Case Study: Calculating the Cost of Future DB Benefit Accrual
Our client is a charity that sponsors a DB pension scheme. Despite rising costs, the charity has kept the scheme open to accrual and also continues to provide discretionary pension increases.
As well as holding assets within the scheme to pay pensions, the charity has a diversified portfolio of non-pension assets to fund its charitable activities.
The pension trustees have written to the charity ahead of the next triennial valuation. They’ve warned of a large increase in employer contributions for ongoing accrual and for a past service deficit. In addition, the trustees may request that some of the charity’s non-pension assets be transferred into the pension scheme.
On this basis the charity will likely have to close the scheme for ongoing benefit accrual and stop its longstanding policy of paying discretionary pension increases to inflation proof pre 1997 pension.
Before making a final decision, the charity asked us to provide an independent view on DB funding and investing.
The Current Approach
DB funding discussions currently focus on the discount rate. The actuary recommends a prudent 'gilts plus' discount rate, with the margin above gilts being based on the investment strategy and the strength of the employer covenant.
While there is general agreement that the charity is strong, covenant and the ability of the employer to support risk are not brought into funding calculations in an objective way. Instead, 'actuarial judgment' is used to transpose covenant strength into a suitably prudent discount rate.
Investment discussions focus on strategies that reduce ‘value-at-risk’ and maximise ‘interest rate protection’. As a result the pension scheme holds an ever larger proportion of its assets in gilts – even though the charity continues to hold a diversified portfolio of assets to fund its activities.
Because of falling interest rates and an increasingly conservative investment strategy, over several valuation cycles the pension liability and employer contribution rate have increased substantially.
Our Proposal - Focus On Prudent Outcomes
A key tenet of DB funding legislation is ‘prudence’. While DB schemes are permitted to embrace a degree of risk, to ensure pensions are secure, any risks must be sensible and carefully managed.
As the objective of funding is to provide members with secure pensions, we recommended that the charity and pension trustees make benefit security the focus of discussion, not narrow measures like 'discount rate' and 'value of risk’.
For example, the charity and trustees could agree to fund and invest so that the pension scheme has just enough assets to be 90% certain of paying all pensions in full without recourse to the employer.
The technical provisions are then defined as the smallest pool of assets, so that when the scheme is fully funded and efficiently invested, it will have a 90% chance of paying all pensions in full. The contribution rate for ongoing accrual will be the rate needed to maintain benefit security at 90%. The optimal investment strategy isn't the allocation which minimises value-at-risk, it is the strategic asset allocation which maximises the chance that all pensions are paid in full.
Alternate objectives could be to fund and invest for an 80% or a 100% chance of paying all benefits in full.
A higher benefit security target will mean larger technical provisions and a higher contribution rate for ongoing accrual. In addition, because a portfolio of gilts and bonds can be arranged to exactly match pensions, a higher benefit security target also means a conservative gilts orientated investment strategy - or a growth orientated investment strategy with a suitably large risk reserve. Holding enough assets to be 100% sure of paying all pensions would be akin to solvency funding.
Plan For Failure
A riskier benefit security target (for example, holding the smallest pool of assets that provides an even 50% chance of paying all benefits in full) will mean smaller technical provisions, a lower contribution rate for ongoing accrual and an aggressive investment strategy. As this funding plan comes with greater risks it's more likely that mitigation measures, such large deficit contributions, reduced discretionary benefits or closure for accrual may be needed in the future.
Where pensions are exposed to risk, the trustees and employer should check that the employer is able to support the risks and they should agree, in advance, the steps to take if risks crystalize. Holding enough assets to be 80% sure of paying all pensions would not, on its own, be a sufficiently complete funding plan.
For example, employer deficit contributions will likely be the first action for a scheme that goes into deficit, and the trustees and employer should carry out a modelling exercise to check the employer is strong enough to pay the contributions needed to ensure benefits are paid in full.
If the modelling reveals scenarios where the required contributions are unaffordable, then repeat this analysis allowing for both deficit contributions and a reduction in discretionary benefits (so no discretionary pension increases, lower transfer values, lower commutation factors, etc). If there are still scenarios where pensions are not paid in full, then the employer should consider closing for benefit accrual and / or (in the case of the charity) transferring non-pension assets into the pension scheme.
We helped the charity better understand the pension scheme's finances, the impact of risk and how this inter-relates with the charity's own finances.
Our modelling showed that, if it wished, the charity could continue offering a DB pension to its employees and that this was affordable.
We demonstrated that a combination of deficit contributions and reduced discretionary benefits would be enough to cover all conceivable risks that could arise in the future. We also showed that there was no immediate need for significant deficit contributions or for non-pension assets to be transferred into the pension scheme.
Please contact us if you would like to discuss this.