Archive for September 2010

David Davison

Recent government announcements are likely to have a significant financial impact on pension scheme funding, the actuarial assumptions used, commutation factors and early or late retirement.

In June’s budget the government announced that it intended for future increases in public sector pensions to be linked to changes in the Consumer Prices Index (CPI). Historically such pensions were linked to increases in the Retail Prices Index (RPI).

A subsequent statement by the Pensions Minister on the 8th July confirmed that the government also intends to use CPI for determining statutory minimum increases which apply to private sector pensions. Read more »

Alan Collins

Warning – your actuary could be overstating your FRS 17 liabilities by up to 10% or possibly even more!!

The maturity or ‘term’ of your pension scheme is becoming increasingly important in setting assumptions for actuarial valuations and hence determining the value of the liabilities. In particular, FRS 17 states that scheme liabilities should be discounted at “the current rate of return on a high quality corporate bond (generally accepted to be AA rated bonds) of equivalent currency (£) and term to the scheme liabilities”.

So what about the term? This is the interesting, though unfortunately slightly technical bit!! Until a few years ago bond discount rates were generally unadjusted for term in FRS 17 calculations. The liabilities were therefore wrongly assumed to be of the same term as the maturity of the bond index (usually 12-13 years). Pension schemes are normally of a much longer term nature, from around 20 to 30 years on average. Between 2006 and 2008 where long term interest rates were unusually lower than short term rates, there was a significant push by audit firms for schemes to discount the liabilities using these lower rates – this significantly pushed up the magnitude of FRS 17 liabilities.

Recent movements in the shape of the interest rate yield curve mean that medium to long-term interest rates are now significantly higher than the rates implied by the AA index. For those firms already using a “yield curve” approach to assumption setting, the discount rate appropriate for FRS 17 will now be higher than the index yield and so FRS 17 liabilities will reduce, all else being equal (assuming the auditor agrees of course!!). It may no longer be appropriate to continue using the unadjusted bond index value as the discount rate, as this would currently overstate the pension scheme liabilities. All very easy for me to say you might think but what does this mean?

I estimate that for an average scheme, adopting a yield curve approach now could increase the FRS 17 discount rate by up to 0.5% per annum (or even more at very long terms), which would reduce FRS 17 liabilities by around 10%. So, if you receive FRS 17 assumptions advice or disclosures which stick rigidly to the AA bond index for setting the FRS 17 discount rate, you may wish to ask your advisor to reconsider, or seek separate actuarial advice.

For further information on FRS 17 assumption setting or other matters surrounding your scheme, please contact myself or any other member of the actuarial team at Spence & Partners.

Alan Collins

I read a recent article on the investment returns achieved by the ICI pension fund . The ICI fund was one of the first funds to implement a Liability Driven Investment (LDI) strategy back in the year 2000.

The article was lauding the fact that the fund had returned an average of 5.5% per annum over the last 10 years compared to 3.7% per annum for the average UK defined benefit pension scheme, according to the WM All Funds universe. All good news you might say, but on closer inspection what is it actually telling us, other than that the 3.7% per annum achieved by the average pension scheme is lamentable?

As most readers of this article will recognise, the purpose of an LDI fund is to provide returns which match the timing and nature of the cashflows required by the scheme. In broad terms, the LDI fund should rise in value if interest rates fall, or inflation rises. This will “match” the rise in liabilities (if a number of other assumptions hold). The converse is expected if interest rates rise, or inflation reduces.

In my view the article is really telling us that the fund returns were positive because interest rates fell, (which is good, because that’s what it is supposed to do). It tells us nothing about the real success of the strategy, i.e. how did the fund return relative to the changes in liabilities which it was trying to match, or indeed would a simpler, less costly holding in long terms gilts be just as successful when set against the undoubted cost of this strategy?

Depending on the movements in interest rates and inflation, a very successful LDI strategy could be one which gives rise to negative returns, as long as it matches what it is supposed to match.

So while the article on ICI makes for interesting reading, would it have been more valuable if the apples it described had been compared to other apples rather than a wider selection of fruit?

Neil Copeland

The first time I saw Def Leppard the drummer still had both his arms.

Not many bands visited remote outposts like Belfast back in the early 80’s and we were mightily supportive and indeed grateful to those who did, like Def Leppard. The band had already released a couple of albums but this was the start of the tour to support Pyromania, the album that was to push them into stadia around the world and was a precursor to their absolutely mega-album Hysteria. They put on a great show that night and, indeed, as an ageing rocker, I can attest that they still do.

But, as with many bands, global success will alienate that small sub-group who only ever like a band if no one else has ever heard of them. You know what I mean – the guy or girl who goes “Yeah I saw them in a pub in 1980 when they couldn’t play their instruments and it was only me and my dog in the audience, and they were sohhh cool, but now, like, they’ve just totally sold out and are rubbish. I’m really into Ethel the Frog now”. Luckily for fickle fans everywhere Ethel the Frog were never a success. Not so lucky for Ethel the Frog.

The Governments proposals on the abolition of compulsory annuity purchase seems to be subject to some equally fickle fans, if a recent article in the FT is to be believed.
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