How big is my pension deficit?

Neil Copeland

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What is the difference between a duck? Ask anyone that question and they will know instinctively that it’s a question to which there is no real, meaningful  answer. I usually go with “One of its legs are both the same” and find no one can really challenge me.

There is an article in Professional Pensions which says that accounting deficit figures and actuaries are mistrusted by “equity investors”, whoever they might be.

Now I’m not an actuary, and enjoy a laugh at their expense as much anyone, but, somewhat disturbingly, I found my sympathies were definitely with the actuarial profession on this one.

The reason for the lack of trust is apparently because the “equity investors” ask the question “How big is my pension deficit?” and are upset when the actuaries keep changing the numbers.  At first sight this seems like a reasonable question and doesn’t immediately alert the questioner to its absurdity in the same way that the earlier question about our feathered friend does.

If a meaningful and definitive answer is expected, then that betrays a lack of understanding about the nature of the question, which can have multiple answers at any point in time depending on the context and assumptions made. I can understand people being frustrated by this lack of certainty, but it is precisely this lack of certainty that means final salary schemes pose such risks for employers and has led to scheme closures in large numbers. It’s important to understand the actuary does not create this uncertainty but simply tries to help trustees and scheme sponsors identify and manage it.

For example, in terms of what has to go in the Company accounts,  the actuary is constrained in his answer by the requirements of FRS17. Again, it’s not the actuary’s fault that this approach has turned out to be extremely silly. Actuaries are required to discount liabilities for FRS17 by the yield on AA rated corporate bonds. In the past couple of years corporate bond yields have risen and its not uncommon for companies reporting at 31 March 2009 to be using a discount rate of around 6.8% per annum or higher. At the end of March 2007 the rate would have been around 5.4% per annum. All other things being equal a bigger discount rate means lower liabilities.

Over the same period Gilt yields have moved from 4.78% pa at March 2007 to 3.73% pa at end of March 2009. Buyout costs are linked primarily to gilt yields and many trustees have used gilt related bases for their ongoing scheme valuation – albeit allowing for a level of outperformance as a result of investing in real assets. All other things being equal a smaller discount rate means higher liabilities.

What this means, invariably, is that Finance Directors have been getting one message from their accounting numbers and a different message from their pension scheme trustees when negotiating funding rates. They and “equity investors” are right to mistrust the methodology for accounting for pension costs but wrong to mistrust the actuaries who, in the case of FRS17, effectively just crunch the numbers.

The reality is you can only know the true cost of a final salary pension scheme by adding up all the pensions and benefits paid out to members and spouses up to the point that the last beneficiary dies. Prior to that it is all just guesswork, but surely an educated guess is better than crossing our fingers and hoping everything will be all right?

I think it is also important for sponsors, particularly of closed schemes, to understand that, in reality, they are on the hook for the buyout debt. Advisers often shy away from this unpalatable truth as this is invariably a big scary number. But once you’ve closed a scheme, you’re in the endgame, and inevitably at some stage you will need to get to a point where buying out the scheme is achievable. Different schemes will make progress towards this goal at differing paces – there is no one size fits all plan. Nor am I suggesting that schemes should automatically target buyout funding once they close, especially if the reality is that the possibility of buyout can only be considered as a long term aspiration.

Once scheme sponsors recognise buyout as their long term objective they can take steps to manage that liability down over a period of time to bring the possibility of actual buyout and the removal of a potential millstone from around the Company’s neck that bit closer. So the situation is not hopeless and you can take proactive steps to deal with your final salary scheme. However, it probably requires you to trust your actuary and understand that he or she can come up with real answers – the key is asking the right questions.

Neil Copeland

Post by Neil Copeland

Director, pensions consultant and adviser to trustees and employers on all aspects of work based pension schemes.