On the (funding) level

When I read Allan Martin's earlier blog on how pension-scheme reserves routinely fail to include expenses, I was so surprised I had to ask him if it was really true.  As a former life-insurance actuary, any reserve which didn't include an allowance for expenses simply wasn't a complete assessment of the liability in my view.  My amazement was reawakened recently when I received a statement about my preserved pension from a former employer.  An excerpt from the statement is shown below:

Table 1. Excerpt from summary funding statement.

 Actuarial valuation
as at
31 December 2013
Assets £2,904m
Estimated amount required
to provide benefits
£2,574m
Surplus/Deficit £330m
Funding level 113%

 

On the face of it, a pension scheme with a funding level of 113% sounds good.  However, below the table was the following caveat:

"The figures in the table do not allow for Scheme expense reserve, which was £28m at 31st December 2013."

 

Since I don't recall seeing this kind of caveat on previous pension statements, perhaps this sort of disclosure can be viewed as a (small) amount of progress.  For the scheme in question, including the expense reserve means that the funding level falls from 113% to 112% — no big deal for this rather large pension scheme, but much bigger drops are possible for the kind of small scheme Allan Martin was writing about.

So, my benefits must be well covered in a scheme with a funding level of 112%?  Not exactly, because that funding level is not based on a market assessment of the cost of providing benefits.  Elsewhere in the pension statement is this telling remark:

"an additional £663m would be required to buy insurance policies [to secure scheme benefits] and so that on this "buy-out" basis the Scheme was 81% funded."

 

A buy-out basis is an estimate of the market price of the risk.  It is intended to represent what an insurer would charge to take on the liability to pay the pension benefits.  It is arguably the most useful assessment of the funding level, since it is market-consistent (or an approximation thereof).  Unlike pension schemes, insurance-company reserves under Solvency II have to be calculated on a market-consistent basis, with additional capital on top to withstand 99.5% of scenarios that could arise over the following year.

There is an irony here: I said I was a former life-insurance actuary, and so my preserved benefits are actually in a pension scheme run by an insurer.  A quirk of regulations allows pension schemes to do all sorts of things forbidden to an insurer, such as not including expenses in non-market-consistent reserves.  This means that a liability sitting in the pension scheme has a lower reserve than the same liability would if it were an annuity sitting on the insurer's balance sheet.  This is not just a UK phenomenon, as many other territories have the same quirk (one reason why Solvency II in the EU only applies to insurers, not pension schemes).  The insurance-company regulator, the PRA, is aware of this quirk and so requires that insurers have a proper, market-consistent assessment of their pension-scheme liabilities.  However, as a pension-scheme member I won't see these calculations, as they are private between the regulator and the insurer.

This then raises a question for the pension-scheme industry: what is the use of a funding calculation that under-states the market price of providing benefits?  Are pension-scheme members not simply being misled?  After all, if members take a transfer value calculated on this kind of "funding basis", they will very quickly find out that they cannot purchase the same level of benefits they are giving up on the open market.

 

Comments

Allan Martin
(Apr 19, 2017)
19th April 2017

I looked back at my earlier blog and was pleasantly pleased not to be embarrassed! The ILGS yield quoted however shows the time period and that has exacerbated the deficit problems with pure cash (not heroic investment assumptions) now being required to pay off funding shortfalls. Could I also say -

1. There is a growing lobby to ignore the traditional "gilts+" approach and just assume, say, 5% nominal returns. This will just increase the unreality compared to market price. An exceptional employer covenant is required. Very few schemes are big enough to take a self-sufficiency or “live off dividends” approach and none have convinced the PPF of a zero risk!

2. Transfer values are based on "best estimates", usually much more optimistic than the prudent technical reserves. The resulting 50% chance of inadequacy is often ignored by members and IFAs and is the next mis-selling scandal.

3. I understand that insurers are now being challenged by the PRA on their reserving for staff pension schemes – consistency between their annuity book and their staff pension annuity book. Watch out for more transfers and reassurance of the latter.

Sadly the reality of contractual defined benefit pension promises has not hit the £1.5tn+ of unfunded public sector pension promises where Generation Z is underwriting the long term UK GDP growth assumption of CPI+2.8% per annum. Guaranteed future austerity?
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Stephen Richards
Stephen Richards is the Managing Director of Longevitas