is that technical provisions are not well defined. Particularly serious is the choice available in determining the discount rate, which the regulations say can be based on either government (or other high-quality) bond yields or the expected investment return on the scheme assets. The choice of discount rate can lead to substantial variations in technical provisions, but with members being unaware of such discretion, this makes the disclosure almost meaningless.
In practice, trustees typically choose the discount rate as a prudent expected investment return. Such a valuation has an important role in helping the sponsor assess what contributions need to be made to the scheme. It takes advanced credit for expected future investment returns in excess of risk-free, matching market instruments, and this reduces the value placed on the liabilities, typically by up to 40%, compared with a risk-free discount rate.
This approach was called a 'budgeting framework' in the sessional paper by Cowling et al (British Actuarial Journal, 2012) but the authors argued that it is inadequate for disclosing the financial strength to members. After all, the liabilities depend on matters such as inflation, years of service and mortality, and don't automatically reduce if the trustees and sponsoring employer choose a higher risk investment strategy. There are also unfunded schemes, which still have liabilities even without an expected investment return.
The alternative to a budgeting framework is a 'matching framework', where liabilities are valued with reference to market instruments with matching cashflows; and Cowling et al pressed for this to be the focus of disclosure to members. Now the buyout cost is a matching approach, but assumes trustees transfer their obligations to an insurer, whereas we wish to understand the position if trustees fulfil their obligations. That could lead to discounting at government bond yields, although we can justify using yields on risky assets minus the effect of risk; for example, Solvency II's approach of using swap rates with a small credit risk adjustment. It is also fair to adjust for the illiquidity of defined benefit liabilities. Some simplifications may be needed for practicability, and the outcome should be regulations prescribing the discount rate as the gilts or swaps yield together with some margin.
Press for change
Trustees may still wish the SFS to include a funding ratio using the budgeting framework, perhaps in the context of explaining contribution levels. Such disclosure should not be compulsory and, if made, must avoid leading to confusion and should not undermine the relevance to members of the matching framework.
The actuarial profession can play an important role in helping to shape relevant regulation, perhaps greater with post-Brexit freedoms. I suggest it should press for a change in the regulations regarding disclosures in the SFS, to require the use of a discount rate based on a matching framework in order to provide a more meaningful and consistent measure of a pension scheme's financial strength.
Chris O'Brien is a senior associate at the Centre for Risk, Banking and Financial Services, Nottingham University Business School