FRS17 and the Actuarial Magician

Blog 02 Jan 2008 By
Smoke and mirrors is a metaphor for, amongst other things, an insubstantial explanation or description. The source of the saying is based on magicians’ illusions, where magicians make objects appear or disappear by extending or retracting mirrors amid a confusing burst of smoke. The expression may have a connotation of virtuosity or cleverness in carrying out such a trick.

If we extend the analogy to the pension’s sphere and the black arts of the actuary, smoke and mirrors seems a pretty apt description for our old friend FRS17. One minute you have a deficit and then, hey presto, its gone. And then, just when you’ve relaxed, with a wave of the hand and a modest run on the equity markets, you’re deficit is back again, having been hiding behind your ear all along.

But like all “magic” tricks once you understand how the FRS17 illusion works, then you wonder how you let yourself be fooled by it.
The end of 2007, start of 2008 saw the warlocks, wizards and magi of the actuarial profession revealing massive funding improvements and even surpluses to their enraptured audience. Now, barely a month into 2008, we can see again just how illusory pension scheme surplus is.

According to press release from Aon dated 22 January 2008, the recent stock market turmoil caused the biggest ever single daily increase in FRS17 deficits. At the close of business on Monday, the aggregate shortfall of the 200 largest British DB schemes grew from £2bn on 31 December last year to £33bn, The press release went on to say “Many companies have recently reported their deficits at December 31 and so will have narrowly escaped the agony of watching their quoted balance sheet deteriorate over a matter of days. This will be of great concern, however, to the many companies which are due to prepare annual accounts at 31 March.”

That’s all right then! Lucky timing can allow all those firms reporting at 31 December 2007 to conclude they don’t have a problem and don’t need to take any action to address the highly volatile liability hanging like a millstone round their company’s neck!

And another thing. What caused the reduction in deficits or emergence of surpluses reported at the end of 2007?  Well, there were a number of factors.

Firstly, genuine tangible improvement was the result of companies making a more realistic assessment of their liabilities and paying more money into their schemes.

Secondly, there were further improvements in the equity markets. At the risk of stating the obvious, this improvement is as ephemeral and volatiles as, well, smoke.

This point also highlights one problem with FRS17. Essentially it assumes that all pension schemes are invested solely in AA rated corporate bonds, but in the real world most schemes are not, and retain a high equity bias in their investments. You can, therefore, in certain circumstances, see your assets fall in value at the same time as your liabilities, as measured by FRS17, increase.

Thirdly, and this is the interesting one, there was an improvement in corporate bond yields. Sounds like a good thing doesn’t it? Let’s apply a little thought to what that actually means for pension schemes.

Since June 2003 solvent companies which sponsor final salary pension schemes in the UK are required, if they want to walk away from their scheme, to provide sufficient funds to fully guarantee members benefits, usually by means of an annuity purchase with an insurance company. This is known as the “buy-out” liability. The cost of purchasing this guarantee is related to a number of factors including gilt yields, the extreme caution of insurance company actuaries and a hoped for healthy profit margin for the insurer. This makes it very expensive.

So let’s not kid ourselves. Regardless of whatever number a company puts in its accounts, its real contingent liability in respect of a final salary pension scheme is the buy-out cost. Whilst companies can take action to manage their buy-out liability to some extent, there will come a point where it makes sense to buy-out the residual liabilities.

So what was happening to buy-out valuations towards the end of 2007? Gilt yields deteriorated, so companies real contingent liabilities were actually increasing.

As mentioned above corporate bond yields were improving. This is important for FRS17 because the discount rate used to arrive at the value of your liabilities in FRS17 terms is determined by the yield on AA rated corporate bonds.

Now what does that “improving” bond yield actually mean?

One of the reasons that corporate bond yields increase is because the market thinks the risk of default is increasing. Higher risk equals higher potential returns.

So FRS 17 deficits reduce because the market thinks there is more risk of problems in the corporate arena, which is likely to impact on both share prices and the chance of a corporation redeeming its bonds.

Which is where pensions schemes invest a lot of their funds.  Am I the only one who sees a problem with this?

What we saw at the end of 2007 was finance directors being presented with figures that would justifiably lead them to conclude that their pension problem was getting smaller when their contingent liabilities measured on a buy-out basis were actually increasing

As I write, the equity markets have enjoyed something of a rally and no doubt someone, somewhere, is writing an article about the biggest ever one day reduction in FRS17 liabilities. It will probably be headlined “Problem? What Problem?”.

It is important to understand that actuaries are professional mathematicians, not alchemists. No matter how hard they try, and no matter how clever the presentation, no mathematical model can really turn lead into gold.

Only when you properly understand the nature of your problem can you take appropriate steps to manage it. Look behind the smoke and mirrors.


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