This paper is motivated by The Pensions Regulator (TPR)’s review of its Code of Practice on funding for defined benefit schemes and aims to suggest how trustees and regulators should monitor the extent to which scheme assets are adequate to cover liabilities. It concludes that current practice is inadequate and needs to change.
A review is carried out of papers on not only this subject but also (to collect ideas rather than automatically apply them to pensions solvency valuations) pensions and insurance accounting and regulation.
Current practice is “scheme-specific funding” which permits discretion on choice of discount rates and other assumptions; the paper is concerned that this can lead to bias, and that trends in a scheme’s solvency can be obscured by changing assumptions. This also leads to the funding ratio communicated to scheme members having little meaning.
The paper suggests that regulators should require a valuation that is based on sound principles, objective, fair, neutral, transparent and feasible. A prescribed methodology would replace discretion.
It concludes that the benefits to be valued are those arising on discontinuance of the scheme, without allowing for future salary-related benefit increases, which are felt to no longer be a constructive obligation of employers.
The valuation should, it is suggested, use market values of assets, which is largely current practice.
Liabilities should reflect the trustees fulfilling their liabilities, rather than transferring them to an insurer (which may introduce artificialities).
The discount rate should follow the “matching” approach, being a market-consistent risk-free rate: this is consistent with several papers to the profession in recent years. It avoids the problems of the “budgeting” approach, where the discount rate is based on the expected return on assets – this can be used to help set contribution levels but is not suitable for determining the value of liabilities, which depends on salary, service, longevity, etc and (very largely) not on the assets held. In principle, the liability value can be adjusted for illiquidity. Credit risk of the employer should not be allowed for.
Liabilities should reflect the (probability-weighted) expected value of future cash flows and should not be increased by prudent margins or risk margins (which would lead to a non-neutral figure). Risk disclosures are needed to understand and manage risks.
The resulting funding ratio is a consistent measure, to be disclosed to members, which can be used to manage the scheme, and by regulators as the basis for requiring action. Scheme-specific management using data such as the employer covenant means that immediate action to ensure 100% solvency on the proposed basis would not necessarily be appropriate.
The author encourages the profession to advise TPR on the above lines.