Jonathan Stapleton asks how we should be valuing defined benefit scheme liabilities and whether the current methodology is fit for purpose
It should be easy. Promise someone a certain income in the future and then pay the pensions when they fall due.
But how should you value how much those future promises are worth today?
Accounting standards - introduced at the turn of the century - used AA corporate bond yields as a proxy for the discount rate that should be used to value schemes.
But several years of falling bond yields has led to liabilities rising to eye-watering highs - and led many to conclude that current valuation methodologies are wrong.
This week, First Actuarial launched a new scheme funding index, the First Actuarial Best Estimate index (FAB), which challenges the traditional 'gilts plus' approach to valuing defined benefit (DB) pension funds, using instead a 'best-estimate minus' approach that starts from the expected return on the assets they actually hold and deducts an explicit margin for prudence.
Using this methodology, DB schemes have never been better funded and have an aggregate surplus of around £358bn and an overall funding level of 133% - figures that contrast starkly with current PPF7800 figures, which show a deficit of £419bn and an overall funding level of 78%.
As First Actuarial partner Rob Hammond explained: "Historical low gilt yields have led to historical reported deficit levels of DB pension funds. But, a reduction in gilt yields doesn't necessarily translate into an increase in pension fund deficits, particularly if that pension fund doesn't invest solely in gilts."
In this issue of Professional Pensions, Con Keating also wades into the debate.
He says much of the debate surrounding the valuation of liabilities consists of shouting about whether the yield on gilts; the yield on AA corporate bonds; or the expected return on assets should be used as the discount rate for liabilities.
Keating believes all these arguments are wrong and questions why discount rates of any kind should be used for liability valuation.
Debate over the correct valuation to use when valuing schemes - or whether to use one at all - is often passionate and it should be no surprise we have failed to reach a satisfactory resolution.
But a resolution is sorely needed - especially at a time when increasing numbers of businesses and schemes are struggling under the weight of ever expanding deficits. If these valuation methods are indeed wrong, then they must be changed. And soon.
Jonathan Stapleton is editor-in-chief of Professional Pensions
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