difference of opinion

Is the perception that the pension bulk buyout option is too expensive a reality, or is it an illusion generated by an industry which values pension scheme obligations in very different ways?

It is a fact that the price an insurance company would charge for assuming the commitment of paying member pensions into the future is typically higher than the FRS17 valuation. The difference is largely a result of two fundamentally different reporting environments: companies are able to run their pension schemes at a deficit, while insurers are required to hold additional reserves.

On average, a DB scheme with both pensioners and deferred members might typically expect the FRS17 figure to be approximately 80pc of the full value. This difference is at the heart of the notion that buyouts are expensive, when the actual risk premium paid to the insurer may be only 10-12pc.

There are a number of reasons driving this difference:

Life expectancy assumptions
Current accounting standards allow mortality assumptions to vary significantly and many companies’ FRS17 statements habitually understate life expectancy.

However, the Accounting Standards Board recently published six recommendations to improve FRS17 including transparent disclosure of mortality assumptions. These are likely to come into effect by the end of this year and will bring FRS17 much closer to 100pc of the best estimate liability and more in line with insurance industry estimations.

Differences in investment return over the long term
FRS17 is clear in its requirement that company reporting should assume a discount rate based on AA corporate bonds. While this is a reasonable basis, it does not reflect the extremely long duration of the liabilities.

In order to truly match a pension scheme’s liabilities insurers create a portfolio of investments designed to deliver an income stream which closely matches the anticipated benefit payments. In reality this means investing in a range of bonds and overlaying interest rate and inflation swaps to improve the quality of the matching.

Insurers access higher yields through an exposure to credit risk and make an allowance for default in their assumed pricing yields. This approach delivers a more accurate match for liabilities which for most schemes means a lower discount rate than the FRS17 method.

The cost of running the scheme
The buyout price includes an assessment of the costs of administering the pension fund as well as fund management charges between the time of the buyout and the final member dying. In many cases this represents a commitment which will last more than 50 years. By contrast, FRS17 makes no allowance for future costs associated with running the scheme.

This disparity between valuation bases leaves finance directors with a range of choices regarding the level of funding and risk exposure they wish to take. It seems rational for a financial director to run the scheme at a deficit as this generates cheap financing off balance sheet.

This approach tends to be followed as if it were risk free, but in fact fails to reflect that member benefits are exposed to credit risk of the sponsor in addition to investment and mortality risks.

It also seems rational for trustees to accept underfunding while the sponsoring company is a going concern and is in good health. This is particularly true if some of the members remain as employees, as negotiating a reduced exposure to the sponsor credit risk may weaken the sponsor.

Perhaps heed the words of Stewart Ritchie, president of the Faculty of Actuaries, who said in January: “We should not fool ourselves into thinking something like FRS17 is the true value of the liabilities.
“There is only one measure of the ability of the scheme to pay its liabilities and that is the buyout cost. Anything else is just a line in the sand.”

Ian Aley is business development director at Paternoster