An art rather than a science: one way to value the assets, four ways to value the liabilities

Many of us like big numbers. But when it comes to pensions deficits, big numbers are not a good thing.

Britain’s pension deficit values vary from day-to-day and from calculation to calculation. The numbers cited range from hundreds of billions to trillions of pounds. The reason they differ is because there numerous ways of calculating a pension scheme valuation.

The basics

Whether a pension scheme is in surplus or deficit depends whether the pot of assets (the money paid in by employers on behalf of employees) is greater or less than the value of the future liabilities (the pay-outs to scheme members during retirement).

Valuing the asset side of things is comparatively straightforward. “[All methodologies measure] assets at market value. That part of the equation is the same for all… when you’re calculating deficits you start with the market valuation of the assets,” says Ali Tayyebi, defined benefit risk expert at pension specialists Mercer.

Liabilities

So, to the liabilities, for which four main calculations are used.

The calculation that creates the largest deficit value is the buy-out valuation – the cost transferring the schemes assets and liabilities to an insurance company. The valuation is whatever an insurance company is prepared to charge to take on that risk.

With no company to sit behind the scheme to plug any future gaps this inevitably leads to a higher liability valuation.

“It is one that doesn’t get quoted in the media that much because it becomes really about whether a pension scheme trustees are interested in buying out benefits with an insurance company,” he says.

As for numbers that are typically banded around in the media, these are the accounting deficits, or those disclosed in company financial statements. The liabilities in this scenario are discounted – adjusted to a value in today’s terms – using AA corporate bonds yields. As these are higher than a risk free reference like a UK gilt, it reduces the liability valuation, reducing deficit values.

“The trustees of a pension scheme will not have any influence on this basis, it will be entirely company driven. The use of AA corporate bonds is for consistency, if you like, across different companies,” says Tayyebi.

Lifeboat

The Protection Pension Fund (PPF) recently valued its aggregate deficit at £408bn. This is the cost the that the PPF ascribes all the UK’s schemes if they were to falls into the PPF’s hands.

Unlike the other calculations, the level of benefits paid to members if a scheme falls into the PPF is capped at £33,678 per year. Furthermore any inflationary pay-out increases are linked to the lower CPI rather than the RPI that most schemes in Britain are tied to.

However, Tayyebi explains, although the amount of liabilities paid out by the PPF is likely to be lower in absolute terms, because it applies a lower discount factor to these liabilities (this time usually gilt yields) the liability is increased.

Cash top-ups

The fourth type of methodology is called the technical provision, also referred to as the funding basis or tri-annual valuation. Typically this valuation is not disclosed. However, it is arguably the most important method says Tayyebi.

“This is the valuation the trustees will calculate each three years that then determines the cash contribution that the employers would need to pay,” he says.

As to how the liability is calculated under this method, this is where science and art meet each other head-on.

“It is far less formulaic than any of the others and typically it has to be agreed between the trustees of the company. If the trustees are able to say that where they feel they have a strong employer covenant and they need less prudence in the assumptions, they could have, a higher discount rate that could therefore lead to a lower calculation of the liability,” he says.

Tayyebi adds that there isn’t a simple answer to the deficit valuations: "And the numbers disclosed are usually in aggregate so they ignore the fact that some schemes are in surplus while others are in a much worse position.”