Actuarial valuations to monitor defined benefit pension funding

Abstract

This paper is motivated by The Pensions Regulator (TPR)’s review of its Code of Practice on funding for defined benefit schemes and aims to suggest how trustees and regulators should monitor the extent to which scheme assets are adequate to cover liabilities. It concludes that current practice is inadequate and needs to change. A review is carried out of papers on not only this subject but also (to collect ideas rather than automatically apply them to pensions solvency valuations) pensions and insurance accounting and regulation. Current practice is “scheme-specific funding” which permits discretion on choice of discount rates and other assumptions; the paper is concerned that this can lead to bias, and that trends in a scheme’s solvency can be obscured by changing assumptions. This also leads to the funding ratio communicated to scheme members having little meaning. The paper suggests that regulators should require a valuation that is based on sound principles, objective, fair, neutral, transparent and feasible. A prescribed methodology would replace discretion. It concludes that the benefits to be valued are those arising on discontinuance of the scheme, without allowing for future salary-related benefit increases, which are felt to no longer be a constructive obligation of employers. The valuation should, it is suggested, use market values of assets, which is largely current practice. Liabilities should reflect the trustees fulfilling their liabilities, rather than transferring them to an insurer (which may introduce artificialities). The discount rate should follow the “matching” approach, being a market-consistent risk-free rate: this is consistent with several papers to the profession in recent years. It avoids the problems of the “budgeting” approach, where the discount rate is based on the expected return on assets – this can be used to help set contribution levels but is not suitable for determining the value of liabilities, which depends on salary, service, longevity, etc and (very largely) not on the assets held. In principle, the liability value can be adjusted for illiquidity. Credit risk of the employer should not be allowed for. Liabilities should reflect the (probability-weighted) expected value of future cash flows and should not be increased by prudent margins or risk margins (which would lead to a non-neutral figure). Risk disclosures are needed to understand and manage risks. The resulting funding ratio is a consistent measure, to be disclosed to members, which can be used to manage the scheme, and by regulators as the basis for requiring action. Scheme-specific management using data such as the employer covenant means that immediate action to ensure 100% solvency on the proposed basis would not necessarily be appropriate. The author encourages the profession to advise TPR on the above lines.

A Comparative Study of Immediate Annuities and Ordinary Annuities in establishing the Phantom of Zero Liability Under the Trusteeship Pension Valuation Structure

“…We observe in Chen and Matkin (2017) that since employee's salaries are inadvertently introduced to inflation uncertainties, salaries growth and the stock market should be positively correlated across a long-time horizon. When the employee's salary profile is reviewed upwards, then Brien (2020); Wang et al (2021) argue that optimal investment on the risky asset declines although in order to earn robust returns, the pension manager should inject more funds to buy risky asset instruments. The authors noted that when the employee's salary increases, the living reserve fund markedly improves, and the risk tolerance will be strong such that the investment trajectories become more volatile.…”

The Actuarial Conditions for the Valuation of Pension Liability to Become Zero Under Minimum Funding Standard Architecture

“…An actuarial valuation represents an appraisal of a pension scheme financial profile serving as regular check to ensure that the trustees funding program is not adversely altered. In [4] (Brien, 2020), [8] (Dufresne, 1988a); [9] Dufresne, 1988b); and [10] (Gang & David, 2017) valuation represents the actuaries' estimate of the scheme's solvency where the liabilities are computed as the cost of purchasing annuities from a life office. We observe that the valuation exercise is carried out at a specified date (valuation date) and it is conducted on behalf of the trustees by the scheme's actuary.…”

Gerenciamento de premissas atuariais de planos previdenciários patrocinados por companhias abertas brasileiras para atendimento ao CPC 33 (R1)

“…A alocação dos ativos que compõem o VJA é diretamente afetada pela contabilização de planos previdenciários, uma vez que o risco presente nos planos é parcialmente impulsionado por essa alocação (Barthelme et al, 2019). Destaca-se que o atuário responsável deve incluir na avaliação as estimativas para a solvência do plano de acordo com as regulamentações existentes (O'Brien, 2020).…”