First Actuarial versus the world: DB’s glass half full or half empty?

When it comes to pension funding, it seems the glass is very much half empty. These days you are never too far from the words ‘soaring DB pension scheme deficits’, yet few talk about the huge amounts of money being paid in by employers, or the valuable benefits being paid out to members.

Two glasses, both half-full of green liquid.Whether it’s print, web or broadcast media, there is no shortage of financial services organisations delivering gloomy headlines for media outlets, this publication included, always on the lookout for bad news stories.

So against such a background what should we make of the sunny pronouncements of First Actuarial, whose First Actuarial Best (FAB) index last month showed the 6,000 DB schemes in the UK enjoying a healthy £270bn surplus? That number is in stark contrast to JLT Employee Benefits’ January version of its monthly index that shows the funding position of all UK private sector defined benefit DB pension schemes under the standard accounting measure (IAS19) as being £263bn – almost 50 per cent up from 12 per cent earlier.

Screen Shot 2017-02-10 at 14.26.50“The point of the FAB index is to show the best estimate position of the UK’s 6,000 defined benefit pension schemes, based on the expected return on the assets they actually hold, without worrying about fluctuations in gilt yields. Gilt yields are currently through the floor which is resulting in huge funding deficits being calculated where the funding valuation basis is set with reference to gilt yields. But if you are not investing in gilts then why would you make your calculation on the basis that you are?” says First Actuarial partner Rob Hammond, the man behind the index.

The FAB Index is calculated using publicly available data underlying the PPF 7800 Index which aggregates the funding position of 5,945 UK DB pension schemes on a section 179 basis, together with data taken from The Purple Book, jointly published by the PPF and the Pensions Regulator. Next month’s figures will be out in about a week or so, and whatever has happened to gilt yields, it is certain to be in the black.

Nobody is questioning the accuracy of the statements being made about the gulf in assets and liabilities when it comes to buyout cost or the measure required to be shown in a company’s accounts. Nor do critics of the FAB index question its accuracy. So who should trustees, sponsors and journalists be listening to?

Pension consultant John Ralfe argues the First Actuarial perspective is plain wrong. Ralfe says: “By saying pension liabilities should be valued by reference to return on assets not by reference to bonds, First Actuarial are effectively saying that the actuaries have got it wrong, that accountants have got it wrong, that TPR and the PPF have got it wrong and that the people who are buying and selling bulk annuities have got it wrong.

“I sometimes feel like we are back in the early part of the last decade. Wasn’t this an argument that was fought and won back then?”

JLT Employee Benefits director Charles Cowling agrees that First Actuarial’s more positive perspective is part right. He says: “I have some sympathy with what First Actuarial are saying. At one level their analysis is entirely correct. If you factor in what you can expect over the next 40 years, then you will meet the promises to pensioners in most schemes. However this analysis misses two key issues, and so it is slightly misleading to say what they say without highlighting these two key points.

“Firstly, the fundamental purpose of the pension scheme is to hold a pool of assets for if the employer goes under. If you are happy that the employer will always be there then you can run on a pay-as-you-go basis. The reality is that a lot of companies do not have a 40-year shelf life.
“Secondly there is the shareholders perspective. The way the legislation is constructed is that the shareholders are giving a guarantee. So if the assets aren’t enough they have to make up the difference. That guarantee has economic costs. Take the Tata scheme – it is reasonably well funded. The problem you have trying to find a buyer for it is the buyer has to underwrite the massive guarantee for the pensions. If you only look at the expected investment return you ignore the cost of that guarantee. The cost of the guarantee affects the employer’s cost of borrowing and the ability to buy and sell businesses.”
Mercer risk and professional leader, UK retirement Deborah Cooper is only half convinced. She says: “You have to fund on an IAS 19 basis because that is what is in the accounts. The discount rate is driven by corporate bond yields, so there is not a lot of wriggle room with them. We have a principle-based regime and First Actuarial have their own approach to setting assumptions. But you do need some sort of discipline.
“If you use a different approach they are in surplus but if you use another one they are not. It is a pointless argument. The central point should be, do you need to pay more money in or not? Whether you will or not will depend on what your plans are. And if you want to buy out. So some trustees are worried about the employer so they might feel less complacent.”

First Actuarial agrees that the FAB approach is for schemes that are sponsored by strong employers. “We argue that schemes with a strong employer should be funding more in line with a best estimate position, and more prudence should be introduced for schemes with weaker employers or those targeting buyout.

“With regard to the sponsor’s cost of borrowing, it depends how big the scheme is relative to the organisation itself. If it is important to a company for its banking covenant not to have a big accounting deficit then yes they should fund higher, but if not, then there is no need to be overly prudent.  The trustees of a scheme certainly won’t complain if an employer wants to fund at a higher level,” says Hammond.

Ralfe meanwhile is categorical in his view that the value of an asset is its actual value, not a value it might have in the future. He says: “All financial assets and liabilities — for companies, banks, insurers and pensions — should be valued at market values, and applying any ‘smoothing’ or ‘judgment’ is just a  smokescreen.

“Traded financial instruments — shares and bonds — are simply valued by the market. Non-traded instruments, including pension liabilities, should be valued by looking at traded instruments with the same cash flows. What is the market value of a bond portfolio with the same payments, timing and certainty as the pension promises?

“AA corporate bond yields, reflecting the underlying economics, have been used to value pension liabilities for accounting since FRS17 was published, way back in 2000. And in the real world, when insurance companies buy pension liabilities from companies, their prices use bond-based market values.

“Valuing pension liabilities using the ‘expected return on assets’ fails to explain how unfunded pension liabilities are valued where there are no assets. Do the liabilities have no value or an infinite value?”

Hammond believes that a bigger picture issue is at stake however – that there is a constant drip of negativity around DB pensions that could be contributing to an overall hardening of attitudes of finance directors to them. “All this negativity in the media around deficits is likely to increase a negative view in the minds of finance directors, influencing decisions made around closing schemes, and asking employers to contribute more to the scheme than they need to reducing the money they have to invest in the business.”

Cooper says: “I agree that the focus on the here and now is not particularly helpful but for companies that have to report now, it is understandable that they look at it like that.”