Do valuation assumptions matter?

I have read with interest First Actuarial’s article on recasting  the PPF7800 index using, what they believe may be, more “realistic” assumptions for asset returns.

For those who haven’t read it the data look promising. The latest PPF7800 numbers quote a funding level, based on mark-to-market assumptions, of 78%(i.e. a Gilts based discount rate). First Actuarial have created the FAB Index in which this deficit, by moving the assumptions to a more “realistic” basis (based on expected returns rather than gilt returns) , becomes a surplus of 133%.

Now, the reason for the FAB Index  is to highlight that the pensions landscape is not all doom and gloom and that schemes are in a better position than the press would have us believe.

Looking simply at the difference in funding level, it seems as though they have done the job. But doing this misses an important point: the funding level in itself does not tell you how likely a scheme is to meet pension payments.

We have previously written about this with respect to the steel pension scheme. Whilst many will debate about the precise level of the assumptions, my point is more basic:  the assumptions behind any given funding level effectively set the benchmark return for assets which, if achieved, will be enough to pay anticipated pension payments.

To put it another way, let us assume the PPF7800 uses a “stupidly low” discount rate of 1.5%.  Whilst this gives a low funding level of 78%, the return required from assets to meet pensions is also “stupidly low” at 1.5%. In the FAB Index the weighted discount rate is 4.4%, which means that although we see a surplus of 133%, to pay the benefits, the assets need to generate 4.4%.

Whilst the assumed ambition of the regulator for pension schemes is to invest in gilts, ultimately there is no need to do so. Therefore, if you have an asset allocation that you believe can generate 4.4% per annum, and it does, then you will pay all of your pensions whichever Index you assume for your valuation.  Put another way:

  • If you start with a funding level of 78% and a benchmark of 1.5%, then earning 4.4% a year means you are outperforming your benchmark by almost 3% a year and closing that gap rapidly
  • If you start with a funding level of 133% and a benchmark of 4.4% then you are simply achieving your benchmark and maintaining a decent funding position
  • In both cases all pensions will be paid (assuming the maths has been done correctly to get the 4.4%)

So, yes, it is nice to see a positive number about pensions but whether you start with, and maintain, a high funding level or start with a low funding level and increase it rapidly, the ultimate end is the same.  Changing the assumptions doesn’t change what we need to pay.


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