Presented to the Institute of Actuaries Students' Society

on 19th March 1985

ACTUARIAL VALUATIONS OF
PENSION SCHEMES

by

P. Worthington BSc, FIA

 1. INTRODUCTION

1.1 The objective of this paper is to discuss the approach that

is appropriate to the actuarial valuation of a pension scheme and
which depends on both the circumstances of the particular scheme
and on the purposes to which the valuation results are to be put.
I believe that, while there is no substitution for actual
experience of a situation, an objective discussion can frequently
bring forward points and develop ideas in advance of the situation
arising in practice.

1.2 Both the accountancy profession and the OPB have published
reports requiring greater disclosure in and discussion of pension
scheme valuations and the Institute of Actuaries has, in response,
published EXD2 followed by GN9 which set out the items which
should be considered in actuarial reports. This paper discusses
items covered by GN9 as well as covering other aspects of the
actuarial valuation.

1.3 There are three areas in which pension schemes and those
providing them with actuarial advice are being put under external
pressure:
(i) There is increasingly an unwritten requirement for pension
schemes to increase pensions in payment. The sources of
such pressure include the press, pensioners, the
government, the OPB, active members (prospective
pensioners) and to a lesser extent, perhaps, the members of
the actuarial profession itself.
(ii) Some industries have experienced greater changes in the
number of members withdrawing than was previously the case
and the benefits available on withdrawal are, due to
preservation, contracting out, non-franking and (imminently
due) to the revaluation of deferred pensions, considerably
greater than ever before.
(iii) There is an increasing requirement for discussion of
actuarial matters from bodies outside the profession such
as accountants, the OPB, the government and trade unions.
Actuaries are being requested to provide certificates and
statements giving their opinion of the current and likely
future financial position of pension schemes.

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1.4 I have, throughout t h i s paper, based my comments on the
situation of a privately invested final salary pension scheme
where the investments are either held directly or in managed fund
investments of some kind. However, I hope that many of the points
made will be seen as equally applicable to other pension schemes.

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 2. THE PURPOSES OP AND CORRESPONDING APPROACHES
TO AN ACTUARIAL VALUATION

2.1 The purposes of an actuarial valuation of a pension scheme

must be to provide the actuary with a l l the information he
requires to give sound a c t u a r i a l advice to his c l i e n t , normally
the trustees or the employing company, to enable him to satisfy
any legal requirements in r e l a t i o n to that scheme, e.g. the
provision of a Contracting-out C e r t i f i c a t e , and to provide any
a c t u a r i a l statements about the financial position of the scheme
that may be required.

2.2 The valuation may be the regular, normally t r i e n n i a l ,

valuation of the pension scheme or i t may be a special valuation
undertaken because of significant recent or prospective changes to
the scheme necessitating a valuation. In either event, the f i r s t
step i s to decide on the uses to which the r e s u l t s are to be put.
Once the purposes have been defined the actuary w i l l be in a
position to consider the approach he will adopt, the assumptions
he will make, the approximations which can and cannot be justified
and the methods that are to be used to place values on the assets
and the l i a b i l i t i e s being taken into account.

2.3 One frequent requirement from a valuation is the provision

of a statement for inclusion in the scheme accounts or in a notice
to members indicating either the level of benefits that would be
available to members in the event of the scheme's discontinuance
or the relationship between the assets and accrued benefits: the
two are not the same. I have concentrated on the discontinuance
statement because the actuarial considerations concerned encompass
those of the alternative statement. The actuary is being requested
to give his opinion on a factual matter (the assets to be taken
into account physically exist and the full membership details of
the scheme are available) only made theoretical by the scheme not
actually having been discontinued. He must address himself to the
situation as i t exists; the future intentions of the company (the
funding plan) do not form part of the formula. The discontinuance
position is discussed in Section 3.

2.4 If the membership of the scheme i s contracted-out of the

additional component of the State scheme, the actuary will

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regularly be required to provide an Actuarial Certificate A
covering the following 5 years and enabling the membership to
remain contracted-out. The c e r t i f i c a t e covers the existing
position, and therefore involves a similar approach to the
discontinuance position, and also the short terra (5 years) future
position. The Actuarial Certificate A i s discussed further in
Section 4.

2.5 The funding rate that i s adopted for a p a r t i c u l a r pension

scheme i s a function of both the chosen pace of funding and the
strength of the actuarial assumptions made. The pace of funding
and funding objectives can be discussed by the actuary with his
client the decision making responsibility being given to one or
other of them, depending on the rules of the scheme. The actuary
should draw h i s c l i e n t s a t t e n t i o n to any advantages and
disadvantages that exist, and their consequent short and long term
effect, in the various approaches available. However, the final
decision on funding objectives may well rest with the company and
the actuary must then frame his investigations towards providing
appropriate advice. Most actuaries w i l l agree that there i s no
perfect set of financial and other assumptions to be made as to
the future experience of a pension scheme. For a p a r t i c u l a r
scheme, one set of assumptions will be stronger or weaker than
another and the whole spectrum of assumptions made by actuaries in
the on-going valuations of pension schemes forms a range from the
strongest to the weakest with probably some general broad
agreement as to the region in which the "average" assumptions l i e .
If a particular company i s currently eager to put money aside in
the pension fund against the prospect of less profitable times in
the future (i.e. adopt a more forward funding plan) then the
situation may exist where quite strong assumptions would produce a
balanced position with the c a p i t a l i s e d value of current and
prospective assets equalling that of current and prospective
liabilities. An actuary would be j u s t i f i e d in making these
assumptions provided that the financial implications for the
future should the assumptions made prove, in fact, too prudent are
carefully explained to the company. The assumptions clearly can
not be so strong as to advance the funding of the scheme to a
level unacceptable to the Inland Revenue. On the other hand, a
company may c u r r e n t l y be r e l u c t a n t to i n c r e a s e i t s annual

Page 4
commitment to the pension scheme and a balanced position may only
be obtained by use of a weak valuation basis or a funding plan
which delayed the funding of scheme benefits. These are more
difficult circumstances for the actuary. He must certainly draw
his client's attention to the fact that he considers the funding
rate to be too low and also to the consequences that will ensue in
the future if the experience of the scheme accords with actuarial
assumptions he would prefer to adopt: the company may, in the
event, be in the position of deciding on the funding rate that
will actually be paid. The question that arises i s whether the
actuary should adopt his preferred moderate basis showing a
considerable capitalised shortfall in the on-going funding
position, perhaps alienating his client, or adopt an "in-between
basis" showing a smaller capitalised s h o r t f a l l , encouraging a
moderate funding increase, while at the same time suggesting that
some further increase would not be discouraged. This is clearly a
matter for individual decision. The purpose of this brief
discussion of the on-going valuation basis i s to emphasise that
there i s no correct set of assumptions to be adopted for a l l
pension schemes or for any particular pension scheme and that the
actuary should have some f l e x i b i l i t y in his approach if he i s to
provide advice which i s in accordance with his professional
judgement while at the same time providing an acceptable way
forward for the pension scheme. The on-going valuation i s
discussed further in Section 5.

2.6 Sales and purchases of companies often involve pension

arrangements. Four parties are involved (the vendor company, the
vendor's pension scheme, the purchaser company and the purchaser's
pension scheme) although the agreement of sale is often only made
between the vendor company and the purchaser company. The amount
available for transfer from the vendor's pension scheme i s
dependent upon that scheme's rules. Should i t be agreed that a
greater sum i s to be t r a n s f e r r e d in the l i g h t of accrued
l i a b i l i t i e s , then the l i a b i l i t y to meet the difference f a l l s on
the vendor company. Similarly, the purchaser's pension scheme
cannot make available more benefit than the transfer payment
provides without other financial support. Again, any promise of
additional benefit must be financed by the company making the
promise. Both companies and trustees require actuarial advice
although frequently only two actuaries are involved each advising

Page 5
both a company and scheme trustees.

2.7 During the a c t u a r i a l valuation of a pension scheme more

information on that particular scheme is available to the actuary
than at any other time. I t i s therefore the opportunity for him
to consider the whole spectrum of advice that he i s providing and
may be required to provide in r e l a t i o n to that scheme. He
provides advice on such matters as the level of transfer payments,
the level of benefits granted in respect of transfer payments
received, early retirement and l a t e retirement percentages,
commutation terms and numerous other matters concerning individual
members.

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 3. THE DISCONTINUANCE POSITION

3.1 I t has become increasingly common, and i s now mandatory

through GN9, for pension scheme actuaries to provide a written
statement following each valuation giving their opinion concerning
the security of the benefits available to the members of a scheme
in the event of i t s discontinuance. EXD2 refers specifically to
this point using the phrase "value of the accrued l i a b i l i t i e s " and
GN9 uses the term "accrued benefits". I interpret these terms (in
line with the guidance given in GN9) to be the l i a b i l i t y imposed
upon the scheme in relation to each member by granting him, had he
been a normal leaver on the winding up date, the benefit required
through the effect of "preservation" under Social Security Act
1973 and (if appropriate) of the guaranteed minimum pensions for
employees who are contracted out under Social Security Pensions
Act 1975. These benefits have been increased further through
legislation prohibiting the practice of "franking" and prospective
legislation to require schemes to revalue deferred pensions during
the period prior to payment commencing.

3.2 In order to be a true discontinuance c e r t i f i c a t e the

calculations must assume the immediate withdrawal of further
company financial support: both the scheme's future expenses and
any State scheme premiums would need to be met from the assets
available.

3.3 I t is important to consider the use to which the statement

is to be put, the people to whom i t i s to be presented, their
likely level of understanding of the terminology that is available
to the actuary for inclusion in the statement and the assumptions
that the reader will implicitly make about the statement unless i t
clearly states otherwise. The statement must state clearly the
level of benefit that could be provided in the event of the
scheme's discontinuance. For example, a statement incorporating,
as i t s main phrase, the words "all benefits to which the members
would have become entitled had they withdrawn from the scheme on
that date" would appear to be quite clear. However, even t h i s
could be argued as vague on the point of early retirement options
which could be treated differently depending on whether or not the
trustee's consent is required before they are available. A
statement using the words "the assets then accumulated by the

Page 7
trustees were sufficient to secure the level of benefits at that
date" i s not at a l l clear. In a winding up the level of benefits
is often stated in the rules to be the amount that the assets are
sufficient to secure.

3.4 GN9 indicates that a discontinuance statement should be

provided for a pension scheme as a regular event and further that
the percentage cover should be given if i t i s less than 100 per
cent. I agree that the percentage cover, if in excess of 100 per
cent, should not necessarily be given as i t may easily be taken by
the less well informed as a sign that a pension scheme has money
to spare and thus could be used to increase the pressure for
improvements in benefits which cannot be afforded. The difficulty
in according with GN9 and giving the percentage cover if less 100
(of which in principle I am in favour as i t creates pressure for
funding improvements to poorly funded schemes by informing members
of their level of security) i s the assumptions that must be made
in the calculation of that figure. The need to make assumptions
means that the figure becomes an opinion rather than a fact and i s
therefore open to dispute. The major considerations to be taken
into account when completing the discontinuance calculations are
discussed in the following paragraphs.

3.5 If the rules of the pension scheme in question provide for

pensions in payment to be increased on a guaranteed basis then i t
would be factually incorrect if these increases were not taken
into account in the benefits valued. However, some pension schemes
have a history of providing pension increases although they are
not guaranteed in the rules. A reasonable expectation of future
increases may well exist. Such increases are being funded by the
company either by making special funding payments or by forgoing
contribution abatements at successive valuations and, in the
context of a discontinuance, I feel that i t i s reasonable to
assume that the scheme need not continue to grant future increases
as i t will receive no further company financial support. However,
unless a discontinuance certificate is clearly worded a reader may
easily receive the impression that the expectation of future
pension increases would be supported.

Page 8
3.6 If the members of the pension scheme are contracted out of
the additional component of the State pension scheme then a part
of each member's benefit could be secured by the payment of an
Accrued Rights Premium to the DHSS provided, of course, that the
scheme rules allowed some offsetting reduction of benefit in these
circumstances. In current conditions this would be cheaper than
securing the benefit elsewhere. However, the ARP market level
adjustment is being varied each year until 1988 when the premiums
will be larger than they are at present. I feel that a statement
should not rely on the current adjustment rather than the higher
post 1988 adjustment in order to break the OPB 100 per cent level.
The level of funding would need to r i s e if the discontinuance
cover were not to be eroded in the future. The problem remains
that the Government Actuary may recommend further adjustment after
1988.

3.7 Two methods exist for placing a value on the accrued

l i a b i l i t i e s not secured by the payment of State scheme premiums:
(i) the actuary could calculate the assets he would require
were he advising a closed fund designed to provide those
benefits; or
(ii) the actuary could calculate the amount that a reputable
insurance company would charge if the scheme trustees were
to purchase the benefits.
Method (i) would require the actuary to make allowance for the
future expenses of administering the scheme, over perhaps the
following 60 years. I t would also be a matter of opinion, at the
date of discontinuance, as to whether or not the a c t u a r i a l
assumptions adopted were too s t r i n g e n t or i n s u f f i c i e n t l y
stringent; only the future experience of the closed fund would
provide the answer.
Method (ii) involves no such problems, or at l e a s t passes them
over to the insurance company, and i s therefore the method I would
use even though i t can be expected to provide a conservative
figure.

3.8 The most common approach to determining the t o t a l premium

that an insurance company would charge i s to obtain a set of
typical single premium rates for immediate and deferred annuities
and to apply these to the calculated benefits. However, if an
insurance company were to take over the full portfolio and to

Page 9
calculate the required total premium on the basis of future cash
outflows i t could considerably improve on those single premium
rates by noting the greater amount of total benefit that could be
matched and met without the need for reinvestment. It is
theoretically possible to have a mix of immediate and deferred
annuities which could be supported without any reinvestment and
hence for which the purchase price could be calculated using the
interest rate available in the market. I am unaware of any
situation where an insurance company has agreed to use rates other
than i t s single premium rates with perhaps a small reduction on
account of the volume of the business. The point i s therefore
perhaps more theoretical than practical.

3.9 Having placed a value on the discontinuance l i a b i l i t i e s the

actuary must also place a value on the scheme's assets. The total
of the single premiums that an insurance company would charge is a
current cost and the appropriate valuation of the assets i s
therefore market value. The following problems can arise and
should be identified:
(i) Large portfolios of investments cannot be turned into cash
within a short space of time without producing a
significantly lower sum than their quoted market value.
The assumption must therefore be made that the insurance
company approached would accept most, if not a l l , of the.
existing portfolio of investments as the consideration.
The question then arises as to how to deal with a large
portfolio with substantial overseas or other investments
where an insurance company may not find the portfolio
acceptable for a large volume of U.K. immediate and
deferred annuities. If the point is of significance to the
statement being provided, the solution may be to include
the investments at a written down value or to qualify the
statement accordingly.
(ii) Some pension schemes have large property holdings. Market
values are usually prepared on the basis of a willing buyer
and a willing seller and in times when the property market
i s weak a forced sale may be v i r t u a l l y impossible at any
reasonable price. Properties may be held at book value,
which may be an over or an under valuation. Even recent
property valuations by professional advisers can provide

Paae 10
 figures which are found to be considerably wide of the mark
when a property is actually sold p a r t i c u l a r l y if a forced
sale i s necessary.
(iii) Portfolios may include unquoted investments, although
usually not significant holdings, which produce valuation
problems similar to property holdings.
(iv) The assets of a pension scheme can include shares and fixed
interest stock of the employing company as well as debtors.
Debtors can be divided between the employing company and
other debtors. This l a s t category will probably be small
and can normally be taken at f u l l value, the scheme
accountants should have included any necessary bad debt
provision. More care is required for any debts owed by the
company and any company stocks and shares held. Should
they be excluded, be included at a written down value
recoginising their probable worth in a discontinuance
situation or be included at full value with a suitable note
on self investment? Some contracted-in pension schemes have
a large percentage investment in the employing company and
only the last course of action would enable a 100 per cent
discontinuance certificate to be given.

3.10 If a true discontinuance of the pension scheme i s being

considered allowance needs to be made for the expenses involved.
If the pension scheme is a large scheme the assumption may be
possible that the margins already included in the calculations
will be sufficient to cover any expenses. For small pension
schemes this is unlikely to be true and proper allowance should be
made. Even if the company has normally met the expenses of the
scheme, the winding-up provisions invariably provide for the
scheme to meet i t s own expenses.

3.11 I have dwelt at length on the problems involved in giving a

discontinuance statement for a pension scheme because I feel that
all problems should be identified for each pension scheme before
the actuary, in the majority of cases, can dismiss them due to the
size of the margin of safety i n d i c a t e d by his initial
calculations. I believe t h a t I have also i l l u s t r a t e d the
significant expense that would be involved if a discontinuance
certificate giving an accurate percentage cover were required in
a l l cases. However, in those schemes where these i n i t i a l

Page 11
calculations indicate a cover of less than 120 per cent, say, then
closer attention must be paid to the problems noted above. In
particular, where more accurate calculations indicate that the
cover i s less than 100 per cent, and should t h i s figure be
published, then i t becomes very important that the pension scheme
actuary is fully aware of the assumptions underlying the figure he
i s giving. The pressure for some short term financial plan to
correct this situation will be produced and the employing company
will undoubtedly wish to question the actuary or at least discuss
the assumptions made in the calculations. It is always possible
that the employing company may decide to commission i t s own
discontinuance valuation separately from the trustees.

Page 12
 4. THE ACTUARIAL CERTIFICATE A

4.1 The actuarial calculations and considerations that enable

an actuary to sign an Actuarial Certificate A (which allows
members of a pension scheme to be contracted out of the
additional component of the State scheme) are not dissimilar from
those of Section 3, the discontinuance position. However, there
are a number of differences t h a t should be noted in the
investigation:
(i) The Actuarial Certificate covers both the current position
and the position during the subsequent 5 years. There are
thus two elements to be considered, the existing level of
funding and the rate of contribution being paid to the
scheme. In the large majority of schemes this latter item
i s significantly in excess of the minimum required and
l i t t l e investigation i s needed. Situations do arise
however where, because of a recent large redundancy
exercise for example, the current funding rate has been
reduced to a low l e v e l and further consideration i s
required before the Certificate can be signed.
(ii) The order of priority of the l i a b i l i t i e s of the pension
scheme i s important. Although GMPs for active members
normally have priority over the provision of full leaving
service benefits for active members there can be exceptions
to this, particularly in respect of benefits accrued prior
to April 197 8. The provision of an Actuarial Certificate A
would therefore, considering only the current situation,
normally require a lower level of active member benefit
security than the provision of a discontinuance certificate
showing at least 100 per cent cover.
(iii) The C e r t i f i c a t e A r e q u i r e s t h a t a l l reasonable
eventualities during the 5 year period must be taken into
account. These include the p o s s i b i l i t y of significant
numbers of early retirements or withdrawals where the
benefits of the members concerned would move into a prior
l i a b i l i t y class. The early retirement aspect i s now
referred to in an undertaking that the OPB require the
employer to sign. I t is unclear to me whether or not this
reduces the actuary's responsibility in this respect. The
withdrawal point remains.

Page 13
(iv) The OPB have set firm guidelines on the approach to be
taken to concentrations of investment and to self
investment.

Page 14
 5. THE ON-GOING ACTUARIAL VALUATION

5.1 The on-going funding rate for a pension scheme i s by

definition the rate required to secure, on the a c t u a r i a l basis
used and funding plan adopted, the benefits promised. The need to
make assumptions as to the future experience of the scheme means
that the outcome of the calculations is more subjective than the
outcome of the discontinuance calculations where both the assets
held and the l i a b i l i t i e s to be met can both be defined. However,
for the reasons explained in Section 3, I would not necessarily
expect two actuaries acting independently to obtain a much closer
figure for the percentage cover than I would for their recommended
on-going funding r a t e . Few recipients of funding advice would
wish to be presented with a whole range of funding rates based on
varying assumptions; most would much rather receive advice in the
form of a recommended funding r a t e , the effects of which the
actuary is willing to discuss. The object of the on-going
actuarial valuation i s therefore (i) to calculate a single funding
rate that is to be recommended, and (ii) to enable the actuary to
discuss with the trustees and company the effect on the scheme's
financial position that deviations in the future experience of the
scheme, from the assumptions made, would have.

5.2 A valuation basis consists of assumptions as to a l l aspects

of the pension scheme's future experience both with regard to
mortality and other decrements and to financial matters. The
strength of the basis (the smallness of the probability of the
recommended funding rate proving insufficient) cannot be assessed
by looking at any one assumption; the basis must be considered as
a whole. I t i s quite possible to demonstrate for a p a r t i c u l a r
scheme that a valuation basis using a 6 per cent per annum rate of
interest can produce the same on-going funding rate as one using a
10 per cent per annum rate of interest.

5.3 The frequency with which t r u s t e e s , employers and other

parties interested in the pension scheme ask questions which begin
with what if" and proceed to refer to a variation in experience
from the assumptions made, or from one of the assumptions made, i s
increasing. The effect of t h i s has been a tendency to move away
from assumptions incorporating low rates of i n t e r e s t towards
assumptions incorporating a higher rate of interest and where each

Page 15
of the assumptions made can be more readily j u s t i f i e d and
discussed separately rather than by continual reference to the
total basis. This i s analogous to the net premium and gross
premium valuations of a l i f e office. GN9 recommends that in the
p a r t of an a c t u a r i a l v a l u a t i o n report which d i s c u s s e s the
assumptions made "attention should be directed p a r t i c u l a r l y to
those assumptions to which the contribution is sensitive". The
"net premium" basis presents a larger communication problem than
the "gross premium" basis.

5.4.1 The main elements of the actuarial basis for an on-going

valuation of a pension scheme are discussed in the following
paragraphs. My comments assume a "gross premium" basis. The
treatment or valuation of the invested assets of the scheme i s
discussed separately in Section 6.

5.4.2 The three main financial assumptions to be made are (i) the
rate of investment return (income and capital gain combined) that
will be available on future new investments, (ii) the rate of
future salary progression (including both promotion and
inflation), and (iii) the rate of increase of pensions in payment
to be taken into account. The majority of bases currently in use
adopt a rate of return between 7 and 10 per cent per annum; i t i s
unusual to find a non-integral rate of future investment return.
The Government Actuary used a rate of 9 per cent per annum in his
calculations concerning the earnings related State scheme. The
assumed rate of future salary or earnings progression must include
allowance for both i n f l a t i o n a r y and promotional (normally
appropriate to staff employees) increases. These can either be
combined into one assumed r a t e of i n c r e a s e or be t r e a t e d
separately using a salary scale. A combined rate would, in the
majority of bases, be between 0 and 3 per cent per annum lower
than the assumed rate of investment return. There i s growing
pressure for some increases to be provided to pensions in payment.
Where increases are not guaranteed in the scheme rules but there
i s a history of them being granted or a desire to be able to grant
them in the future then some assumed r a t e of i n c r e a s e i s
appropriate, always provided that the rules of the scheme are
phrased in such a manner as to make this acceptable to the Inland
Revenue. Some trustees and employers find i t easier to understand

Page 16
a basis which is less cautious in i t s salary growth assumption but
which includes an allowance for uncovenanted pension increases
rather than one with no allowance for uncovenanted pension
increases but where the salary and interest assumptions are more
stringent. It i s quite possible that these two approaches would
produce similar recommended on-going funding rates and allow
similar levels of pension increases to be granted at subsequent
actuarial valuations. I mention this point as an illustration of
the need to consider the whole actuarial basis, rather than just
one or two elements, when deciding upon i t s strength relative to
another. It also i l l u s t r a t e s the need to consider, in advance,
the questions that may arise and the way in which they can be
answered. Understanding the financial assumptions made means
understanding the consequence of variations from them in the
future experience of the scheme. A combination of experience and a
selection of the calculations now possible by modern computers on
different actuarial assumptions appears essential.

5.4.3 The assumption made concerning the level of future

withdrawal from the scheme is normally either a nil incidence of
future withdrawal or a level of withdrawal that the scheme i s
likely to experience in the situation of the employing company
continuing to trade at i t s current level. Many funding methods
such as the aggregate funding method where the total funding rate
is expressed as a percentage of t o t a l s a l a r i e s have the feature
t h a t , for young members, the value placed on the future
contributions calculated on that member's salary exceed the value
of the liability in respect of both his past and potential future
service; the member i s an "asset" or negative value. The effect
of such a member leaving the scheme, if he i s in addition to the
assumed number of leavers on the valuation basis, is for the
scheme to both lose an asset and incur a l i a b i l i t y in respect of
the benefit granted. This l a t t e r item has, over recent years,
steadily been increased. The question must therefore be asked
"what if the assumed rate of withdrawal proves incorrect?" Should
fewer withdrawals occur than expected then a scheme is unlikely to
be adversely affected because assumed withdrawals are normally at
young ages where a withdrawal reserve would be a positive item.
Should more withdrawals occur than expected then the extent of any
strain will depend on the scheme's level of funding at the ages
concerned: if the past service reserve i s P, the future service

Page 17
reserve is F and the value placed on future contributions C, then
(i) if F>C the valuation reserve will almost certainly support the
leaving service benefit, (ii) if F<C but P+F-c>0 there may again
be no strain depending on the level of P+F-C compared with the
benefit granted, and ( i i i ) if P+F-C<0 a valuation s t r a i n will
occur unless the leaver is also replaced by a new entrant of, say,
the same age and salary so that P w i l l be available to meet the
benefits granted. The effect of future withdrawals cannot always
be ignored because i t is not always appropriate to assume that the
leaver will be replaced by a new entrant.

5.4.4 If, as seems reasonable, we assume that the value of a

withdrawal benefit is less than a past service reserve calculated
on a final salary basis then the seemingly anomolous situation
exists that, although new entrant funding rates are higher on a no
withdrawal assumption than on a with withdrawal assumption, the
aggregate funding rate for a pension scheme i s lower. This
situation is explained by the fact that a marginal increase in the
funding rate for a young member, calculated on a no withdrawal
b a s i s , i s of a much g r e a t e r value than one c a l c u l a t e d
incorporating a withdrawal assumption. I illustrate this with the
crude example of a scheme of two members, one aged 25 and one aged
60 where the new entrant funding rates on a no withdrawal basis
are, say, 8% and 12% respectively. A no withdrawal valuation will
produce an on-going funding rate of perhaps 8.5%. A valuation
that has a withdrawal probability of unity at age 25 will have an
on-going funding rate of 12%.

5.4.5 The experience of some companies over the l a s t 5 or so

years has often been one of a sudden reduction in the work force.
This may be due to an early retirement programme, a redundancy
exercise or the closure or sale of some aspect of the business.
I t would be impossible to build the probability of such a future
experience into a valuation basis. However, such things can and
do happen and i t i s therefore important that the information
provided by the valuation should enable such p o i n t s to be
considered. Frequently the f i r s t that an actuary knows about such
a situation is that the withdrawals have occurred or are occurring
and the client i s now seeking advice on the effect that i t will
have on the pension scheme. The effect will vary from one scheme
to another depending on both the rules of the scheme and the state
of funding of the scheme.

5.4.6 The future experience of a pension scheme w i l l , unless i t

is a closed scheme, include increments by way of new entrants as
well as decrements. Calculation methods can allow for an
incidence of new entrants to the scheme other than by the method
of not using a withdrawal decrement as discussed above. One
effect of including a new entrant increment could be to extend the
term of the calculations to infinity! It is important to consider
the funding rate that w i l l be required to support future new
entrants at a range of ages so that their effect, which can be
either to increase or to decrease the existing funding r a t e , can
be anticipated and taken into account in any advice given. If the
funding rate for typical new entrants i s considerably less than
that brought out by the valuation then, in order to lessen the
current pensions burden, the actuary may well feel able to discuss
the effects of adopting a lower rate than that indicated by
considering only the existing membership, knowing that in future
valuations the on-going funding rate can be expected to fall under
the effect of new entrants. If the funding rate for anticipated
future new entrants is higher than the on-going funding rate then
to recommend the maximum immediate reduction could be to hide the
fact that an increase is anticipated following future valuations.

5.4.7 Many pension schemes provide an immediate pension benefit

to members who r e t i r e due to i l l - h e a l t h . A decrement based on a
suitable pension scheme past experience is appropriate. In recent
years some employing companies have "extended" their definition of
ill-health as a possible alternative to making members redundant.
This i s beyond the actuary's immediate control and the normal
effect is to place a strain on the pension scheme which will then
emerge at the next actuarial valuation. It would not be feasible
to allow for the probability of such a short term future practice
within the decrement table and the actuary's only approach may be
to draw the financial effects of this practice to his c l i e n t ' s
attention as he becomes aware of i t .

5.4.8 The rules of most pension schemes allow members to r e t i r e

early other than on grounds of ill-health. If the level of
benefit available on early retirement i s such that a member
r e t i r i n g early does not place a s t r a i n on the scheme in terms of
increasing the funding rate necessary to support the remaining
members then there i s no need to incorporate any early retirement
decrement in the valuation assumptions. The early retirement
option offered by some schemes, e.g. the f u l l accrued pension
taken immediately if retirement is within 3 or 5 years of normal
r e t i r e m e n t age, i s s i m i l a r to o p e r a t i n g a reduced normal
retirement age for those requesting i t and forms an "option
against the scheme". Some allowance must be made. One method
available is to calculate the age at which the greatest potential
financial s t r a i n e x i s t s and then to calculate the on-going
funding rate assuming that a certain proportion of members retire
at that age, the rest remaining until normal retirement age. The
question to be s e t t l e d i s the proportion to be assumed. One
approach would be to assume 100 per cent but t h i s would almost
certainly not be borne out by the scheme's future experience and
would present a funding rate to the company which was higher than
necessary. The company's opinion must be sought as to whether the
past experience, if any, can be taken as a guide to the future or
whether changes in the company's approach to retirement will vary
significantly the proportion going early.

5.4.9 Many mortality tables are available from which the actuary
can s e l e c t both death in s e r v i c e and death in r e t i r e m e n t
decrements. The mortality of pensioners, and most importantly,
future pensioners should not be understated. I t i s possible to
argue that, depending on the level of death in service benefit, a
table incorporating a high mortality decrement at low ages and a
low mortality decrement at high ages would be the cautious
approach to in service mortality. This may be an i n t e r e s t i n g
theoretical pursuit but in practice I would not anticipate finding
tables much different from A67/70 or some similar experience.

5.5 An on-going actuarial valuation usually includes as assets

both the invested fund and the c a p i t a l i s e d value of future
contributions assuming that they continue to be paid at the
current level. The l i a b i l i t i e s similarly include the capitalised
value of l i a b i l i t i e s both in respect of completed service and in
respect of future service. Subtraction of total l i a b i l i t i e s from
total assets produces a figure often referred to as a "surplus" or

Page 20
a "deficit". This will only emerge, over the future of the
scheme, if the future experience corresponds to the valuation
assumptions made including the maintenance of the current
contribution level. The main factors which have contributed to
this "surplus" or "deficit" will be shown up by an analysis of
surplus normally conducted on the previous valuation basis. It is
important to distinguish between one-off contributory factors and
those indicating long term change. The valuation balance i s often
redressed by the company adjusting the level of i t s future funding
rate over either the short or the long term. If the valuation
reveals a "surplus" then pressure to improve the lot of pensioners
or to improve the benefits accruing to current members can arise.
Any increase in pensions or deferred pensions or in the value of
the benefit payable to one class of member more than another
affects the level of benefit that would be available to active
members in the event of the scheme's discontinuance. If the scheme
i s in the position where leaving service benefits to active
members are covered less than 100 per cent on a t h e o r e t i c a l
discontinuance then the potential inequity of the proposed changes
must be bought to the trustees'/company's attention. If the
scheme were able to support t h i s enhanced level of benefit and
maintain the 100 per cent cover then the p r a c t i c a l requirement
that a pension scheme must be allowed to evolve via pension
increases and other benefit improvements has a bearing on deciding
what i s a fair approach to be taken. If some of the revealed
"surplus" were to be used for benefit increase purposes then this
could be considered as a reduction in the funding rate combined
with a benefit improvement funded by a special additional funding
rate equal in value to the additional benefits granted. The term
of t h i s special payment may be longer than the term of the
additional benefits being provided thus reducing the pace of
funding of the scheme.

5.6 Section 3 discusses statements, provided by the actuary,

covering the discontinuance position of the scheme. Actuaries are
more frequently than previously being requested to provide
statements concerning the adequacy of the on-going funding rate.
(I have assumed that the valuation method used i s an aggregate
funding or similar method and not a discontinuance funding
method.) If the actuarial valuation on which the statement i s
based showed a balanced position, i . e . the capitalised value of

Page 21
future c o n t r i b u t i o n s at the current r a t e was equal to the
difference between the c a p i t a l i s e d value of current and
prospective l i a b i l i t i e s and the value placed on the invested fundf
then a statement along the following lines can be contemplated:
"If the future experience of the scheme is no less favourable than
the f i n a n c i a l and other assumptions underlying the l a t e s t
actuarial valuation then the on-going funding rate will be
sufficient to meet the scheme benefits as they fall due." A
statement of this form frequently meets the requirements of those
seeking i t , often for inclusion in the pension scheme accounts.
However, the statement does not provide a guide as to long term
benefit security because i t does not consider the actuarial
assumptions made. If those assumptions had, for example, involved
a 3 per cent difference between the assumed rates of future salary
growth and investment return then the statement would be less of
an assurance for the future than had the assumed difference been 1
per cent. One way forward, intended to improve the statement, and
which some accountants pursue i s to l i s t the main valuation
assumptions. This format would place on the reader, possibly a
pension fund member or other non actuarial reader, the onus of
interpreting the "strength" of the basis for himself. If he could
do that properly, without training, then surely he should be
joining the actuarial profession. One person who can properly
place the assumptions in context i s the actuary making the
statement and an additional sentence expressing the level of the
actuary's satisfaction with the assumptions adopted could be made.
He may consider adding; "I consider that the assumptions made,
taken together, form a sound financial structure for the on-going
position of this pension scheme". If the basis adopted were
weaker than the actuary would perhaps wish to use, had
circumstances permitted, then his thoughts may run along the
lines; "I consider that the assumptions made, taken together,
although forming a less prudent picture of the future than I feel
may indeed be experienced, do not represent so unlikely an event
as to be unreasonable." Such wording may prove, however, not to
be altogether what the company/trustees had in mind. The question
which I pose i s : "Should an actuary (or the profession
collectively) be content to issue statements concerning the on-
going position of a pension scheme which are both true and
acceptable to the company/trustees but which do not answer the
real question which is being posed?"

Page 22
 6. THE TREATMENT OF THE INVESTED
ASSETS IN THE ON-GOING VALUATION

6.1 The actuarial valuation of the assets and l i a b i l i t i e s of a

pension scheme requites a value to be placed on those assets and
l i a b i l i t i e s each of which consist of a past element and a future
element. Section 5 considers the value placed on the future
assets (i.e. promised future contribution income) and on the
l i a b i l i t i e s both in respect of past and of future service. This
Section considers the value to be placed on the past assets, the
investment portfolio.

6.2 I have only considered investments in the form of a

directly held investment portfolio (including managed fund units).
I have not considered the situation where the invested assets are
in the form of insurance or annuity contracts.

6.3 Traditionally there are three methods of placing a value on

the invested assets, namely; (i) their book value, (ii) their
market value, and (iii) their discounted value obtained by
discounting the stream of investment income and redemption
proceeds that i t is anticipated they will generate in the future.
Both the market value method and to a lesser extent the book
value method have had and do have their proponents and indeed
there are circumstances (for example a mature closed scheme) where
an asset valuation at market value would be the approach
supported by the large majority of actuaries. However, in the
general case of an on-going pension fund, I believe that the
balance of the argument f a l l s in favour of the discounted cash
flow method. I do not intend to r e i t e r a t e the well established
arguments both for and against the discounted cash flow method
except to note, for future reference, the main advantages of the
method. These advantages are (i) i t provides a stable value in
times of temporary market fluctuations so avoiding unnecessary
alterations to the funding rate, and (ii) i t is consistent with
the valuation of the l i a b i l i t i e s and future contributions which
are also valued by discounting future expected cash inflows and
outflows.

6.4.1 I do not, however, believe that the discounted cash flow

Page 23
method does not have any shortcomings, because i t does. Firstly,
i t places a value on the investments which i s neither of the
values (market value and book value) with which the average
pension fund t r u s t e e i s familiar. I t can thus help to create a
mystique about the actuarial valuation which can inhibit a trustee
from making enquiries or seeking c l a r i f i c a t i o n s which would
enhance his understanding of the valuation.

6.4.2 Secondly, and much more importantly from an actuarial point

of view, the method can place a different value on fixed interest
securities relative to their market value than i t does on equities
relative to t h e i r market value. I t i s not unusual for a pension
scheme's investment managers to have a f a i r l y free hand in the
investments that they make and the investment strategies that they
adopt and hence two valuations conducted as l i t t l e as three months
apart could place a significantly different value on the invested
a s s e t s of the same pension scheme i f during t h a t time the
investment manager's view of the correct investment posture had
altered. This weakens one of the main advantages of the method,
that of stability over time.

6.4.3 If the actuary conducting the valuation stuck rigidly to a

system he derived e a r l i e r i t i s t h e o r e t i c a l l y possible for the
results of an actuarial valuation to be deliberately distorted by
the scheme adopting the investment spread which provided a higher
discounted value. I am sceptical about whether or not such a
situation would a r i s e in practice but I can see that i t might,
say, where a company or a subsidiary company with i t s own pension
scheme were being sold and an actuarial report showing as well a
funded pension scheme as possible would be a distinct advantage to
the vendor.

6.4.4 Thirdly, while the discounted cash flow method i s readily

applied to U.K. fixed interest and equity investments, i t is much
less readily applied to other investment sectors, namely overseas
stocks, property, index linked gilts and cash. The proportion of
pension scheme assets invested in the f i r s t three of these sectors
has increased significantly in recent years.

6.4.5 A scheme's overseas holdings can be f a i r l y thinly spread

across numerous markets and there are many areas for which a

Page 24
market index is not available. Investment abroad i s often only in
a few of the economic sectors available and often then only in a
few large companies; a whole market index, if available, i s not
necessarily appropriate. Even where an appropriate index i s
available a decision must be taken as to the dividend growth rate
to be assumed. Can an actuary s u s t a i n the assumption of a
different dividend growth rate to that assumed for U.K. equities?
A lower growth rate assumption could be argued for due to the
added risks in investing abroad. However, if the index yield
(allowing for withholding tax as appropriate) i s less than the
U.K. index yield then the effect would be to write down, relative
to market value, the overseas investments compared with the U.K.
investments. A trustee, or investment manager, with significant
overseas exposure may query why, if the actuary takes such a
pessimistic view of overseas investments, he has not spoken up
more strongly against them when investment policy has been under
discussion. On the other hand, taking into account the added
r i s k s involved through i n v e s t i n g abroad, i t would seem
inappropriate to place a higher value on overseas investments than
on a similar market value of U.K. investments.

6.4.6 property investment can range from a holding of managed

fund property u n i t s , possibly representing a broad property
portfolio, to one or two single large properties . A property
equivalent of the FTA All-Share Index, providing market level and
yield, does not e x i s t . Even if i t did, could i t be used when, in
the case of the single large property, marketability cannot
readily be assumed. Using the actual rental income on the
portfolio held i s a p o s s i b i l i t y but again, as with overseas
investments, some future rate of income growth must be assumed.
The assumption of a rental growth rate which provides either a
more favourable or less favourable value when compared with U.K.
equities can, as with overseas holdings, invite d i f f i c u l t to
answer questions about the actuary's approach to investment
advice.

6.4.7 Index-linked gilts are a recent introduction to the

investment market and are generally considered more an alternative
to equities (or to property) than to fixed interest investments.
A discounted value could be placed on them by making an assumption

Page 25
as to the future level of i n f l a t i o n , consistent with the other
assumptions in the actuarial basis. However, as with the overseas
and property holdings, this could i n v i t e comparisons with the
treatment of a similar market value of U.K. equities.

6.5 The direct or indirect use of market values in most methods

of valuing the invested portfolio raises the additional question
as to the steps to be taken to ensure that the market values shown
are reasonable. If the v a l u a t i o n of stocks and shares i s
conducted by a merchant bank (a professional investment manager)
then can i t be taken without further investigation? Market values
of property holdings, gold, diamonds etc. are normally provided by
professional valuers. Does checking that the valuation has been
conducted by a professional valuer constitute a sufficient check?
These comments are equally important to Section 3, the
discontinuance position.

6.6 Overseas, property and index-linked investments a l l serve

to broaden the equity type investment of the pension scheme by
taking advantage of other investment opportunities and w i l l in
theory provide a more stable market value for the whole portfolio.
An investment manager must not expect a lower return from the
diversified p o r t f o l i o , a more stable market value i s not more
important than long term return. If diversification does not
imply a lower expected long term future investment return than i s
expected from a pure U;K. equity portfolio then, by implication,
treating the four sectors of U.K. e q u i t i e s , overseas stocks,
property holdings and index-linked g i l t s as one combined U.K.
equity portfolio must be a conservative approach. One natural
conclusion i s t h e r e f o r e t h a t if t h e s e s e c t o r s are t r e a t e d
separately, presumably to place a lower value on the non-U.K.
equity investments, then either a positive approach should be
taken to providing investment advice (recommending against these
sectors) or there must be some reason for assuming that the quoted
market values for these investments are not a reliable indication
as to their realisable value.

6.7 The principal purpose of investments i s , as stated by Day

and Jamieson, to meet the l i a b i l i t i e s which they support as they
fall due. The nature of those l i a b i l i t i e s will therefore
influence the nature of the assets held. Most, if not all,

Page 26
pension schemes have the objective of funding each members1
pension by the time that member r e t i r e s or leaves. As a direct
consequence of this I conclude that the f i r s t objective of the
assets of a pension scheme is to support the current and deferred
pensioners (those members who have already left or retired) of the
scheme with the secondary objective of supporting the active
members.

6.8 In the large majority of pension schemes the current and

deferred pensioners represent a fixed money l i a b i l i t y even if
there i s some guaranteed level of pension increases provided by
the scheme. Some schemes do have a history and intention of
providing additional pension increases but these too can be
considered in terms of a fixed money l i a b i l i t y allowing for future
pension increases at an appropriate r a t e . The l i a b i l i t y to be
supported in respect of the active membership is normally related
to future salary levels and is therefore a "real liability". This
division of scheme l i a b i l i t i e s by nature implies, in reasonably
stable economic conditions, an appropriate division of assets by
nature.

6.9 I do not advocate a s t r i c t investment policy of supporting

fixed money l i a b i l i t i e s with fixed money a s s e t s and r e a l
l i a b i l i t i e s with corresponding a s s e t s (the "corresponding
position"). The on-going and expanding nature of a pension scheme
allows variations in investment policy which are designed to
improve the investment r e t u r n r e l a t i v e to t h a t of the
corresponding position. Thus, for example, i t would be wrong to
criticise a scheme that was invested 100 per cent in U.K. equities
provided that this situation were a positive decision in search of
a higher investment return and that the age of the scheme, i t s
funding position and whether or not i t were contracted out allowed
such flexibility.

6.10 My conclusion is that a reasonable and consistent approach

to placing a value on a pension scheme's invested assets would be
to assume a notional portfolio, equal in market value to that of
the portfolio actually held, whose division between fixed interest
investments and equity investments was set equal to that of the
corresponding position. A value would be placed on the notional

Page 27
equity portfolio in the same manner as under the normal discounted
income method. The advantages of t h i s approach over the normal
discounted cash flow method are that i t i s more stable over time,
being i n d e p e n d e n t of the a c t u a l and v a r y i n g p r o p o r t i o n a l
investment in market sectors, and t h a t i t automatically deals with
the overseas, property and index l i n k e d s e c t o r s . The approach
r e t a i n s the disadvantage of i n t r o d u c i n g a t h i r d v a l u a t i o n in
addition to the well understood book value and market v a l u e . In
paragraph 6.6 above I argued that t r e a t i n g a l l non-fixed i n t e r e s t
investments as U.K. equities i s a conservative approach, (else the
i n v e s t m e n t should have been i n U.K. e q u i t i e s ) and t h i s i s
continued by arguing t h a t the suggested corresponding p o s i t i o n
assumption i s a conservative approach to asset valuation, (or else
the investment managers should move to that position immediately).
The argument cannot be extended f u r t h e r , to assuming a complete
investment in any one sector, as such an investment position would
in p r a c t i c e be intended to provide s h o r t term gain r a t h e r than a
long term s t r a t e g y . If i t were intended as a long term s t r a t e g y
then the a s s e t s and the l i a b i l i t i e s of the pension scheme would
not correspond by nature and some a d d i t i o n a l v a l u a t i o n r e s e r v e
would surely be needed to cover t h i s .

6-11 In practice the approach would be as follows:

MV = The market value of the a c t u a l p o r t f o l i o held
FV = The value of the fixed money l i a b i l i t i e s of the
pension scheme valued a t a market r a t e of i n t e r e s t making due
a l l o w a n c e for any g u a r a n t e e d r a t e of pension i n c r e a s e or
uncovenanted future pension i n c r e a s e s . In p r a c t i c e two market
rates of i n t e r e s t might be required since deferred annuities are
generally taken at a lower rate of i n t e r e s t reflecting the need to
reinvest income.
FD = The d i s c o u n t e d v a l u e of t h e same f i x e d money
l i a b i l i t i e s but at the valuation rate of i n t e r e s t , making the same
assumptions as to pension i n c r e a s e s . FD i s the figure a t which
these l i a b i l i t i e s would be included into the valuation.
(1+W) = The write up (or down) to be applied to equity
market values in order to obtain t h e i r discounted value having
regard to the y i e l d on the FTA All-Share Index and the assumed
dividend growth r a t e .
The assets would be included into the valuation a t :
(MV - FV) (1+W) + FD

Page 2 8
6.12 This asset valuation method does not consider the assets
a c t u a l l y held other than by market value and t h i s can be
considered a weakness relative, to the normal discounted income
method. I believe that the following four points more than offset
t h i s : (i) the distribution of the investments held within a
portfolio can be constantly varying under short term influences
and the normal discounted cash flow method, by considering the
actual assets held, can suffer on t h i s count, (ii) the normal
discounted income method cannot i t s e l f r e a d i l y deal with
investment in managed fund units, which form a lesser or greater
part of most investment portfolios, and for which the investment
information available i s sometimes scarce, ( i i i ) the normal
discounted income method, although supposedly based on the assets
held, assumes that all equity investment is in an "average equity"
and does not allow for the p o s s i b i l i t y of a biased portfolio
either by market sector or by type of equity, and (iv) property
overseas and other non fixed i n t e r e s t or equity stocks provide
d i f f i c u l t i e s in the normal discounted income method or at l e a s t
require i t s significant adjustment.

6.13 Two disadvantages do exist for this valuation method

relative to the discounted income method. Firstly, i t may be more
difficult to explain to a trustee or other client and secondly, if
a c l i e n t enquires about the cost of, say, increasing pensions in
payment by 10 per cent, the actuary must either vary the valuation
of assets (this could be quite d i f f i c u l t to explain) or permit
some deviation from the s t r i c t application of the method allowing
any small distortion caused to emerge at the next valuation.

Page 29