An Investor's Guide To Pension Plan Analysis - An Introduction To Actuarial Assumptions.

14th Mar '16 by Tom Firth

6 comments 5889 reads

Following on from a previous introductory article, it’s time to take a closer look into precisely what actuarial assumptions are and how they can influence a company’s balance sheet. We’ll then take a brief look at the accounting standards that impact them and see where and how they could lead to difficulties for investors.

Broadly, the key assumptions we’ll be looking at are the discount rate, the rate of return, the inflation rate, the mortality rates of employees, the average number of years of service by employees and the actual number of employees.

The discount rate...

A discount rate is an annual interest rate that we use to work out the present value of a future cash flow. I will briefly explain this here but to avoid straying too far from the point, I would strongly recommend anyone to look up the ‘time value of money’ in order to learn more about this. It is a central concept in finance and crops up all over the place, in particular in security valuation.

What is the time value of money then? In short, it is the idea that money today is worth more than money tomorrow. This is because it has the ability earn interest in the meantime. For example, let's say I have the ability to deposit my cash today in a bank account earning 10% interest a year (if only!).

Someone then offers me the choice between £ 100 today or £ 105 in one year’s time. If we were unaware of the time value of money I would choose the £ 105 because it is a higher amount. We’re smarter than that though - we know that if we take the £ 100, we can put it in our bank account and earn 10% interest in a year. This means that the £ 100 will actually be worth £ 110 in a year’s time, which is definitely better than receiving £ 105 on that same date. In a nutshell, that is the time value of money.

In this example we would say that the future value (in a year’s time) of the £ 100 is £ 110, assuming a 10% discount (interest) rate. Equally, that £ 110 a year from now has a present value of £ 100, assuming a 10% discount (interest) rate. Notice that if we change the discount rate, then the present value also changes. £ 110 in a…

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pooledaniel

14th Mar '16

I'm a pensions actuary myself so quite familiar territory. I like seeing this discussed as I think it's something a lot of people struggle to understand, or simply ignore. You've done a really good job of writing this up in a way that a layperson can understand.

One point to note on the comments under Number of years service. Under the Projected Unit Credit funding method used for IAS19 (and for every Scheme Funding valuation I've ever seen), the liabilities at any given date allow for accrued service only, and not the expected number of years service that member's will have at retirement. Where there are active members, then there will typically be an allowance for future salary increases up to the point the member is assumed to leave service (be that retirement or some earlier withdrawal).

Ultimately if people continue in service for longer the liabilities will increase over time, but this isn't allowed for in the liabilities at a specific date (if it did, then you would probably have to allow for the PV of future contributions in respect of accrual in your assets).

Any other comments are purely pedantic! :) Again, well done on this - very good write up. Look forward to future posts.

It's been discussed a bit here before, but I think it's also important to understand the difference between Accounting, Scheme Funding and Buyout bases and what this may mean for the company. E.g. SF basis driving required contributions, potential massive hit if the Scheme was bought out etc. Maybe one for the future!

Tom Firth

Hi,

Thanks a lot for the feedback - to be honest with you I am no pensions expert though I have trained as an auditor in a previous life. So while this is semi(-semi)-familiar territory it is an area that is still a bit of a learning curve for me! As you've picked up, I'm trying to get some of these concepts across in as basic a way as I can in order to help equip private investors with the tools they need to analyse their stocks. That's what we're all about at Stockopedia after all!

You quite rightly say that this an area that a lot of investors shy way away from (I don't blame them personally...) and we've had a number of more experienced community members suggest that we could improve on the way we deal with things like pensions schemes in the StockReports etc. This blog series is the start of my thinking on how to accomplish that and we want the finished thing to be as useful a tool as it can be. If you have any other thoughts on the matter (no matter how pedantic!) then your input will be greatly valued. We are, of course, limited by what can be automated and data driven across the number of stocks that we analyse but a tool or range of metrics that helped to identify when a company could be at risk of a pensions write down would be a great addition to many investors' toolkits.

Re your point on the Projected Unit Credit funding method - I actually was not aware of this at all (I did say I wasn't a pro!) and if I understand your comment correctly it seems it could have quite a significant impact on PV calculations, in particular where the ratio of active to inactive members is high and where the average age of active members is low. This would be because there is potential for many more years of service to be accrued on top of the current level relative to a plan where the ratio of active to inactive members is low and the majority of years of service to be accrued have already been accrued. Does that sound about right? That said, presumably defined benefit schemes with a majority of young, active members are very much the exception rather than the rule these days?

My plans for the next couple of blogs on this series, as mentioned above were first of all to put this article into graphical format with a super simple fictional case study to try and demonstrate how some of these inputs can affect liabilities, then I was planning to follow up with a dig at BT's plan. With the disclosure coming in at around 8 pages in their latest accounts I figure there's got to be enough material for a good blog in there! After that though, that is a good idea you've put forward so I'll do some reading and think on it, definitely sounds to be one for the 'intermediate' course on pensions analysis! If you (or any one else reading) have other ideas for topics you'd like to see covered/think are important then just let me know.

Thanks again for taking the time to comment, much appreciated :), especially coming from an expert in the area like yourself!

Tom

CharMar

3rd Aug '16

Tom,

Thank you. You've done a great job with this. I might have to read it several times, which is why I have printed all three articles.
Pensions deficits are indeed a huge issue. But so too might other Off Balance Obligations be to many companies, and I'd like to urge you to do a short and similar series on that please. Auto-retailers and their stock financing, companies with JV obligations, sectors where one should bear in mind that financing structures often involve such commitments. How are they accounted for? Where should investors look for such problems and how should they judge them? We all know gearing can be a great thing for equity returns, but we also know that leverage can cripple very quickly.

Flackwell

Good discussion gents - and hopefully at the end of it we can review all of those pension funds listed on the stock market that have miniscule businesses attached to them such as BT, RSA, BAE, RBS etc etc

Hi all,

Glad you've found the articles helpful - I'll start doing some research for another series on this kind of thing. I actually need to do the last one for this series too...I was planning to apply the discussed ideas to an analysis of BTs balance sheet but things have been busy and I've failed to set aside time to properly research it.

Tom

AnonymousUser192020

Thanks Tom – all good stuff!

Just a couple of comments, as I’m increasingly out of touch with the pensions world:-

It’s worth, if you haven’t already done so, emphasising the distinction between accounting and scheme funding valuations. For a medium/ long term investment horizon arguably it is scheme funding that is the more relevant since it is this, through the deficit recovery plan, that drives the employer’s cash contributions. Selection of discount rate for the funding valuation will be more complex than for the IAS19 valuation – amongst other factors it will reflect actual (and expected) investment strategy and the degree of prudence desired by the trustees and employer (which itself will be a function of the perceived strength of employer covenant). Funding valuations often use differential discount rates for pre- and post-retirement liabilities.

Investment strategy is also a key issue for pension funds. Funds have tended to significantly reduce their equity (especially UK equity) holdings in recent years. Most trustees will be keen to de-risk where this can be achieved without too much strain on the employer. Moving from return-seeking to matching assets (primarily bonds) is a common objective. Some funds engage in ‘dynamic de-risking’ – a buzz word for making incremental switches when equities are relatively highly-valued relative to bonds. According to a Professional Pensions survey in June, there’s a lot of interest in interest rate and inflation hedging strategies. All this will help place the fund in a better position to engage in buy-in/ buy-out transactions with an insurer for significant tranches of liabilities (eg all pensions in payment) when conditions are favourable – for many trustees this is the ultimate de-risking goal. It goes without saying that a fund can’t anticipate equity-style rates of return/discount rates if it doesn’t hold much equities!

There’s a wealth of industry statistics available from the Pensions Regulator and other sources, eg http://www.thepensionsregulator.gov.uk/docs/scheme-funding-appendix-2016.pdf and http://www.thepensionsregulator.gov.uk/docs/scheme-funding-2016.pdf (‘tranche 9’ in this context denotes the most recent batch of triennial scheme funding valuations).

Looking forward to the next instalment in your magnum opus!

An investor's guide to pension plan analysis - an introduction to actuarial assumptions.

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Tom Firth

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