The USS scandal proved that DB scheme members should leave the worrying about funding to trustees, but, as Charlotte Moore asks, should the industry explain the complexities surrounding valuation methodology to re-build trust with its members?
The recent Universities Superannuation Scheme (USS) crisis serves as a cautionary tale for private sector defined benefit (DB) pension schemes. A combination of institutional mistrust and misinformation created a powder keg that resulted in strike action and a fundamental misunderstanding about pension valuations.
This situation underlines a potential problem for defined benefit schemes. In the past, these schemes adopted the same paternalistic attitude to member communications as they did to the investment strategy.
Few schemes tried to explain to their members the complexities of valuing a DB scheme. But that policy does not reflect today’s reality. The USS crisis illustrates how quickly misinformation can spread through social media. For example, a theory claiming last year’s valuation was based on all universities going bust at the same time was repeatedly shared, despite being incorrect.
This crisis in communications could have been contained if the scheme had adopted a more pro-active approach. Explaining the basics of valuation methodologies and the important role played by a covenant sponsor might have reduced the confusion.
But these explanations are far from straightforward. Three different methodologies are used to value a pension, which only adds to the confusion. While each makes use of similar techniques, they vary because they are used for different purposes.
Net present value
The most widely available valuation methodology is the one used for a company’s annual report and accounts. This aims to take a snapshot of the current value of a pension scheme’s assets and its liabilities, which reflects its position on a company’s balance sheet.
The assets are relatively straightforward to value as a market price for investments such as bonds and shares can be obtained. The liabilities are trickier. The scheme has to project the benefits it has promised to pay each of its members until they die. That involves making assumptions about longevity and the future path of inflation. This exercise will give the scheme an idea about the amount of its future liabilities. But to discover the current valuation of those liabilities, the company must discount those cash-flows back to today to determine a net present value (NPV).
Determining NPV requires using a discount rate. It is a similar methodology used to determine the correct value today of an investment with a fixed term paying income every year, such as a bond. In other words, the discount rate should reflect the level of investment returns a scheme can expect from its assets. For the accounting valuation, the choice of discount rates is constrained to one with a link to a corporate bond rate. This reflects a key principle underpinning accounting standards: to make reports consistent.
Marian Elliott, head of actuarial at Redington, says: “Using the same approach to value all pension schemes gives the stakeholder a comparable way to compare the financial strength of different companies.” While the accounting standard is a useful tool, it is limited. “This measure does not tell you what it will cost for a particular pension scheme to provide those benefits or what an insurer would charge you to provide those benefits,” Elliott says.
Passing the buck
An insurance valuation is of particular relevance to private defined benefit schemes. Most are closed and many would like to transfer their assets off the company’s balance sheet and onto that of an insurer. This is usually the most expensive valuation. “The buy-out provider has no incentive to invest in a way which would risk them not being able to meet those liabilities,” Elliott says.
This reflects the stricter regulatory environment for insurance companies. Elliott says: “Insurance companies need to have adequate capital backing to underwrite the promises they have made, as well as making a profit.” Insurers tend to make conservative assumptions about how long people will live and will not expect a great deal of investment out-performance because they cannot demand more cash if they get their assumptions wrong.
To determine how much an insurer will charge to take over the provision of the scheme’s liabilities, it will use a more prudent methodology to the one used to provide the accounting valuation. The insurance company will model the liabilities assuming people will live longer than accounting methods dictate and making conservative inflation assumptions.
They will then determine which assets it needs to hold to guarantee it can meet those benefits, which will typically be a mix of corporate bonds and gilts. These returns will form the discount rate used to carry out the net present valuation of those liabilities.
Sponsor strength
The third and final way of valuing a company pension is one which is specific to a particular scheme. “This can be called the funding valuation, technical provisions or scheme-specific funding,” Elliott says. This valuation represents the trustees trying to determine what assets they need to acquire in order to meet those future benefit payments. “This is very tricky because it requires the balancing of a number of different variables,” Elliott says.
Trustees have two ways to ensure the future benefits can be met: they can either ensure the assets generate sufficient returns to match the liability payments or they can ask the sponsoring company to stump up more cash.
That means there is a relationship between these two sources of funding. Elliott says: “If you have a very strong sponsoring company which will always be able to provide cash if needed, then the pension scheme can afford to take greater investment risk.”
If, however, the sponsor covenant is not particularly strong, then the scheme can be less reliant on the strength of the company and it cannot afford to take greater risk with its investments. Elliott highlights that: “If the sponsor covenant is really weak then the valuation will often be akin to an insurance company pricing for buy-out: there will be very low risk assumptions.”
To determine the discount rate trustees need to ascertain the NPV of a scheme’s liabilities, look at the actual assets it holds in the portfolio and what returns it can expect to generate from those investments. For example, the scheme might expect returns of 4% from its overall portfolio.
Elliott says: “If you have a conservative portfolio, we can use that 4%.” But if the portfolio is riskier, then the scheme might use a lower discount rate of, for example, 3% even if it thought potential returns could be as high as 6%. The strength of the sponsor covenant will also affect the discount rate used. “If the scheme has a strong sponsor it can use the 4% rate, but if the sponsor is weak it will, for example, use a 2% discount rate,” Elliott points out.
If the scheme has a strong sponsor, it can be more bullish about the returns they will get from their portfolio, safe in the knowledge that they can ask for additional cash if those returns do not materialise. But if the sponsor is weak trustees should look to use a lower discount rate, she adds.
This relationship between the expected invested returns and the sponsor has been particularly important in the USS crisis because The Pension Regulator voiced concerns over how the trustees had assessed the strength of the employer covenant. But it is also important to closed private sector occupational pension schemes as there are concerns about the creditworthiness of many of the companies underpinning the 6,000 DB schemes in the UK.
Xafinity Punter Southall principal Martin Hunter says: “Our ‘The Risk of Ruin’ research report predicts that many pension schemes will not be able to pay full benefits to their members, because their employer will fail before the scheme has been able to fulfil all its liabilities.”
There is a strong likelihood that some of those 6,000 schemes are likely to face some kind of insolvency in the decades to come. “We calculate that a third of all DB schemes will not be able to pay full benefits to all their members,” Hunter says.
Reaching out
With such problems hanging over the industry, schemes need to take a more active approach to member communications. Hunter says: “Scheme members need to understand more about the pension valuations, such as is there a risk they might not get the full pension they were promised if their employer goes bust.”
Many members don’t realise, for example, that even when they retire they are still exposed to the risk of their previous employer failing. “When I’ve spoken to pensioners, they are often not aware of this potential problem,” Hunter says. There is a natural reluctance to avoid talking about sensitive issues which are likely to trigger a negative response and that reflex needs to be overcome.
P-Solve co- head Ajeet Manjrekar says: “The industry needs to grasp this nettle because a constant drip of negative news stories will further erode public trust in pensions.”
Ralph Jackson, director at Lansons Communications, adds: “Schemes need to decide how to communicate a negative message in the most positive and transparent way.” It’s about explaining why the scheme finds itself in a particular position and how they will improve the situation.
The first stage is to establish some basic ground rules. Jackson says: “A scheme needs to understand its audience and how to tailor its message to ensure complex factors are explained in simple terms, especially when there is the potential for a crisis to develop.”
By establishing these parameters, a scheme will then be clear about its narrative then it should decide how and to whom this content will be communicated. Jackson says: “When this narrative is challenged by members, the scheme needs to know how it will react.”
A good way to re-establish trust would be to explain to the key stakeholders the nature and the cost of providing DB pension benefits. “People need to be made aware of the three cogs which must work collaboratively together to ensure benefits can be paid,” Manjrekar says.
The Pension Regulator has identified these cogs as the strength of sponsor covenant, contributions received from the sponsoring employer and investment returns. Manjrekar says: “All three of these cogs need to be in a sustainable position so if the assumptions underpinning one of those cogs are downgraded, the others can pick up the slack.”
Focusing on these cogs underlines how all he scheme’s stakeholders need to work together. Manjrekar says: “If unreasonable expectations are put on one of those cogs, acrisis will ensue when it inevitably fails.”
