Meeting defined benefit pension obligations: measurement, risk and flight paths

Abstract

The UK defined benefit pension scheme landscape has changed dramatically over the last few decades. During this period of change, conflicting views regarding the measurement of both assets and liabilities has made communication challenging. This has led to an under appreciation of risk and often suboptimal decision making. This paper seeks to draw together a variety of contrasting views to provide a coherent framework for stakeholders to meet pension scheme obligations over time.The proposed framework encourages agreement between both scheme sponsors and trustees towards a common target through a well articulated plan, or "flight path". In addition, the proposed flight path structure provides a common basis underpinning the measurement of both pension obligations and the risks inherent in any plan to meet those obligations.In an alternative recent framework, the recent paper by the Discount Rate Steering Committee (2011) proposed that discount rate calculations could be broadly split between matching calculations and budgeting calculations, although in their final update (2011) they noted that "in limited circumstances, a blend of matching and budgeting can be relevant." In their final update (2011), the Discount Rate Steering Committee also published in appendix 2 a table setting out how their recommendations, including the budgeting/matching framework, corresponded to the Technical Actuarial Standards published by the Board for Actuarial Standards. This paper develops the existing research beyond discount rates. Flight pathsAs defined benefit pension schemes close to new members and to future accrual (The Pension Regulator's Purple Book 2010), the focus of sponsors and trustees tends to change.Many traditional valuation methods focused on the ongoing nature of schemes, whereas the recent trend has been towards an end game. The change in employer debt regulations on 11June 2003 together with the mass extinction of discretionary increases have also hardened the obligations reinforcing this trend. This focus on an end game is likely to give greater commonality of objectives.Once a common goal is agreed, then stakeholders can focus on the critical stage of the process, which is how they intend to get to their target, also known as a flight path. Any measurement information should support this decision making, rather than being an end in itself.One particular area of debate, which this paper addresses, is how to reconcile the views held by financial economists and those of other market analysts. This paper proposes a robust framework for allowing for investment returns above "risk free" rates.The authors note that the recent crisis has highlighted, once again, that nothing in life is risk free. However, "risk free" rates form a common building block and useful short-hand for much actuarial and financial economic analysis. We have chosen to side-step this debate in this paper. The reader may choose to interpret "risk free" in a UK context as a low credit risk instrument such as a gilt or a suitably well collateralise...

Actuarial valuations to monitor defined benefit pension funding

“…In other cases, the valuation here proposed will help meet the need for the target to relate to solvency (Chapman et al, 2001) and to do so clearly (Cowling et al, 2005). Hatchett et al (2013) argued that a target set using market values (as is the benchmark valuation here) is helpful, by being objective, clarifying the reliance on the firm and what is the matching portfolio (from which departures may be made).…”

“…Further support for market values is from Hatchett et al (2013), who asserted that a scheme's assets will ultimately be valued at market value on the date of settlement (either by paying a benefit to a member or a transfer to another party such as an insurer), meaning that market values are relevant even if scheme decision-makers believe the market is distorted in some way.…”

“…A further possibility is to use swaps, with a credit risk adjustment for bank default, as prescribed by Solvency II. Hatchett et al (2013) suggested that, in the UK context, readers might think of risk-free assets as gilts or suitably well-collateralised swaps with a sufficiently reliable counterparty. Charmaille et al (2013) regarded the normal position to be for swap rates to exceed gilt yields, although this could be reversed in certain circumstances; Foroughi (2012) put forward possible explanations for negative swap spreads at medium to long durations.…”

“…Cowling et al (2005) are concerned that using a discount rate higher than that derived from a matching portfolio is simply a way of reducing the contribution rate at the expense of higher contributions later and lower member security: "an element of self-delusion within the actuarial profession" they called it (page 78). Hatchett et al (2013) accept that, while schemes may wish to take investment risks in order to reduce the cost to the firm, they have a concern that, under current regulations, stakeholders "could change the asset allocation to 'hide' the deficit" (page 292). The author would say that using a budgeting framework means that the liabilities appear to magically reduce if the firm decides to adopt a more risky investment strategy with higher expected returns, and that this is quite wrong: the liabilities depend on factors such as service, salaries and mortality.…”

“…It is fair to add that one paper, a report for the National Association of Pension Funds by Clacher & Moizer (2011), recommends the liabilities be discounted at a rate that reflects the scheme's investment strategy, and this to be combined with a value of assets smoothed to reflect the long-term nature of the pension obligation. However, Clacher has clarified that this proposal is specifically in relation to company accounts rather than valuations for trustees, etc (see comments in the discussion on Hatchett et al, 2013).…”