The writing hand of Mervyn King must be feeling the strain of the inflationary pressures in the UK’s economy. For six quarters in a row, the Bank of England Governor has found himself in the position of having to draft a letter to Chancellor George Osbourne to explain why the Government inflation target has been missed. It may be unfair to blame Mr King as many think that the Chancellor’s target is unrealistically low, including Mr Osbourne himself who seems to accept high inflation as a reality we have to live with for the time being.

High inflation is not always bad – it can encourage economy-boosting spending and more private investment in companies as many investors see stocks and shares as a better option than cash. Unfortunately, it also provides a lot of instability in the economy and the world of pensions. Over the last year, inflation has been the biggest issue on our radar, not least because of the contentious legislation to determine pension valuations based on Consumer Price Index (CPI) rather than the previous gauge of Retail Price Index (RPI) being introduced in the UK.

The recent announcement that CPI rose by 4.5 per cent over the last year compared with an increase in RPI of 5.2 per cent will have a direct economic impact on many pensioners. Those with pensions linked to RPI would gain by almost one per cent each year compared to those with pensions linked to CPI.  Assuming these inflationary rises continued at their present rates, the income of a pensioner currently earning £10,000 each year would rise to just over £16,600 per annum in ten years time under RPI compared with around £15,500 per annum under CPI.

Inflation as it impacts on pensioners is generally accepted to be currently relatively higher as the ‘basket of goods’ includes many items which have increased more rapidly recently, such as food and fuel costs. These tend to represent a greater proportion of income spend for a pensioner whereas other areas of expenditure which have been more stable or reduced.

The current high levels of inflation are highlighting the controversy over the move from RPI to CPI. We have already seen many public sector union leaders calling for a judicial review on this decision and the private sector is not exempt from this either. British Airways have seen three trustees of the pension fund in April resign because of the move from RPI to CPI. 

Future movements in CPI are very difficult to predict.  Even over recent years, there have been a number of occasions that CPI has exceeded RPI so it can therefore not be ruled out that CPI could on occasion give rise to higher increases than are currently paid under RPI.  The basket of goods for CPI could also change – if, for example, housing costs are included, this could substantially close the current gap between it and RPI.

Looking at the impact of inflation from a different perspective, it can also have a roller-coaster effect on pension scheme payments and funding levels.  Inflation caps on pension increases are often overlooked.  Pensions may become significantly devalued if this cap applies for an extended period (irrespective of whether the inflation measure is CPI or RPI). Pension increases are generally capped at a maximum of 5% per annum, and so with inflation at its current level, capping at the 5% level would currently apply under RPI and remain a distinct possibility for the future.

While it would be bad news for pensioners and possibly the wider economy, a run of higher inflation is actually likely to improve scheme funding. Providing the actual inflation level exceeds any cap that a scheme has in place, it will be providing its members below inflation increases which, assuming investment returns do keep pace with inflation, will improve the overall funding of the scheme. The worst possible scenario for scheme funding is likely to be in a period of deflation whereby they would need to effectively pay out increases in excess of inflation and reduce scheme funding.

Perhaps the fine balancing act and the cause and effect implications of rising inflation explain the apparent willingness of the Bank of England and the Government to live with this situation, at least in the short term. However, the longer Mervyn King is required to pen an inflation letter to the Chancellor, the greater impact this will have on UK pensioners.

This article featured in the Scotsman on 24th June 2011.

Posted in: Blog, Media, Media Releases
Tags: inflation, Legislation, Pensions, Retirement, RPI to CPI

Yesterday, the International Accounting Standards Board (IASB) confirmed the much-trailed changes to accounting for pension benefits in accordance with IAS 19. The changes will be effective for accounting years commencing 1 January 2013, though earlier adoption is encouraged.

IAS 19 applies to all UK (and EU) listed Companies, though can be adopted by non-listed companies. The main UK pension accounting standards, FRS 17, is effectively being replaced from 2012, so these changes will generally also affect non-listed companies.

The main changes are as follows:

• The replacement of the expected return on assets element of the profit and loss charge by a credit linked to the discount rate used to measure the liabilities. Therefore given that an interest charge already applies to the liabilities, the final result on the P&L account will effectively be an interest charge (credit) on the plan deficit (surplus); and
• Companies which partially recognise actuarial “experience” in the profit and loss account will either need to fully recognise year on year experience or alter the accounting method to recognise experience gains and losses via the Statement of Recognised Gains and Losses (STRGL).

Further disclosures will also be required in relation to the characteristics of defined benefit plans and the risks which plan sponsors are exposed to by operating these plans.

So, what does this mean?

The main conclusion is that, all else being equal, Company profits will be reduced. It has recently been estimated that the replacement of the expected return credit could reduce UK Company profits by £10 billion per annum.

Where full recognition of actuarial experience is adopted, the profits or losses arising from defined benefit pension schemes will be significantly more volatile.

It has also been argued that the changes will lead to a move away from equity investments by defined benefit pension schemes as holding equities is no longer “rewarded” on the P&L.

However, many within the pensions industry often over-dramatise the attention paid to disclosed pension accounting figures in the profit and loss account. I agree with the views that most analysts already set-aside any windfalls on the P&L associated with the pension scheme, particularly when brought about by the current expected return on assets credit.

It will interesting to see if the changes do hasten a move away from equity investment by schemes. There is already a trend to de-risk and I see this continuing, but doubt whether the major driver will be these accounting changes. More likely, it will driven by trustees and employers who are less willing to be exposed to the risk of volatile funding levels and greater uncertainty in future funding costs.

Posted in: Blog
Tags: Accounting, Actuarial, FRS17, IAS19

I’ve  never had an “ology”, but always fancied one. So I thought I’d have a go at futurology. Futurology is the study of possible, probable, or preferable futures for society and the worldviews that underlie them. There is a debate as to whether this discipline is an art or a science, or just a bit of fun indulged in by the weekend supplements on the Sunday closest to New Year’s Eve.

Obviously there is a spectrum in futurology.  I’d tend not to invest too much faith in those futurologists who cite their predictions as being the result of channeling Thrag, a 9,000 year old lizard-being from the planet Zoltar. But some approaches have a slightly more reputable pedigree , and are essentially the statistical collection and analysis of past and present trends with the goal of accurately extrapolating future trends. When they put it like that, it almost sounds like being an actuary!

So if I apply my ology to the pensions field what might I divine?

Well, what about past and current trends? Recently, Scottish Widows published their seventh annual report on the state of retirement savings across the nation.

The most damning statistic is not a new one – 20% of those surveyed are saving nothing for retirement in 2011, a slight improvement from 21% in 2010.  Also, the survey concludes that just over half of those surveyed are assessed as making enough provision for their retirement.  Somewhat worryingly, the threshold for qualifying as being adequately prepared for retirement, according to the study  is setting aside 12% of pay (including employer contributions) – I don’t think there would be many in the actuarial or financial advisory sector that would conclude that 12% of pay is enough.

The UK does not seem to fare well in retirement savings stakes versus other developed economies – the survey refers to a recent Chartered Insurance Institute report which estimated that the UK Retirement savings gap at £9 trillion.

There is some encouragement to be had relating to the impact of auto enrolment and NEST, with only 11% of those surveyed saying they will opt out rather than be automatically enrolled, so the future trend may be for more retirement saving but at a level, 8% in aggregate, that is unlikely to make a real difference to most people.

A proposal which has generally been welcomed in pension circles is the introduction of a flat rate state pension of £140 per week (in current terms).  I see one of the main positives of this proposal as being that additional savings would be rewarded and not offset against some state benefits as is currently the case.
Indeed, I attended the Actuarial Profession’s annual conference last week and Pensions Minister Steve Webb stated this aspect as a significant advantage of the flat rate pension system.  However, the survey suggests that there is a significant communications and financial education  challenge in convincing the wider public that the flat rate pension system will reward savings, as only 18% of those surveyed stated that the system would lead to them saving more.

The survey also details a high level of expectation on employers to engage in the retirement savings process.  70% believe an employer should provide access to and contribute to a pension arrangement.  More surprisingly, some 40% believe that employers offering a pension scheme should offer a full advice service.  My experience is that the number of employers offering such a service would be significantly less than this level.

Together with moves by the Pensions Regulator to encourage employer engagement in Defined Contribution arrangements and facilitate access for staff to open market options at retirement, it should now be an important consideration for employers to effectively communicate the benefits of retirement savings and also assist with retirement planning for members approaching retirement age.

Finally, to get another angle on the public view on retirement savings I consulted the comments section of the BBC website’s reporting of this story.  At last check, the story had attracted a staggering 327 comments, which at least shows that the public seems to be engaged on the topic of pensions at the moment.  However, comments such as,

“Saving – might as well spend it.”
“most people distrust pensions”
“Don’t bother with pensions – they are unsafe and unprotected.”,

illustrate that trust and belief in retirement savings is still far short of the level required to encourage the general public to engage in the process.  That, for me, is the biggest challenge facing the industry, and indeed our wider society, and a challenge which seems to be getting harder rather than easier over recent years. Financial education needs to be a priority for the UK, and our industry is well placed to play its part, but the Government also has a leading role to play.

So what sort of future do we want?  A future where all our citizens have a meaningful income and standard of living in retirement? Or, in extremis, a dystopian, ageist future in which the state provides for retirement but can only do so by permanently “retiring” everyone reaching a particular age?  I’m afraid, based on the current evidence that, unless we can change society’s behaviour radically, our future is more likely to resemble Logan’s Run than Utopia.

Posted in: Blog
Tags: NEST, Retirement

We have recently produced a helpful guide to FRS17 disclosures for Scotland’s Colleges.

This could be useful to colleges, educational bodies and other charitable organisations: for the organisations themselves as well as their accounting advisers.

“Pension Scheme Accounting Disclosures Under FRS17 – Issues and Options“

Posted in: Blog
Tags: Actuarial, FRS17, Local Government Pension Scheme

If asked about my political views, liberal is not a word that would ever feature in my response. No subscription to the Guardian newspaper here.

However, on reading the discussion paper from Philip Booth and Corin Taylor for the Institute of Economic Affairs (IEA) on “How the older generation should suffer its share of the cuts”, I have had to reassess my thoughts on the virtues of beard growing and sandals.

In short, the paper recommends the abolition of a number of benefits currently provided to older people, namely

• Certain non-cash benefits (free bus travel, free TV licences and the winter fuel allowance);
• Married couples allowance for older people;
• The age adjusted tax-free income allowance; and
• The earnings link to state pensions (which hasn’t even been re-introduced yet!);

The paper also recommends the state pension age is increased to 66 in 2015, a reduction in public sector pension contributions and an accrual rate of 1/45th for future build up of state pension entitlement. Wow – don’t hold back now guys, say what you really think!

Given the need to reduce the national debt, it is right that ancillary benefits paid to pensioners such as free bus travel and free TV licences come under scrutiny. However, it is unlikely that a government of any persuasion is likely to threaten the winter fuel allowance.

I welcomed the proposal in October 2010 to consider a universal state pension of around £140 per week and so would view the proposed use of an accrual system to be a retrograde step.

The comments on the triple lock of increases applying to the state pension seem flawed. Firstly, the price inflation element of the lock changes to CPI from 2012, which is expected to be less valuable than RPI. This fact seems to have been missed, though it does not appear to affect the estimated cost saving.

The estimated cost saving on excluding the link to earnings also assumes wage growth of 2.5% per annum above inflation, which is certainly higher than I would expect – therefore the saving is likely to be significantly less than the reported £5.6 billion per annum.

Some of the other figures seemed to have been produced like a rabbit out of a hat. For example, apparently a conservative estimate of the annual saving on increasing the state pension age to 66 by 2015 would be about £5 billion – this figure is provided without any justification.

The paper does make some bold suggestions in the pensions arena which are certainly worthy of further consideration. Firstly that the full costs of all pension promises should be revealed. I agree that the current cost is being pulled down by over optimistic assumptions about future investment return and await with interest the release of Lord Hutton’s report on 10 March. The removal of final salary linkage is not enough to stem the tide of rising costs and any move to Career Average accrual is only postponing more difficult decisions for a later date.

Secondly, the paper recommends that individual organisations and councils are allowed to negotiate individual pension arrangements with their employees. This would certainly test the value of pension provision – how much more salary would a public sector employer be prepared to offer in return for lower pension contributions? If NEST is enough, then why shouldn’t organisations be allowed to offer more salary in return for lower pension contributions?

In times of economic difficulty, it would seem that suggestions on how to save money are becoming more aggressive. And I am all for a bit of debate, I just think the debates surrounding some of the more outlandish ideas contained here are likely to be short.

Posted in: Blog
Tags: Longevity, Pensions Reform, Politics, Retirement

If life expectancy was measured on the mars bar scale, Kensington and Chelsea would be “fun size” and certain areas of Scotland would be “deep fried”.

I assume pension buyout specialists Pension Corporation use a more sophisticated method of measurement. I read with interest their press release yesterday which stated that pension schemes with Scottish members may be over-estimating life expectancy and therefore actual pension liabilities may be lower than currently estimated. Read more »

Posted in: Blog
Tags: Actuarial, Longevity, Mortality, Pensions, Scotland

I came across an interesting panel discussion in the current issue of Engaged Investor Magazine, where a number of industry experts were asked for their views on developments in pension scheme de-risking. My views on the questions addressed are as follows:

Q1 – Many companies are not able to carry out full buyout in one go. What multi-layered approaches can they take to de-risk their schemes?

The most important first step is for the employer and trustees to agree a common goal for the scheme. In almost all cases (especially closed schemes), the ultimate goal should be to secure all benefits with an insurance company and wind-up the scheme.

An agreed, transparent objective will then set the path towards the ultimate goal. There are many alternative partial de-risking measures that can be taken, most of which can work in parallel. These include employer led exercises such as:

• a transfer exercise, offering members the opportunity to transfer their scheme benefits to an alternative arrangement via an incentive in the form of an increased transfer value, or sometimes a cash payment; or
• a pension increase swap exercise, where members give up future pension increases in return for a higher initial pension.

These exercises can generate significant savings to the employer relative to the ultimate cost of buyout. They are unlikely to generate significant immediate savings on ongoing funding costs or FRS 17, though they do contribute to reducing the risk profile of the scheme.

These exercises can be run in tandem with providing opportunities to members to retire early from the scheme, which can generate savings on cash commutation and also insurers prefer the “certainty” of pensioners rather than deferred members. In conjunction with the company, the trustees can also move towards a lower risk investment strategy, using bonds or LDI type investments, and also consider partial insurance such as pensioner buy-ins. I would caution that for schemes with young pensioners or where the pensioner group makes up a small proportion of the liabilities, it may not be efficient to use significant resources of the scheme to obtain insurance covering only a small portion of the liabilities. There are also opportunities developing in the market to enter into a staged buyout process with insurers, where the terms are agreed up front but the whole premium is not required at the outset.

Nor should the trustees overlook the potential for non-cash funding, such as parental guarantees, contingent assets or “asset-sharing” with the company, such as the whisky-bond deal completed by Diageo .

Q2 – In what ways did trustees’ de-risking choices change during 2010?

The choices remained broadly unchanged, though it was a year of massive change in defined benefit pensions, particularly on the legislative front. The single largest issue was Steve Webb’s RPI/CPI summer bombshell, which is expected to have a significant effect on pension scheme funding. Most schemes are expected to see a reduction in liabilities of between 5-15% depending on the nature of the scheme rules.

This meant that larger exercises tended to be shelved as trustees waited for the full impact of the change in inflation measure to come through. I would say the introduction of innovative non-cash funding solutions and the focus by trustees on obtaining enforceable security was the other main development in de-risking.

The emergence of longevity swaps was supposed to be the big-ticket item for 2010, but this remains the preserve on the very largest of schemes and I don’t see that changing any time soon.

Q3 – What early steps, such as data cleansing, communications and legal considerations, should be undertaken before entering into a de-risking activity?

The quality of pension scheme data can be highly variable. It can be held in multiple formats, for very long periods of time and is often subject to major change (e.g. after mergers, systems migrations, legislative changes). When entering a liability management exercise and moving ultimately towards winding-up a scheme, every effort must be made to ensure that members have the correct pension entitlement. The key message on data is that full and accurate data will reduce the cost of staff communication and liability management exercises as well as ultimately buying annuities as it helps to reduce underwriters’ pricing for uncertainty.

The communication process is also vital, both between the employer/trustees and the member. Possibly even more important is the communication between a financial advisor and the member during an employer’s de-risking exercise.

The need for proper legal input almost goes without saying, but the emergence of the RPI/CPI issue and continued problems with sex equalisation and other scheme amendments, mean that assistance from your friendly pensions lawyer is a necessity, not a luxury.

Posted in: Blog
Tags: Buyout, Corporate, Data, De-risking, Legislation, Pension Funding, Pensions, Pensions End Game, Transfer Incentives, Transfer Values, Wind up

Throughout my work in the pensions industry, I find myself continually being surprised by the effects of small print, either in scheme rules, insurance policies or in the legislative framework governing pension schemes. So you would think that I always check the finer detail.

And if you can’t remember to check the small print, at least remember “case law”.

But alas, before embarking on my return journey home to Glasgow from nearby York on Wednesday, I did neither.

To help control my employer’s expenses, I did some research and found that purchasing an advance single train ticket from York to Glasgow for my return journey was the most cost effective approach. On departure from the meeting, I was offered a lift by car to Darlington (heading in the right direction) where I could connect with my train. Good idea, yes?

On arrival at Darlington, I checked at the ticket desk – “My ticket is still fine, given that I’m catching the same train?” Simple answer, surely, but always polite to check. The response was a bit of a shock. The lady behind the desk, I didn’t catch her name – let’s just call her Mrs Jobsworth, said “No, that would count as a “broken” journey . You would need to go back to York to catch the train but you’ll be too late. It will cost £40 to change the ticket over.” I was then handed a leaflet containing said small print which confirmed I had to start and end my journey at the stations stated on the ticket. The fact that I was using their services for a lesser period didn’t seem to count.

Now in my mind, travelling back to York to try and catch a train which will shortly arrive in the station I was actually in struck me as possibly one of the most stupid suggestions I had ever heard. Mrs Jobsworth’s final suggestion was that I could just “chance my arm” to see if I got away with it. My predicament did eventually remind me of a staggering piece of “case law” – that of Professor Martyn Evans, who was charged an additional £155 by the same train company for getting off a stop early compared with the destination on his ticket (it was subsequently waived).

So chance my arm I did, and low and behold, an outbreak of common sense. I took my seat (which was no doubt unused between York and Darlington), I gave a truthful account to the conductor and he said “It’s the same train you are on, so no problem”. I didn’t try to correct him with Mrs Jobsworth’s small print.

Lessons Learned

1. Always check the small print;
2. Remember the case law;
3. Sometimes it’s worth chancing your arm; and
4. If you look hard enough, there are still pockets of common sense to be found.

Posted in: Blog
Tags: Actuarial, Legislation

As the year-end approaches, I thought it was worth taking a back-to-basics look at the underlying actuarial assumptions used in FRS 17 calculations and what flexibility exists to change the results depending on the specific circumstances of each organisation.

So what is FRS17?

FRS17 is an accounting standard used to assess the balance sheet impact and pension costs associated with the operation of occupational pension schemes. For defined benefit arrangements (e.g. final salary pension schemes), the balance sheet asset or liability for the organisation is calculated as the surplus or deficit of the scheme assessed in accordance with assumptions appropriate for FRS 17.  The pension cost is a combination of the cost to the organisation of providing benefits built up over the past year and an interest charge applied to the liabilities built up in the past, offset by a credit in respect of the expected return on the scheme’s assets.  The elements of the pension cost are again calculated in accordance with assumptions appropriate for FRS 17.  Some organisations who participate in multi-employer schemes retain an opt-out, whereby the pension cost is set equal to the amount of employer contributions and there is no balance sheet impact.  This opt-out continues to be placed under serious scrutiny by company auditors and is looking increasing untenable.

FRS17 Assumptions

The responsibility for the FRS17 assumptions adopted lies with the directors/trustees of each organisation.  The agreement of the auditor is required, and the organisation should seek the advice of an actuary on the assumptions.  There is a considerable degree of flexibility in setting these assumptions and the impact of small changes to the assumptions can be quite substantial (some examples are provided in the table below).

In many cases, the assumptions proposed by the actuary will be based on the “average” index values and mirror those assumptions used for the Trustees funding valuation and therefore may not be appropriate for the individual circumstances of each organisation.  As the assumptions are the responsibility of the directors/trustees, they are entitled to request that the actuary carries out their calculations on alternative assumptions which they feel might be more appropriate.

It is important as early as possible in the process for each organisation to consider whether the assumptions proposed are appropriate and take suitable action if not.  However, it is not appropriate to “cherry pick” assumptions on a year by year basis as directors/trustees need to ensure a consistent approach is used.

FRS17 requires a market-related approach, with assets being taken at their market value.  Liabilities are valued using the ‘discount’ rate equivalent to that available on AA corporate bonds.  The rate should be adjusted to make it appropriate for the maturity of the scheme’s liabilities (this will depend on the proportion of pensioner and active members in the scheme).   Other assumptions (e.g. pension increases, mortality) are on a best estimate basis.  The expected return on asset assumption is set independently of the liability discount rate.  The assumptions should be mutually compatible and lead to best estimates of the future cash flows arising from the Scheme’s liabilities.  The assumptions should also reflect market conditions at the reporting date.

How assumptions can change from organisation to organisation

As noted above, the impact of small changes to FRS 17 assumptions can have a significant impact on the organisation’s balance sheet asset/liability and pension costs.  The main assumptions driving FRS 17 disclosures are the rate at which future values are discounted to “present day” terms (the discount rate), the expected rate of future price and salary inflation and the life expectancy of members.  Taking a scheme with a total liability of £30 million, an indication of the impact of assumption changes on the balance sheet would be as follows:-

*- liabilities are reduced by increasing the discount rate and increased by reducing the discount rate.

There would be corresponding increases in the liability if the opposite changes occur (i.e. reduced discount rate, higher salary and price inflation and higher life expectancy).  Therefore, it is clear that setting assumptions can have a material outcome on the organisation’s balance sheet.  The impact on the pension costs are more difficult to quantify but pension costs are generally lower when liabilities are lower and assets are higher.

My earlier blog entitled “Throw your actuary a curve ball on FRS 17” discusses the impact of changing the underlying assumptions in further detail.

It is worth noting the potential move to using the Consumer Price Index (CPI) as the measure of price inflation for the purposes of regulating occupational pension schemes.  Given that historically, on average, CPI has been around 0.5% per annum lower than RPI, this change places a lower current value on future pension payments and so reduces the liability of organisations in respect of pension benefits.  Typically, this change could reduce overall pension liabilities by around 10%.  If you have year end FRS 17 disclosures coming up, this point should be addressed with your advisor as soon as possible.

Summary

It is worth remembering that the assumptions used for FRS17 purposes are no more than assumptions – the assumptions used for the ongoing funding of each scheme will be different and give rise to different costs and liabilities and the costs and liabilities associated with a cessation valuation (the amount an organisation has to pay if it leaves a scheme) will be significantly higher.

If you are part of a multi-employer scheme which makes full FRS 17 disclosures (i.e. the opt-out does not apply), actuaries will provide participants with a briefing note outlining the assumptions they will base the calculations on and these will be carried out on a consistent basis for all participants and will therefore, in most circumstances, not reflect the specific circumstances of the participating organisation and may be more conservative than the organisation might deem to reflect a best estimate approach resulting in higher liabilities, and therefore higher disclosed deficits. Independent advice at an early stage will allow assumptions appropriate to each organisation to be set and ensure that the ultimate results need be run only once.

Posted in: Blog
Tags: Accounting, Actuarial, FRS17