Presented to the Institute of Actuaries Students' Society

on 19th March 1985

ACTUARIAL VALUATIONS OFPENSION SCHEMES

by

P. Worthington BSc, FIA

1. INTRODUCTION

1.1 The objective of this paper is to discuss the approach that

is appropriate to the actuarial valuation of a pension scheme and

which depends on both the circumstances of the particular scheme

and on the purposes to which the valuation results are to be put.

I believe that, while there is no substitution for actual

experience of a situation, an objective discussion can frequently

bring forward points and develop ideas in advance of the situation

arising in practice.

1.2 Both the accountancy profession and the OPB have published

reports requiring greater disclosure in and discussion of pension

scheme valuations and the Institute of Actuaries has, in response,

published EXD2 followed by GN9 which set out the items which

should be considered in actuarial reports. This paper discusses

items covered by GN9 as well as covering other aspects of the

actuarial valuation.

1.3 There are three areas in which pension schemes and those

providing them with actuarial advice are being put under external

pressure:

(i) There is increasingly an unwritten requirement for pension

schemes to increase pensions in payment. The sources of

such pressure include the press, pensioners, the

government, the OPB, active members (prospective

pensioners) and to a lesser extent, perhaps, the members of

the actuarial profession itself.

(ii) Some industries have experienced greater changes in the

number of members withdrawing than was previously the case

and the benefits available on withdrawal are, due to

preservation, contracting out, non-franking and (imminently

due) to the revaluation of deferred pensions, considerably

greater than ever before.

(iii) There is an increasing requirement for discussion of

actuarial matters from bodies outside the profession such

as accountants, the OPB, the government and trade unions.

Actuaries are being requested to provide certificates and

statements giving their opinion of the current and likely

future financial position of pension schemes.

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1.4 I have, throughout this paper, based my comments on thesituation of a privately invested final salary pension schemewhere the investments are either held directly or in managed fundinvestments of some kind. However, I hope that many of the pointsmade will be seen as equally applicable to other pension schemes.

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2 . THE PURPOSES OP AND CORRESPONDING APPROACHES

TO AN ACTUARIAL VALUATION

2.1 The purposes of an actuarial valuation of a pension scheme

must be to provide the actuary with a l l the information he

requires to give sound actuarial advice to his c l ient , normally

the trustees or the employing company, to enable him to satisfy

any legal requirements in relation to that scheme, e.g. the

provision of a Contracting-out Certif icate, and to provide any

actuarial statements about the financial position of the scheme

that may be required.

2.2 The valuation may be the regular, normally t r iennial ,

valuation of the pension scheme or i t may be a special valuation

undertaken because of significant recent or prospective changes to

the scheme necessitating a valuation. In either event, the first

step is to decide on the uses to which the results are to be put.

Once the purposes have been defined the actuary will be in a

position to consider the approach he will adopt, the assumptions

he will make, the approximations which can and cannot be justified

and the methods that are to be used to place values on the assets

and the l iabil i t ies being taken into account.

2.3 One frequent requirement from a valuation is the provision

of a statement for inclusion in the scheme accounts or in a notice

to members indicating either the level of benefits that would be

available to members in the event of the scheme's discontinuance

or the relationship between the assets and accrued benefits: the

two are not the same. I have concentrated on the discontinuance

statement because the actuarial considerations concerned encompass

those of the alternative statement. The actuary is being requested

to give his opinion on a factual matter (the assets to be taken

into account physically exist and the full membership details of

the scheme are available) only made theoretical by the scheme not

actually having been discontinued. He must address himself to the

situation as i t exists; the future intentions of the company (the

funding plan) do not form part of the formula. The discontinuance

position is discussed in Section 3.

2.4 If the membership of the scheme is contracted-out of the

additional component of the State scheme, the actuary will

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regularly be required to provide an Actuarial Certificate A

covering the following 5 years and enabling the membership to

remain contracted-out. The cert if icate covers the existing

position, and therefore involves a similar approach to the

discontinuance position, and also the short terra (5 years) future

position. The Actuarial Certificate A is discussed further in

Section 4.

2.5 The funding rate that is adopted for a particular pension

scheme is a function of both the chosen pace of funding and the

strength of the actuarial assumptions made. The pace of funding

and funding objectives can be discussed by the actuary with his

client the decision making responsibility being given to one or

other of them, depending on the rules of the scheme. The actuary

should draw his c l ients a t ten t ion to any advantages and

disadvantages that exist, and their consequent short and long term

effect, in the various approaches available. However, the final

decision on funding objectives may well rest with the company and

the actuary must then frame his investigations towards providing

appropriate advice. Most actuaries will agree that there is no

perfect set of financial and other assumptions to be made as to

the future experience of a pension scheme. For a particular

scheme, one set of assumptions will be stronger or weaker than

another and the whole spectrum of assumptions made by actuaries in

the on-going valuations of pension schemes forms a range from the

strongest to the weakest with probably some general broad

agreement as to the region in which the "average" assumptions l ie.

If a particular company is currently eager to put money aside in

the pension fund against the prospect of less profitable times in

the future (i.e. adopt a more forward funding plan) then the

situation may exist where quite strong assumptions would produce a

balanced position with the capitalised value of current and

prospective assets equalling that of current and prospective

l i ab i l i t i e s . An actuary would be just if ied in making these

assumptions provided that the financial implications for the

future should the assumptions made prove, in fact, too prudent are

carefully explained to the company. The assumptions clearly can

not be so strong as to advance the funding of the scheme to a

level unacceptable to the Inland Revenue. On the other hand, a

company may currently be re luctant to increase i t s annual

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commitment to the pension scheme and a balanced position may only

be obtained by use of a weak valuation basis or a funding plan

which delayed the funding of scheme benefits. These are more

difficult circumstances for the actuary. He must certainly draw

his client's attention to the fact that he considers the funding

rate to be too low and also to the consequences that will ensue in

the future if the experience of the scheme accords with actuarial

assumptions he would prefer to adopt: the company may, in the

event, be in the position of deciding on the funding rate that

will actually be paid. The question that arises is whether the

actuary should adopt his preferred moderate basis showing a

considerable capitalised shortfall in the on-going funding

position, perhaps alienating his client, or adopt an "in-between

basis" showing a smaller capitalised shortfall, encouraging a

moderate funding increase, while at the same time suggesting that

some further increase would not be discouraged. This is clearly a

matter for individual decision. The purpose of this brief

discussion of the on-going valuation basis is to emphasise that

there is no correct set of assumptions to be adopted for all

pension schemes or for any particular pension scheme and that the

actuary should have some flexibility in his approach if he is to

provide advice which is in accordance with his professional

judgement while at the same time providing an acceptable way

forward for the pension scheme. The on-going valuation is

discussed further in Section 5.

2.6 Sales and purchases of companies often involve pension

arrangements. Four parties are involved (the vendor company, the

vendor's pension scheme, the purchaser company and the purchaser's

pension scheme) although the agreement of sale is often only made

between the vendor company and the purchaser company. The amount

available for transfer from the vendor's pension scheme is

dependent upon that scheme's rules. Should i t be agreed that a

greater sum is to be transferred in the l ight of accrued

l iabi l i t ies , then the l iabi l i ty to meet the difference falls on

the vendor company. Similarly, the purchaser's pension scheme

cannot make available more benefit than the transfer payment

provides without other financial support. Again, any promise of

additional benefit must be financed by the company making the

promise. Both companies and trustees require actuarial advice

although frequently only two actuaries are involved each advising

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both a company and scheme trustees.

2.7 During the actuarial valuation of a pension scheme more

information on that particular scheme is available to the actuary

than at any other time. I t is therefore the opportunity for him

to consider the whole spectrum of advice that he is providing and

may be required to provide in relation to that scheme. He

provides advice on such matters as the level of transfer payments,

the level of benefits granted in respect of transfer payments

received, early retirement and late retirement percentages,

commutation terms and numerous other matters concerning individual

members.

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3 . THE DISCONTINUANCE POSITION

3.1 It has become increasingly common, and is now mandatory

through GN9, for pension scheme actuaries to provide a written

statement following each valuation giving their opinion concerning

the security of the benefits available to the members of a scheme

in the event of i t s discontinuance. EXD2 refers specifically to

this point using the phrase "value of the accrued liabilities" and

GN9 uses the term "accrued benefits". I interpret these terms (in

line with the guidance given in GN9) to be the liability imposed

upon the scheme in relation to each member by granting him, had he

been a normal leaver on the winding up date, the benefit required

through the effect of "preservation" under Social Security Act

1973 and (if appropriate) of the guaranteed minimum pensions for

employees who are contracted out under Social Security Pensions

Act 1975. These benefits have been increased further through

legislation prohibiting the practice of "franking" and prospective

legislation to require schemes to revalue deferred pensions during

the period prior to payment commencing.

3.2 In order to be a true discontinuance certificate the

calculations must assume the immediate withdrawal of further

company financial support: both the scheme's future expenses and

any State scheme premiums would need to be met from the assets

available.

3.3 It is important to consider the use to which the statement

is to be put, the people to whom i t is to be presented, their

likely level of understanding of the terminology that is available

to the actuary for inclusion in the statement and the assumptions

that the reader will implicitly make about the statement unless i t

clearly states otherwise. The statement must state clearly the

level of benefit that could be provided in the event of the

scheme's discontinuance. For example, a statement incorporating,

as i ts main phrase, the words "all benefits to which the members

would have become entitled had they withdrawn from the scheme on

that date" would appear to be quite clear. However, even this

could be argued as vague on the point of early retirement options

which could be treated differently depending on whether or not the

trustee's consent is required before they are available. A

statement using the words "the assets then accumulated by the

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trustees were sufficient to secure the level of benefits at that

date" is not at all clear. In a winding up the level of benefits

is often stated in the rules to be the amount that the assets are

sufficient to secure.

3.4 GN9 indicates that a discontinuance statement should be

provided for a pension scheme as a regular event and further that

the percentage cover should be given if i t is less than 100 per

cent. I agree that the percentage cover, if in excess of 100 per

cent, should not necessarily be given as i t may easily be taken by

the less well informed as a sign that a pension scheme has money

to spare and thus could be used to increase the pressure for

improvements in benefits which cannot be afforded. The difficulty

in according with GN9 and giving the percentage cover if less 100

(of which in principle I am in favour as i t creates pressure for

funding improvements to poorly funded schemes by informing members

of their level of security) i s the assumptions that must be made

in the calculation of that figure. The need to make assumptions

means that the figure becomes an opinion rather than a fact and is

therefore open to dispute. The major considerations to be taken

into account when completing the discontinuance calculations are

discussed in the following paragraphs.

3.5 If the rules of the pension scheme in question provide for

pensions in payment to be increased on a guaranteed basis then i t

would be factually incorrect if these increases were not taken

into account in the benefits valued. However, some pension schemes

have a history of providing pension increases although they are

not guaranteed in the rules. A reasonable expectation of future

increases may well exist. Such increases are being funded by the

company either by making special funding payments or by forgoing

contribution abatements at successive valuations and, in the

context of a discontinuance, I feel that i t i s reasonable to

assume that the scheme need not continue to grant future increases

as i t will receive no further company financial support. However,

unless a discontinuance certificate is clearly worded a reader may

easily receive the impression that the expectation of future

pension increases would be supported.

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3.6 If the members of the pension scheme are contracted out of

the additional component of the State pension scheme then a part

of each member's benefit could be secured by the payment of an

Accrued Rights Premium to the DHSS provided, of course, that the

scheme rules allowed some offsetting reduction of benefit in these

circumstances. In current conditions this would be cheaper than

securing the benefit elsewhere. However, the ARP market level

adjustment is being varied each year until 1988 when the premiums

will be larger than they are at present. I feel that a statement

should not rely on the current adjustment rather than the higher

post 1988 adjustment in order to break the OPB 100 per cent level.

The level of funding would need to rise if the discontinuance

cover were not to be eroded in the future. The problem remains

that the Government Actuary may recommend further adjustment after

1988.

3.7 Two methods exist for placing a value on the accrued

liabilities not secured by the payment of State scheme premiums:

(i) the actuary could calculate the assets he would require

were he advising a closed fund designed to provide those

benefits; or

(ii) the actuary could calculate the amount that a reputable

insurance company would charge if the scheme trustees were

to purchase the benefits.

Method (i) would require the actuary to make allowance for the

future expenses of administering the scheme, over perhaps the

following 60 years. I t would also be a matter of opinion, at the

date of discontinuance, as to whether or not the actuarial

assumptions adopted were too s t r ingent or insuf f i c i en t ly

stringent; only the future experience of the closed fund would

provide the answer.

Method (ii) involves no such problems, or at least passes them

over to the insurance company, and is therefore the method I would

use even though i t can be expected to provide a conservative

figure.

3.8 The most common approach to determining the total premium

that an insurance company would charge is to obtain a set of

typical single premium rates for immediate and deferred annuities

and to apply these to the calculated benefits. However, if an

insurance company were to take over the full portfolio and to

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calculate the required total premium on the basis of future cash

outflows i t could considerably improve on those single premium

rates by noting the greater amount of total benefit that could be

matched and met without the need for reinvestment. I t is

theoretically possible to have a mix of immediate and deferred

annuities which could be supported without any reinvestment and

hence for which the purchase price could be calculated using the

interest rate available in the market. I am unaware of any

situation where an insurance company has agreed to use rates other

than i ts single premium rates with perhaps a small reduction on

account of the volume of the business. The point is therefore

perhaps more theoretical than practical.

3.9 Having placed a value on the discontinuance liabilities the

actuary must also place a value on the scheme's assets. The total

of the single premiums that an insurance company would charge is a

current cost and the appropriate valuation of the assets is

therefore market value. The following problems can arise and

should be identified:

(i) Large portfolios of investments cannot be turned into cash

within a short space of time without producing a

significantly lower sum than their quoted market value.

The assumption must therefore be made that the insurance

company approached would accept most, if not a l l , of the.

existing portfolio of investments as the consideration.

The question then arises as to how to deal with a large

portfolio with substantial overseas or other investments

where an insurance company may not find the portfolio

acceptable for a large volume of U.K. immediate and

deferred annuities. If the point is of significance to the

statement being provided, the solution may be to include

the investments at a written down value or to qualify the

statement accordingly.

(ii) Some pension schemes have large property holdings. Market

values are usually prepared on the basis of a willing buyer

and a willing seller and in times when the property market

is weak a forced sale may be virtually impossible at any

reasonable price. Properties may be held at book value,

which may be an over or an under valuation. Even recent

property valuations by professional advisers can provide

Paae 10

figures which are found to be considerably wide of the mark

when a property is actually sold particularly if a forced

sale is necessary.

(iii) Portfolios may include unquoted investments, although

usually not significant holdings, which produce valuation

problems similar to property holdings.

(iv) The assets of a pension scheme can include shares and fixed

interest stock of the employing company as well as debtors.

Debtors can be divided between the employing company and

other debtors. This last category will probably be small

and can normally be taken at full value, the scheme

accountants should have included any necessary bad debt

provision. More care is required for any debts owed by the

company and any company stocks and shares held. Should

they be excluded, be included at a written down value

recoginising their probable worth in a discontinuance

situation or be included at full value with a suitable note

on self investment? Some contracted-in pension schemes have

a large percentage investment in the employing company and

only the last course of action would enable a 100 per cent

discontinuance certificate to be given.

3.10 If a true discontinuance of the pension scheme is being

considered allowance needs to be made for the expenses involved.

If the pension scheme is a large scheme the assumption may be

possible that the margins already included in the calculations

will be sufficient to cover any expenses. For small pension

schemes this is unlikely to be true and proper allowance should be

made. Even if the company has normally met the expenses of the

scheme, the winding-up provisions invariably provide for the

scheme to meet i t s own expenses.

3.11 I have dwelt at length on the problems involved in giving a

discontinuance statement for a pension scheme because I feel that

all problems should be identified for each pension scheme before

the actuary, in the majority of cases, can dismiss them due to the

size of the margin of safety indicated by his i n i t i a l

calculations. I believe that I have also i l l u s t r a t e d the

significant expense that would be involved if a discontinuance

certificate giving an accurate percentage cover were required in

all cases. However, in those schemes where these i n i t i a l

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calculations indicate a cover of less than 120 per cent, say, then

closer attention must be paid to the problems noted above. In

particular, where more accurate calculations indicate that the

cover is less than 100 per cent, and should this figure be

published, then i t becomes very important that the pension scheme

actuary is fully aware of the assumptions underlying the figure he

is giving. The pressure for some short term financial plan to

correct this situation will be produced and the employing company

will undoubtedly wish to question the actuary or at least discuss

the assumptions made in the calculations. It is always possible

that the employing company may decide to commission i t s own

discontinuance valuation separately from the trustees.

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4 . THE ACTUARIAL CERTIFICATE A

4.1 The actuarial calculations and considerations that enable

an actuary to sign an Actuarial Certificate A (which allows

members of a pension scheme to be contracted out of the

additional component of the State scheme) are not dissimilar from

those of Section 3, the discontinuance position. However, there

are a number of differences that should be noted in the

investigation:

(i) The Actuarial Certificate covers both the current position

and the position during the subsequent 5 years. There are

thus two elements to be considered, the existing level of

funding and the rate of contribution being paid to the

scheme. In the large majority of schemes this latter item

is significantly in excess of the minimum required and

l i t t l e investigation is needed. Situations do arise

however where, because of a recent large redundancy

exercise for example, the current funding rate has been

reduced to a low level and further consideration i s

required before the Certificate can be signed.

(ii) The order of priority of the l i ab i l i t i es of the pension

scheme is important. Although GMPs for active members

normally have priority over the provision of full leaving

service benefits for active members there can be exceptions

to this, particularly in respect of benefits accrued prior

to April 197 8. The provision of an Actuarial Certificate A

would therefore, considering only the current situation,

normally require a lower level of active member benefit

security than the provision of a discontinuance certificate

showing at least 100 per cent cover.

(iii) The Cer t i f i ca t e A requi res that a l l reasonable

eventualities during the 5 year period must be taken into

account. These include the possibility of significant

numbers of early retirements or withdrawals where the

benefits of the members concerned would move into a prior

l iabi l i ty class. The early retirement aspect is now

referred to in an undertaking that the OPB require the

employer to sign. It is unclear to me whether or not this

reduces the actuary's responsibility in this respect. The

withdrawal point remains.

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(iv) The OPB have set firm guidelines on the approach to betaken to concentrations of investment and to selfinvestment.

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5 . THE ON-GOING ACTUARIAL VALUATION

5.1 The on-going funding rate for a pension scheme is by

definition the rate required to secure, on the actuarial basis

used and funding plan adopted, the benefits promised. The need to

make assumptions as to the future experience of the scheme means

that the outcome of the calculations is more subjective than the

outcome of the discontinuance calculations where both the assets

held and the l i ab i l i t i e s to be met can both be defined. However,

for the reasons explained in Section 3, I would not necessarily

expect two actuaries acting independently to obtain a much closer

figure for the percentage cover than I would for their recommended

on-going funding rate. Few recipients of funding advice would

wish to be presented with a whole range of funding rates based on

varying assumptions; most would much rather receive advice in the

form of a recommended funding rate, the effects of which the

actuary is willing to discuss. The object of the on-going

actuarial valuation is therefore (i) to calculate a single funding

rate that is to be recommended, and (ii) to enable the actuary to

discuss with the trustees and company the effect on the scheme's

financial position that deviations in the future experience of the

scheme, from the assumptions made, would have.

5.2 A valuation basis consists of assumptions as to all aspects

of the pension scheme's future experience both with regard to

mortality and other decrements and to financial matters. The

strength of the basis (the smallness of the probability of the

recommended funding rate proving insufficient) cannot be assessed

by looking at any one assumption; the basis must be considered as

a whole. It is quite possible to demonstrate for a particular

scheme that a valuation basis using a 6 per cent per annum rate of

interest can produce the same on-going funding rate as one using a

10 per cent per annum rate of interest.

5.3 The frequency with which trustees, employers and other

parties interested in the pension scheme ask questions which begin

with what if" and proceed to refer to a variation in experience

from the assumptions made, or from one of the assumptions made, is

increasing. The effect of this has been a tendency to move away

from assumptions incorporating low rates of interest towards

assumptions incorporating a higher rate of interest and where each

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of the assumptions made can be more readily justified and

discussed separately rather than by continual reference to the

total basis. This is analogous to the net premium and gross

premium valuations of a l i fe office. GN9 recommends that in the

part of an actuar ia l valuation report which discusses the

assumptions made "attention should be directed particularly to

those assumptions to which the contribution is sensitive". The

"net premium" basis presents a larger communication problem than

the "gross premium" basis.

5.4.1 The main elements of the actuarial basis for an on-going

valuation of a pension scheme are discussed in the following

paragraphs. My comments assume a "gross premium" basis. The

treatment or valuation of the invested assets of the scheme is

discussed separately in Section 6.

5.4.2 The three main financial assumptions to be made are (i) the

rate of investment return (income and capital gain combined) that

will be available on future new investments, (ii) the rate of

future salary progression (including both promotion and

inflation), and (iii) the rate of increase of pensions in payment

to be taken into account. The majority of bases currently in use

adopt a rate of return between 7 and 10 per cent per annum; i t is

unusual to find a non-integral rate of future investment return.

The Government Actuary used a rate of 9 per cent per annum in his

calculations concerning the earnings related State scheme. The

assumed rate of future salary or earnings progression must include

allowance for both inf lat ionary and promotional (normally

appropriate to staff employees) increases. These can either be

combined into one assumed rate of increase or be treated

separately using a salary scale. A combined rate would, in the

majority of bases, be between 0 and 3 per cent per annum lower

than the assumed rate of investment return. There is growing

pressure for some increases to be provided to pensions in payment.

Where increases are not guaranteed in the scheme rules but there

is a history of them being granted or a desire to be able to grant

them in the future then some assumed rate of increase is

appropriate, always provided that the rules of the scheme are

phrased in such a manner as to make this acceptable to the Inland

Revenue. Some trustees and employers find i t easier to understand

Page 16

a basis which is less cautious in its salary growth assumption but

which includes an allowance for uncovenanted pension increases

rather than one with no allowance for uncovenanted pension

increases but where the salary and interest assumptions are more

stringent. It is quite possible that these two approaches would

produce similar recommended on-going funding rates and allow

similar levels of pension increases to be granted at subsequent

actuarial valuations. I mention this point as an illustration of

the need to consider the whole actuarial basis, rather than just

one or two elements, when deciding upon i t s strength relative to

another. It also i l lustrates the need to consider, in advance,

the questions that may arise and the way in which they can be

answered. Understanding the financial assumptions made means

understanding the consequence of variations from them in the

future experience of the scheme. A combination of experience and a

selection of the calculations now possible by modern computers on

different actuarial assumptions appears essential.

5.4.3 The assumption made concerning the level of future

withdrawal from the scheme is normally either a nil incidence of

future withdrawal or a level of withdrawal that the scheme is

likely to experience in the situation of the employing company

continuing to trade at i t s current level. Many funding methods

such as the aggregate funding method where the total funding rate

is expressed as a percentage of total salaries have the feature

that, for young members, the value placed on the future

contributions calculated on that member's salary exceed the value

of the liability in respect of both his past and potential future

service; the member is an "asset" or negative value. The effect

of such a member leaving the scheme, if he is in addition to the

assumed number of leavers on the valuation basis, is for the

scheme to both lose an asset and incur a l iab i l i ty in respect of

the benefit granted. This lat ter item has, over recent years,

steadily been increased. The question must therefore be asked

"what if the assumed rate of withdrawal proves incorrect?" Should

fewer withdrawals occur than expected then a scheme is unlikely to

be adversely affected because assumed withdrawals are normally at

young ages where a withdrawal reserve would be a positive item.

Should more withdrawals occur than expected then the extent of any

strain will depend on the scheme's level of funding at the ages

concerned: if the past service reserve is P, the future service

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reserve is F and the value placed on future contributions C, then

(i) if F>C the valuation reserve will almost certainly support the

leaving service benefit, (ii) if F<C but P+F-c>0 there may again

be no strain depending on the level of P+F-C compared with the

benefit granted, and (iii) if P+F-C<0 a valuation strain will

occur unless the leaver is also replaced by a new entrant of, say,

the same age and salary so that P will be available to meet the

benefits granted. The effect of future withdrawals cannot always

be ignored because i t is not always appropriate to assume that the

leaver will be replaced by a new entrant.

5.4.4 If, as seems reasonable, we assume that the value of a

withdrawal benefit is less than a past service reserve calculated

on a final salary basis then the seemingly anomolous situation

exists that, although new entrant funding rates are higher on a no

withdrawal assumption than on a with withdrawal assumption, the

aggregate funding rate for a pension scheme is lower. This

situation is explained by the fact that a marginal increase in the

funding rate for a young member, calculated on a no withdrawal

basis, i s of a much greater value than one calculated

incorporating a withdrawal assumption. I illustrate this with the

crude example of a scheme of two members, one aged 25 and one aged

60 where the new entrant funding rates on a no withdrawal basis

are, say, 8% and 12% respectively. A no withdrawal valuation will

produce an on-going funding rate of perhaps 8.5%. A valuation

that has a withdrawal probability of unity at age 25 will have an

on-going funding rate of 12%.

5.4.5 The experience of some companies over the last 5 or so

years has often been one of a sudden reduction in the work force.

This may be due to an early retirement programme, a redundancy

exercise or the closure or sale of some aspect of the business.

It would be impossible to build the probability of such a future

experience into a valuation basis. However, such things can and

do happen and i t is therefore important that the information

provided by the valuation should enable such points to be

considered. Frequently the first that an actuary knows about such

a situation is that the withdrawals have occurred or are occurring

and the client is now seeking advice on the effect that i t will

have on the pension scheme. The effect will vary from one scheme

to another depending on both the rules of the scheme and the state

of funding of the scheme.

5.4.6 The future experience of a pension scheme will , unless i t

is a closed scheme, include increments by way of new entrants as

well as decrements. Calculation methods can allow for an

incidence of new entrants to the scheme other than by the method

of not using a withdrawal decrement as discussed above. One

effect of including a new entrant increment could be to extend the

term of the calculations to infinity! It is important to consider

the funding rate that will be required to support future new

entrants at a range of ages so that their effect, which can be

either to increase or to decrease the existing funding rate, can

be anticipated and taken into account in any advice given. If the

funding rate for typical new entrants is considerably less than

that brought out by the valuation then, in order to lessen the

current pensions burden, the actuary may well feel able to discuss

the effects of adopting a lower rate than that indicated by

considering only the existing membership, knowing that in future

valuations the on-going funding rate can be expected to fall under

the effect of new entrants. If the funding rate for anticipated

future new entrants is higher than the on-going funding rate then

to recommend the maximum immediate reduction could be to hide the

fact that an increase is anticipated following future valuations.

5.4.7 Many pension schemes provide an immediate pension benefit

to members who retire due to i l l -heal th. A decrement based on a

suitable pension scheme past experience is appropriate. In recent

years some employing companies have "extended" their definition of

ill-health as a possible alternative to making members redundant.

This is beyond the actuary's immediate control and the normal

effect is to place a strain on the pension scheme which will then

emerge at the next actuarial valuation. It would not be feasible

to allow for the probability of such a short term future practice

within the decrement table and the actuary's only approach may be

to draw the financial effects of this practice to his client 's

attention as he becomes aware of i t .

5.4.8 The rules of most pension schemes allow members to ret ire

early other than on grounds of i l l -health. If the level of

benefit available on early retirement is such that a member

retiring early does not place a strain on the scheme in terms of

increasing the funding rate necessary to support the remaining

members then there is no need to incorporate any early retirement

decrement in the valuation assumptions. The early retirement

option offered by some schemes, e.g. the full accrued pension

taken immediately if retirement is within 3 or 5 years of normal

retirement age, i s s imilar to operating a reduced normal

retirement age for those requesting i t and forms an "option

against the scheme". Some allowance must be made. One method

available is to calculate the age at which the greatest potential

financial strain exists and then to calculate the on-going

funding rate assuming that a certain proportion of members retire

at that age, the rest remaining until normal retirement age. The

question to be settled is the proportion to be assumed. One

approach would be to assume 100 per cent but this would almost

certainly not be borne out by the scheme's future experience and

would present a funding rate to the company which was higher than

necessary. The company's opinion must be sought as to whether the

past experience, if any, can be taken as a guide to the future or

whether changes in the company's approach to retirement will vary

significantly the proportion going early.

5.4.9 Many mortality tables are available from which the actuary

can select both death in service and death in re t i rement

decrements. The mortality of pensioners, and most importantly,

future pensioners should not be understated. I t is possible to

argue that, depending on the level of death in service benefit, a

table incorporating a high mortality decrement at low ages and a

low mortality decrement at high ages would be the cautious

approach to in service mortality. This may be an interesting

theoretical pursuit but in practice I would not anticipate finding

tables much different from A67/70 or some similar experience.

5.5 An on-going actuarial valuation usually includes as assets

both the invested fund and the capitalised value of future

contributions assuming that they continue to be paid at the

current level. The l iabi l i t ies similarly include the capitalised

value of l iabil i t ies both in respect of completed service and in

respect of future service. Subtraction of total l iabi l i t ies from

total assets produces a figure often referred to as a "surplus" or

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a "deficit". This will only emerge, over the future of the

scheme, if the future experience corresponds to the valuation

assumptions made including the maintenance of the current

contribution level. The main factors which have contributed to

this "surplus" or "deficit" will be shown up by an analysis of

surplus normally conducted on the previous valuation basis. It is

important to distinguish between one-off contributory factors and

those indicating long term change. The valuation balance is often

redressed by the company adjusting the level of i t s future funding

rate over either the short or the long term. If the valuation

reveals a "surplus" then pressure to improve the lot of pensioners

or to improve the benefits accruing to current members can arise.

Any increase in pensions or deferred pensions or in the value of

the benefit payable to one class of member more than another

affects the level of benefit that would be available to active

members in the event of the scheme's discontinuance. If the scheme

is in the position where leaving service benefits to active

members are covered less than 100 per cent on a theoretical

discontinuance then the potential inequity of the proposed changes

must be bought to the trustees'/company's attention. If the

scheme were able to support this enhanced level of benefit and

maintain the 100 per cent cover then the practical requirement

that a pension scheme must be allowed to evolve via pension

increases and other benefit improvements has a bearing on deciding

what is a fair approach to be taken. If some of the revealed

"surplus" were to be used for benefit increase purposes then this

could be considered as a reduction in the funding rate combined

with a benefit improvement funded by a special additional funding

rate equal in value to the additional benefits granted. The term

of this special payment may be longer than the term of the

additional benefits being provided thus reducing the pace of

funding of the scheme.

5.6 Section 3 discusses statements, provided by the actuary,

covering the discontinuance position of the scheme. Actuaries are

more frequently than previously being requested to provide

statements concerning the adequacy of the on-going funding rate.

(I have assumed that the valuation method used is an aggregate

funding or similar method and not a discontinuance funding

method.) If the actuarial valuation on which the statement is

based showed a balanced position, i .e. the capitalised value of

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future contributions at the current rate was equal to the

difference between the capital ised value of current and

prospective liabilities and the value placed on the invested fundf

then a statement along the following lines can be contemplated:

"If the future experience of the scheme is no less favourable than

the financial and other assumptions underlying the l a t e s t

actuarial valuation then the on-going funding rate will be

sufficient to meet the scheme benefits as they fall due." A

statement of this form frequently meets the requirements of those

seeking i t , often for inclusion in the pension scheme accounts.

However, the statement does not provide a guide as to long term

benefit security because i t does not consider the actuarial

assumptions made. If those assumptions had, for example, involved

a 3 per cent difference between the assumed rates of future salary

growth and investment return then the statement would be less of

an assurance for the future than had the assumed difference been 1

per cent. One way forward, intended to improve the statement, and

which some accountants pursue is to l i s t the main valuation

assumptions. This format would place on the reader, possibly a

pension fund member or other non actuarial reader, the onus of

interpreting the "strength" of the basis for himself. If he could

do that properly, without training, then surely he should be

joining the actuarial profession. One person who can properly

place the assumptions in context is the actuary making the

statement and an additional sentence expressing the level of the

actuary's satisfaction with the assumptions adopted could be made.

He may consider adding; "I consider that the assumptions made,

taken together, form a sound financial structure for the on-going

position of this pension scheme". If the basis adopted were

weaker than the actuary would perhaps wish to use, had

circumstances permitted, then his thoughts may run along the

lines; "I consider that the assumptions made, taken together,

although forming a less prudent picture of the future than I feel

may indeed be experienced, do not represent so unlikely an event

as to be unreasonable." Such wording may prove, however, not to

be altogether what the company/trustees had in mind. The question

which I pose i s : "Should an actuary (or the profession

collectively) be content to issue statements concerning the on-

going position of a pension scheme which are both true and

acceptable to the company/trustees but which do not answer the

real question which is being posed?"

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6. THE TREATMENT OF THE INVESTED

ASSETS IN THE ON-GOING VALUATION

6.1 The actuarial valuation of the assets and l i ab i l i t i es of apension scheme requites a value to be placed on those assets andl iabi l i t ies each of which consist of a past element and a futureelement. Section 5 considers the value placed on the futureassets (i.e. promised future contribution income) and on thel iabi l i t ies both in respect of past and of future service. ThisSection considers the value to be placed on the past assets, theinvestment portfolio.

6.2 I have only considered investments in the form of adirectly held investment portfolio (including managed fund units).I have not considered the situation where the invested assets arein the form of insurance or annuity contracts.

6.3 Traditionally there are three methods of placing a value onthe invested assets, namely; (i) their book value, (ii) theirmarket value, and (iii) their discounted value obtained bydiscounting the stream of investment income and redemptionproceeds that i t is anticipated they will generate in the future.Both the market value method and to a lesser extent the bookvalue method have had and do have their proponents and indeedthere are circumstances (for example a mature closed scheme) wherean asset valuation at market value would be the approachsupported by the large majority of actuaries. However, in thegeneral case of an on-going pension fund, I believe that thebalance of the argument falls in favour of the discounted cashflow method. I do not intend to reiterate the well establishedarguments both for and against the discounted cash flow methodexcept to note, for future reference, the main advantages of themethod. These advantages are (i) i t provides a stable value intimes of temporary market fluctuations so avoiding unnecessaryalterations to the funding rate, and (ii) i t is consistent withthe valuation of the l i ab i l i t i es and future contributions whichare also valued by discounting future expected cash inflows andoutflows.

6.4.1 I do not, however, believe that the discounted cash flow

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method does not have any shortcomings, because i t does. Firstly,

i t places a value on the investments which is neither of the

values (market value and book value) with which the average

pension fund trustee is familiar. I t can thus help to create a

mystique about the actuarial valuation which can inhibit a trustee

from making enquiries or seeking clarifications which would

enhance his understanding of the valuation.

6.4.2 Secondly, and much more importantly from an actuarial point

of view, the method can place a different value on fixed interest

securities relative to their market value than i t does on equities

relative to their market value. I t is not unusual for a pension

scheme's investment managers to have a fairly free hand in the

investments that they make and the investment strategies that they

adopt and hence two valuations conducted as l i t t l e as three months

apart could place a significantly different value on the invested

assets of the same pension scheme if during that time the

investment manager's view of the correct investment posture had

altered. This weakens one of the main advantages of the method,

that of stability over time.

6.4.3 If the actuary conducting the valuation stuck rigidly to a

system he derived earlier i t is theoretically possible for the

results of an actuarial valuation to be deliberately distorted by

the scheme adopting the investment spread which provided a higher

discounted value. I am sceptical about whether or not such a

situation would arise in practice but I can see that i t might,

say, where a company or a subsidiary company with i ts own pension

scheme were being sold and an actuarial report showing as well a

funded pension scheme as possible would be a distinct advantage to

the vendor.

6.4.4 Thirdly, while the discounted cash flow method is readily

applied to U.K. fixed interest and equity investments, i t is much

less readily applied to other investment sectors, namely overseas

stocks, property, index linked gilts and cash. The proportion of

pension scheme assets invested in the first three of these sectors

has increased significantly in recent years.

6.4.5 A scheme's overseas holdings can be fairly thinly spread

across numerous markets and there are many areas for which a

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market index is not available. Investment abroad is often only in

a few of the economic sectors available and often then only in a

few large companies; a whole market index, if available, is not

necessarily appropriate. Even where an appropriate index is

available a decision must be taken as to the dividend growth rate

to be assumed. Can an actuary sustain the assumption of a

different dividend growth rate to that assumed for U.K. equities?

A lower growth rate assumption could be argued for due to the

added risks in investing abroad. However, if the index yield

(allowing for withholding tax as appropriate) is less than the

U.K. index yield then the effect would be to write down, relative

to market value, the overseas investments compared with the U.K.

investments. A trustee, or investment manager, with significant

overseas exposure may query why, if the actuary takes such a

pessimistic view of overseas investments, he has not spoken up

more strongly against them when investment policy has been under

discussion. On the other hand, taking into account the added

risks involved through investing abroad, i t would seem

inappropriate to place a higher value on overseas investments than

on a similar market value of U.K. investments.

6.4.6 property investment can range from a holding of managed

fund property units, possibly representing a broad property

portfolio, to one or two single large properties. A property

equivalent of the FTA All-Share Index, providing market level and

yield, does not exist. Even if i t did, could i t be used when, in

the case of the single large property, marketability cannot

readily be assumed. Using the actual rental income on the

portfolio held is a possibility but again, as with overseas

investments, some future rate of income growth must be assumed.

The assumption of a rental growth rate which provides either a

more favourable or less favourable value when compared with U.K.

equities can, as with overseas holdings, invite difficult to

answer questions about the actuary's approach to investment

advice.

6.4.7 Index-linked g i l t s are a recent introduction to the

investment market and are generally considered more an alternative

to equities (or to property) than to fixed interest investments.

A discounted value could be placed on them by making an assumption

Page 25

as to the future level of inflation, consistent with the other

assumptions in the actuarial basis. However, as with the overseas

and property holdings, this could invite comparisons with the

treatment of a similar market value of U.K. equities.

6.5 The direct or indirect use of market values in most methods

of valuing the invested portfolio raises the additional question

as to the steps to be taken to ensure that the market values shown

are reasonable. If the valuation of stocks and shares i s

conducted by a merchant bank (a professional investment manager)

then can i t be taken without further investigation? Market values

of property holdings, gold, diamonds etc. are normally provided by

professional valuers. Does checking that the valuation has been

conducted by a professional valuer constitute a sufficient check?

These comments are equally important to Section 3, the

discontinuance position.

6.6 Overseas, property and index-linked investments all serve

to broaden the equity type investment of the pension scheme by

taking advantage of other investment opportunities and will in

theory provide a more stable market value for the whole portfolio.

An investment manager must not expect a lower return from the

diversified portfolio, a more stable market value is not more

important than long term return. If diversification does not

imply a lower expected long term future investment return than is

expected from a pure U;K. equity portfolio then, by implication,

treating the four sectors of U.K. equities, overseas stocks,

property holdings and index-linked g i l t s as one combined U.K.

equity portfolio must be a conservative approach. One natural

conclusion i s therefore that if these sectors are t rea ted

separately, presumably to place a lower value on the non-U.K.

equity investments, then either a positive approach should be

taken to providing investment advice (recommending against these

sectors) or there must be some reason for assuming that the quoted

market values for these investments are not a reliable indication

as to their realisable value.

6.7 The principal purpose of investments i s , as stated by Day

and Jamieson, to meet the liabili t ies which they support as they

fal l due. The nature of those l i a b i l i t i e s wil l therefore

influence the nature of the assets held. Most, if not a l l ,

Page 26

pension schemes have the objective of funding each members1

pension by the time that member ret i res or leaves. As a directconsequence of this I conclude that the f i r s t objective of theassets of a pension scheme is to support the current and deferredpensioners (those members who have already left or retired) of thescheme with the secondary objective of supporting the activemembers.

6.8 In the large majority of pension schemes the current anddeferred pensioners represent a fixed money l iab i l i ty even ifthere is some guaranteed level of pension increases provided bythe scheme. Some schemes do have a history and intention ofproviding additional pension increases but these too can beconsidered in terms of a fixed money liability allowing for futurepension increases at an appropriate rate. The l iab i l i ty to besupported in respect of the active membership is normally relatedto future salary levels and is therefore a "real liability". Thisdivision of scheme l i ab i l i t i e s by nature implies, in reasonablystable economic conditions, an appropriate division of assets bynature.

6.9 I do not advocate a s t r ic t investment policy of supportingfixed money l i a b i l i t i e s with fixed money assets and reall i a b i l i t i e s with corresponding assets (the "correspondingposition"). The on-going and expanding nature of a pension schemeallows variations in investment policy which are designed toimprove the investment return re la t ive to that of thecorresponding position. Thus, for example, i t would be wrong tocriticise a scheme that was invested 100 per cent in U.K. equitiesprovided that this situation were a positive decision in search ofa higher investment return and that the age of the scheme, i t sfunding position and whether or not i t were contracted out allowedsuch flexibility.

6.10 My conclusion is that a reasonable and consistent approachto placing a value on a pension scheme's invested assets would beto assume a notional portfolio, equal in market value to that ofthe portfolio actually held, whose division between fixed interestinvestments and equity investments was set equal to that of thecorresponding position. A value would be placed on the notional

Page 27

equity portfolio in the same manner as under the normal discounted

income method. The advantages of t h i s approach over the normal

discounted cash flow method are that i t i s more stable over time,

being independent of the a c t u a l and varying p r o p o r t i o n a l

investment in market sectors, and that i t automatically deals with

the overseas, property and index linked sectors . The approach

retains the disadvantage of introducing a third valuation in

addition to the well understood book value and market value. In

paragraph 6.6 above I argued that treating a l l non-fixed interest

investments as U.K. equities is a conservative approach, (else the

investment should have been in U.K. e q u i t i e s ) and t h i s i s

continued by arguing that the suggested corresponding posi t ion

assumption is a conservative approach to asset valuation, (or else

the investment managers should move to that position immediately).

The argument cannot be extended fur ther , to assuming a complete

investment in any one sector, as such an investment position would

in pract ice be intended to provide short term gain rather than a

long term strategy. If i t were intended as a long term strategy

then the asse ts and the l i a b i l i t i e s of the pension scheme would

not correspond by nature and some addi t ional valuation reserve

would surely be needed to cover this .

6-11 In practice the approach would be as follows:

MV = The market value of the actual por t fol io held

FV = The value of the fixed money l i a b i l i t i e s of the

pension scheme valued at a market ra te of i n t e r e s t making due

allowance for any guaranteed r a t e of pension i n c r e a s e or

uncovenanted future pension increases . In pract ice two market

rates of interest might be required since deferred annuities are

generally taken at a lower rate of interest reflecting the need to

reinvest income.

FD = The discounted value of the same fixed money

l i ab i l i t i e s but at the valuation rate of interest , making the same

assumptions as to pension increases. FD i s the figure at which

these l i a b i l i t i e s would be included into the valuation.

(1+W) = The write up (or down) to be applied to equity

market values in order to obtain the i r discounted value having

regard to the yield on the FTA All-Share Index and the assumed

dividend growth rate.

The assets would be included into the valuation a t :

(MV - FV) (1+W) + FD

Page 2 8

6.12 This asset valuation method does not consider the assetsactually held other than by market value and th i s can beconsidered a weakness relative, to the normal discounted incomemethod. I believe that the following four points more than offsetthis : (i) the distribution of the investments held within aportfolio can be constantly varying under short term influencesand the normal discounted cash flow method, by considering theactual assets held, can suffer on this count, (ii) the normaldiscounted income method cannot i t s e l f readily deal withinvestment in managed fund units, which form a lesser or greaterpart of most investment portfolios, and for which the investmentinformation available is sometimes scarce, (iii) the normaldiscounted income method, although supposedly based on the assetsheld, assumes that all equity investment is in an "average equity"and does not allow for the possibili ty of a biased portfolioeither by market sector or by type of equity, and (iv) propertyoverseas and other non fixed interest or equity stocks providedifficulties in the normal discounted income method or at leastrequire i t s significant adjustment.

6.13 Two disadvantages do exist for this valuation method

relative to the discounted income method. Firstly, i t may be more

difficult to explain to a trustee or other client and secondly, if

a client enquires about the cost of, say, increasing pensions in

payment by 10 per cent, the actuary must either vary the valuation

of assets (this could be quite difficult to explain) or permit

some deviation from the strict application of the method allowing

any small distortion caused to emerge at the next valuation.

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