Posts by Alan

Alan Collins

Alan Collins

Head of Trustee Advisory Services at Spence he provides actuarial, funding and investment advice to trustees and sponsors of ongoing defined benefit schemes.
Alan Collins

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.

Alan Collins

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.

Alan Collins

UPDATE : FRS17 has been updated to FRS102 follow the link to find out how this affects you

 

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:-

Change Reduction in liability
Discount rate increased 0.25% per annum* £1.8 million
Salary inflation less 0.25% per annum (assuming 50% of members are active) £0.5 million
Price inflation and salary inflation less 0.25% per annum £1.8 million
Life expectancy reduced by 1 year £0.8 million

*- 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.

Alan Collins

‘Ello, I wish to register a complaint.  Much like Monty Python’s famous Norwegian Blue parrot, private sector defined benefit pension schemes are dead.  They are not resting, stunned or even pining for the fjords – they’re stone dead.

I therefore believe the calls by the UK pensions industry to shield defined benefit pension schemes from the effects of Solvency II are somewhat misplaced.  If the only reason for not adopting Solvency II is to prevent the further closures of such schemes, then these calls do not stand up to scrutiny.  Schemes have been closing rapidly under the existing regime and will continue to do so irrespective of European legislation.

Many employers overburdened by regulation and the dawning realisation of the real cost of pension guarantees have called time on defined benefit provision. The adoption of Solvency II may well further hasten this inevitable demise. For a large number of schemes, accepting this now will be a good thing in the long run.

The closure of schemes leaves two main issues: (1) should defined benefits constitute a cast-iron promise to beneficiaries and (2) how do we best close the funding gaps to ensure all liabilities are met?

The magnitude of UK defined benefit obligations have grown over time, often beyond the sponsors’ control. Layer upon layer of legislation, primarily relating to guaranteed indexation, has left employers to fund obligations which were not present or intended when schemes were first set up.  In effect, this has hindered the private sector from delivering pensions which can be guaranteed.

Beneficiaries certainly believe a promise is a promise and fully expect employers to stand behind their obligations irrespective of the above problems.  This feeling is heightened by the fact that fewer and fewer beneficiaries have an ongoing mutual interest in the prospects of the sponsor. However, by allowing measures which rely so heavily on employers, it is also clear that the UK funding regime has never been set up in a way to match the understanding of the beneficiaries.  It is a structure based on hope rather than expectation.

As integration across member states continues and the workforce in the EU becomes increasingly mobile, I would expect that benefit promises made by companies in all EU states will face harmonised regulation and enforcement. UK residents who end up working in other EU states would fully expect benefit promises to be honoured just as our European counterparts would surely expect the same protection working in the UK.

The expectation of benefit promises being honoured seems to make it inevitable that there will be levelling up of pension legislation across the EU, whether by Solvency II or other means.

The National Association of Pension Funds claims that the UK system already provides a strong level of protection for its members through the employer covenant, The Pensions Regulator (tPR) and the Pension Protection Fund. While the current regime is undoubtedly more robust, any inference that the existence of the PPF is a justification for a lower funding target should be discounted.

In support of this view, the Association of Consulting Actuaries believes that the current directive with its requirement for the prudent funding of technical provisions is providing ‘an appropriate balance between protecting members’ benefits and keeping the cost to employers at an affordable level’.  While balance is appropriate, I believe it would be a mistake to retain a lower funding target because it is all that can be afforded in the short-medium term.  It is much better to aim for the right target, even if it is going to take longer to get there.

As well as possible directives on Solvency II, there are a number of additional factors which support stronger funding targets such as the views of the Accounting Standards Board; the ultimate legal obligation on employers is already set at buyout; and the dominance of solvency levels in pension related discussions during mergers & acquisitions, where FRS and technical provisions are cast aside.

For all but the very largest of schemes, the only realistic end game is to buy out all of the remaining benefits with an insurance company as soon as it is affordable and efficient to do so.  In the meantime, the need for employer flexibility and the reluctance of tPR to accept very long-term recovery plans have lead to the adoption of weaker funding targets which rely on the ethereal employer covenant.  However this is the system we must work within at the moment.

Whichever way we end up reserving for and funding schemes, the UK pensions industry needs to face up to the fact that its biggest task is dealing with legacy deficits and not propagating the virtues of future benefit accrual.  The private sector defined benefit experiment has failed and the best that can be done is to ensure that current obligations to members are met. It is time to admit that the parrot is truly dead.

Alan Collins

I was in attendance on Friday at the first presidential address to the newly formed Institute and Faculty of Actuaries.

Mr Bowie’s speech was upbeat and set out an exciting vision for the future direction of the Profession. He was right to talk up the skill set that an actuary has to offer the wider business community, and reinforced that these skills are uniquely combined with a desire to act in the public interest and perform the role of a “trusted advisor”.

Innovation is not necessarily something we actuaries are renowned for, but the address included some promising signs. Tales of actuaries branching out into other areas such as banking, risk management and even electricity pricing were intriguing and should be pursued with vigour by the Profession. Spence & Partners will also look at the new Chartered Enterprise Risk Actuary (CERA) qualification with interest and see what the attainment of these skills could bring to our business.

All good, positive stuff, but my concern is: Who’s listening?

My reason for being in London was, in part, to meet up with three financial/pensions journalists. Not one was aware that the presidential address was taking place that day, and at least one did not recall who the Profession’s president actually was. Not a good start!

Rarely do we hear from the Profession on matters of great public interest, such as the ongoing debates around the ageing population and public sector pensions or the much talked about “inflation switch” from RPI to CPI. This void is filled by bodies such as the Pensions Policy Institute or the Office for National Statistics or even one-man bands such as Ros Altmann or John Ralfe. I long for the day that the Profession has the confidence to make its voice heard on important issues and fully support initiatives to make this happen.

On Friday, like most events at the Profession, I still qualified as “the young man sitting at the back”. This is a fairly worrying indictment of the Profession’s lack of engagement with younger members once the exams have been completed.

From the outside, I have always felt that the Profession has had the manoeuvrability of an oil-tanker when it comes to adapting to a fast-changing business environment – council for this, committee for that, with no clear agenda or purpose. Like Mr Bowie, I hope the recent merger of the Faculty and Institute can be a catalyst for change.

To sum up Friday’s event, I am confident that his message in the address was the right one, but am concerned that it was being delivered to the wrong audience (or worse still, no audience at all).

Alan Collins

Open market option for all?

I read with interest the guidance to individuals with money purchase benefits published on 2 November by the Pensions Regulator (tPR) and echo comments from Pensions Minister Steve Webb that “choices we make at retirement are amongst the most important of our lives” and “shopping around can provide better value for money and significantly boost retirement income”, and those from tPR’s acting Chief Executive Bill Galvin who has stated that “members could miss out on a higher retirement income because they are not well-supported in making good choices”.

The engagement of the Pensions Regulator in the education process within occupational defined contribution schemes is welcome, and emphasis has rightly been given to the potential benefits to members of obtaining independent financial advice. In particular, the guidance should act as a reminder to Trustees of schemes which provide both defined benefits and money purchase benefits that the members with money purchase benefits deserve due care and attention.

However, the guidance appears to be in stark contrast to the regulatory approach and pending legislation governing defined benefit arrangements, particularly those containing contracted-out rights. The “presumption of guilt” surrounding transferring benefits out of a defined benefit arrangement, and the potential end to the ability to transfer contracted out rights from defined benefit to money purchase arrangements in 2012, would seem to be at odds with the ethos of encouraging members to make choices which best suit their own circumstances.

For example, the value contained in some defined benefits (such as a prescribed level of pension increases or spouse’s pensions where the member is single or where the spouse already has a substantial pension), could be used to provide alternative benefits which are more suited to the needs of the individual concerned. Also the value of a money purchase pension pot can be retained on the death of the member, whereas this event may cause the value of a defined benefit to be significantly eroded .

I would therefore ask that members of defined benefit arrangements continue to be afforded the same opportunities to exercise their “Open Market Option” in the future.

Alan Collins

The UK Accounting Standards Board (ASB) has commenced a consultation exercise on the FRS 17 accounting treatment of changing the inflation measure for future pension increases from the Retail Price Index (RPI) to the Consumer Price Index (CPI). It is generally accepted that a change to CPI from RPI will reduce the value of pension scheme liabilities, possibly by upwards of 10 per cent.

The ASB’s Urgent Issues Task Force (UITF) correctly steers away from the precise implications of the government announcements and concentrates on the accounting implications of any changes that may occur.

In my view, Read more »

Alan Collins

Estimating life expectancy is an important part of an actuary’s job. Last month’s Office of National Statistics (ONS) report on the issue of life expectancy certainly brought a real focus to this important aspect of our role and, as a man who lives in one of the lowest ranked areas for longevity in the UK, it also cast a bit of an unwelcome shadow over my day.

Confronted by headlines such as ‘Scotland the Grave’ and ‘Increase in North-South Life Expectancy Divide’, the Scottish media highlighted how the recently published ONS survey showed how the average UK man will live until he is 77.9, compared with only 75.4 years in Scotland. The comparable figures for women are 82.0 and 80.1 respectively.

Somewhat worryingly for me, the average male in Glasgow will die aged 71.1 years. Unsurprisingly, given the health issues that continue to plague many parts of this city, this is the lowest for any area in UK. This is in sharp contrast to Kensington and Chelsea where the average man can expect to live for 84.4 years, exposing a staggering gap of over 13 years in life expectancy between two regions of the same country.

There are important lessons in the ONS study for actuaries, as well as for sponsoring employers and trustees of defined benefit schemes. For defined benefit arrangements, it is the scheme (and ultimately the sponsoring employer) who is exposed to the risk of how long each member lives. The longer each member lives, the longer a pension will need to be provided for and hence the cost of providing the pension increases.

The study reinforces the need to consider and manage the risks associated with life expectancy on a scheme-by-scheme basis. For each additional year of life expectancy, the reserves required – and the ultimate cost of the scheme – increase by around three per cent. So taking the extremes above, the reserving requirements could vary by up to 40 per cent!

However, we need to be careful on drawing conclusions from this study on two fronts. Firstly, members of pension schemes tend to live a lot longer than those with no pension provision – which gives me some personal comfort in relation to the above statistics. This is borne out of many studies on life expectancy by insurance companies and by analysing data from self-administered pension schemes. Currently, most pension schemes assume that current pensioners will live into their mid-late eighties and that future pensioners will live into their nineties.

Secondly, in my view – and this is where views in the actuarial profession differ – it is not geography but socio-demographic factors that matter where life expectancy is concerned. If geography alone was a significant factor, why would the gap in life expectancy between neighbouring areas such as Glasgow and East Dunbartonshire be over seven years, whereas the gap between Glasgow and Manchester is less than three years and only around four years between Glasgow and areas in London? This point was summed up by Duncan McNeil, Labour MSP for Greenock and Inverclyde, who said: “someone in my community can expect to live around 10 years less than someone else who lives just minutes along the road in a better-off area.”

This is why analysis at a postcode level is so important, where life expectancy is considered on a street by street basis. This is the most effective and accurate current method for assessing life expectancy for most pension schemes. I would urge trustees of schemes and sponsoring employers to ensure this area is given appropriate attention and that a postcode analysis is carried out at least every three years to coincide with the formal valuation of a scheme’s funding level. The only reason for departing from this is if your scheme is large enough to conduct its own mortality study. However, this would only apply to schemes with thousands or even tens of thousands of pensioner members.

Before I get completely morose about the ONS report and the implied implications on a Glaswegian male like myself, I can take some comfort that there are other factors at play in determining what ultimately accounts for the number of innings we are likely to be on this earth. It is important that these are also accounted for on a wider scale for those of us who manage pension schemes to ensure we have the appropriate funding levels in place.

Alan Collins

Following the recommendations of the Pensions Commission in 2006, the previous Government proposed the introduction of the National Employment Savings Trust (NEST), to address the lack of pension provision for employees who do not have access to workplace pension schemes.

From the perspective of employers, a major issue surrounding NEST is the likely cost of implementing the scheme, especially the associated administrative costs. An independent review has been carried out into the proposals for NEST – Making Auto Enrolment Work, which seeks to address the question as to whether the cost to employers imposed by NEST is necessary and proportionate.

Prior to the review, the proposed structure for NEST had the following key features:

  • Every business with at least one eligible employee must comply with the regulations.
  • An eligible employee is one who earns enough to pay National Insurance contributions.
  • All eligible employees must be enrolled immediately in the workplace pension scheme.
  • Employees are to be enrolled automatically, without need for application forms
  • Contributions are calculated from qualifying earnings (earnings in excess of the National Insurance Primary Threshold, currently £5,035 per annum, which include variable items such as overtime payments and bonuses).
  • Will be introduced in stages, commencing with employees of large companies, commencing in October 2012.
  • Minimum employer contributions commence at 1% of qualifying earnings from 2012 rising to 3% by 2017.
  • Minimum employee contributions commence at 1% of qualifying earnings from 2012 rising to 5% by 2017.

After consultation with business and the pensions industry, the authors of the report made the following key recommendations (which the new Government has welcomed).

  • Every business with at least one eligible employee must still comply with the regulations.
  • Contribution levels and phasing of contributions remain unchanged.
  • The earnings threshold at which an employee is automatically enrolled is increased to be equal to the personal allowance for income tax (currently £7,475 per annum). The threshold at which contributions are payable remains the National Insurance primary threshold.
  • An optional waiting period of three months should be introduced before an eligible employee is automatically enrolled. However, employees may choose to opt in at any time, and the company would then need to pay contributions.
  • The system by which employers can certify that their defined contribution schemes meet the required contribution levels should be simplified.
  • Further de-regulation measures should be introduced to ease the administrative burden on employers.
  • The current cap on contributions (£3,600 per annum) and ban on transfers in and out of NEST is to be reviewed in 2017.

The impact of the recommendations is to reduce the number of eligible employees by around 1 million, which will reduce the costs associated with NEST, especially for companies with a high proportion of low-paid workers. Further simplification and cost reduction is achieved by simplifying the certification process for businesses with current defined contribution schemes and by reducing the number of short-term employees who would be automatically enrolled. Clearly, the proposals surrounding NEST will continue to cause displeasure amongst small employers. There also continues to be a risk that contributions are levelled down in existing schemes to match the minimum requirements of NEST.

Employees may also choose to opt-out of their employer’s scheme. However, employers are not permitted to induce employees to opt out of pension schemes, and a company which did so would be fined from £1,000 to £5,000 (depending on the number of employees).

Please contact us for further information or visit the NEST website.

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.