Trustee Xtra Issue 3 - Engaged Investor

TRUSTEEXTRAPUBLISHED BYENGAGEDTHE MAGAZINE FOR UK TRUSTEESTHIS ISSUE CAN ALSO BE DOWNLOADED AT www.engaged-investor.comISSUE 3 / JULY 2007Read up on this topic inside: actuarial assumptions – are you getting it right?ON THIS PAGEWhy assumptions matter totrustees and how our survey helpsyou benchmark your fundON PAGE 2How a cross-section of trustees settheir assumptions. Compare theirapproach and viewsON PAGE 3Experts give their views on the keyassumptions. Do your opinions tallywith that of your advisers’?ON PAGE 4Our survey partner Paternosteroutlines their views on the toughdecisions you face as a trusteeASSUMPTIONS SURVEYWhat are your assumptions?Take part in our benchmark survey of actuarial assumptions and find out how your scheme compares withothers like it. How do you set your key assumptions and how confident are you of making the best decision?AS A TRUSTEE you have to formallyvalue the liabilities of your pensionscheme every three years.But as any trustee who has gonethrough this process since April 2006will know, it is now your responsibilityto set all the actuarial assumptions– they can no longer be delegated toyour actuary.This means deciding the discountrate, the interest rate assumptions,long-term inflation predictions, salaryinflation and of course mortality rates.It is a weighty task and one manyfeel ill-equipped to tackle. But by beingforced to plunge into the detail of eachassumption, trustees are waking up tothe considerable risks they run of gettingthe predictions wrong.In a bid to find out what assumptionstrustees are setting, how they goabout the task and how comfortablethey are with the result, EngagedInvestor has teamed up with buy-outprovider Paternoster to undertake thefirst trustee survey of its kind.By taking part in our survey, youwill help to paint a picture of the landscapetrustees operate in. And for thefirst time, you will find out how yourassumptions compare with those ofyour peers’ up and down the country.We want to know if some trusteesare setting widely different assumptionsfrom others: and you as a trusteeneed to know this too.Most trustees are only familiar withtheir own scheme and its decisions:here’s a chance to benchmark yourscheme against others like it.WE WANT TO KNOW:How do you go about deciding on yourassumptions? What range of optionsdo you consider? How influential is theactuary and the other advisers on yourdecision-making? How many views doyou seek, or do you rely heavily on theopinion of your actuary?What decision did you make? Tellus the assumptions you made and atthe end of our survey we will publishthe aggregated findings. See how yourscheme compared to the universe ofUK-based defined benefit pensionschemes, large and small. The fullresults will be available in the Septemberedition of Engaged Investor.Are you comfortable with the decision-makingprocess? How confidentare you of making the right decision,and did it feel right that you, thetrustees, were responsible for thedetailed assumptions you made? Howcould the process have been improvedand what would you do differently?Do you feel that the actuarialprocess is prone to serious error andthat your liability projections run a realrisk of missing the mark? Are you tooconservative – and so putting an unnecessaryburden on the company sponsorand members for additionalcontributions? Or are you too optimistic– leaving your scheme at risk of beingunder-funded in the future and at riskof not meeting your promises to members?There are no right answers to thefine art of predicting the future – if therewere, we’d tell you what they are.Instead, give us your views and takepart in our trustee assumptions survey.You can take part anonymouslyand we will publish our findings in theSeptember issue. TXwww.engagedinvestor.com/trusteesurveyDO YOU WANT TO RECEIVE TRUSTEEXTRA BY EMAIL?SEND YOUR EMAIL ADDRESS TO trusteextra@newsquestspecialistmedia.comYOU CAN UNSUBSCRIBE AT ANY TIMEAre the assumptions you make about your DB pension scheme valid?How does your position on interest, mortality and discount rates stack upagainst other schemes?Take part in our survey online now at www.engaged-investor.com/trusteesurvey

THE TRUSTEE VIEWHow trustees workTrustees share their insights into a changing role and the actuarial assumptions they make.Find out what challenges your peers are facing and how they are overcoming them.GKN TRUSTEEBLUE CHIP PHARMACEUTICAL COMPANYAnthony DeeleyMembership: 56,000How do you approach actuarialassumptions?“We look at the return on assets and thediscount rate plays an important role. Wealso look at inflation and expected pay rises– we talk to the company about this as theyare more in control. And increasingly, thesedays, we are having to pay a lot of attentionto longevity – both as seen in the widelyused national tables and in our ownscheme-specific tables, which we startedto collect data on four years ago. We useour company’s data to build a picture ofwhether our own experience will bedifferent compared to other tables.”How do your mortality tables compare tothe standard ones?“They are mirroring them reasonablyclosely – of course as the nature of ourmembership changes this could change.”How has mortality changed in GKN?“We were a heavy-duty metal bashingcompany and today’s workers work in anentirely different environment. A lot of theolder industries have since gone and beenreplaced by far more hi-tech ones and solife expectancy will probably be longer thantheir counterparts 20 years ago.”How has your role changed?“Under the previous regulatory regime, youwere almost entirely reliant on theactuaries, now the responsibility liessquarely on the trustees.”What impact has this had?“The whole thing has tightened up andimposed a greater burden. A trustee used tostart work at 10.30am and go on until 5pm,now it’s more like 8.30am to 6pm. For a lotof big schemes like ours, the investmenthas become far more complex with hedgefunds, equity and alternative investments –and monitoring has become far greater.”John WatsonMember-nominated trustee of blue chippharmaceutical companyWhat kind of actuarial assumptions doyou make?For the long term, we use the usual tablesand we build in an extra year-and-a-halfbased on our company-specific data. Theassets are actually invested in bonds andequities, but we assume the bond return forour investment valuation.What are your company-specific mortalitytables like?We have got several pensions schemesdue to mergers, and we look at the datafrom each of the schemes. We take theworst-case and build in a conservativebuffer and what we have found is thatpeople tend to live longer than thestandard mortality tables predict. Wehave taken a very conservative approach.How long have you been a trustee?I have been a trustee for three years, andprior to this I was on a pensions consultingcommittee – so I have been involved in thescheme for five years.How has your role and the amount of timeyou are spending on it, changed over theyears?The amount of time has gone upexponentially, mostly for training. ThePension Regulator modules have been aGod-send. They are computer-basedtraining modules and we also attend a lot ofseminars. It’s good for learning bestpractices.What are the biggest challenges?Understanding all the legal changes is thebiggest problem and more recently the shiftin focus from DB to DC schemes and onimproving the DC schemes.FRIENDS PROVIDENT TRUSTEEJames MackayMembers: 14,000How has the role changed?“The role has become much more difficult with newregulations and codes of practice and the increasedinvolvement with the employer. This wasn’t something wehad to consider in the past.”How has the role of your employer changed?“We are finding that the employer is playing a bigger andbigger role in the scheme than they used to. They are evenhaving a greater say and involvement in consulting usabout our investment strategy, which is something theyused to leave to the trustees.”EMI GROUP PENSIONS TRUSTEERoy CaustonMembers: 21,700What assumptions do you make?“We look at inflation, pay increases, mortality and thedemographics of it all – but the main thing you look at isinvestment return”How has the role changed?“The tax simplification has created a lot more extra work”What kind of valuation has your pension scheme made?“We try to make it conservative because we are a verymature scheme.”AVIVA PENSION FUND TRUSTEEJohn BristerMembers: 80,000How has valuing your pension changed?“The discount rate, which is goverend by gilt rate, hasbeen the biggest single factor and the other is improvingmortality. This is what we have had to take into account.”Why is the discount rate important?“The discount rate is the most important of all, becausethat can change the liability quite markedly. The higher thediscount rate, the closer you are to closing the deficit.”Who has been helpful in preparing for a valuation?“Actuaries are strongly influential.”THE ENGAGED INVESTOR TEAMPublished by Engaged Investor, Trustee Extra is a bi-monthly reportfocusing on a key aspect of trusteeship that has made the news butwhich has wider implications for your role as a trustee and thescheme you run.More than mere background, we talk to all industry players, includingtrustees, and put the issue in context to show what you as a trusteecan learn from it.Printed by The Manson Group, Reynolds House, 8 Porters Wood, Valley RoadIndustrial Estate, St Albans, Hertfordshire, AL3 6PZPlease prefix all telephone numbers with +44 (0) 20 7618 Pleaseprefix all emails with name.surname@newsquestspecialistmedia.comEDITOR Bob Campion 3485DEPUTY EDITOR Robert Melia-Watson 3081REPORTER Rose Fison 3458ART EDITOR Vitali Golev 3489ADVERTISING MANAGER Stuart Hall 3096SUBSCRIPTIONS MARKETING EXECUTIVEThomas Morey 3463PUBLISHING DIRECTOR Shân Millie 3085NEWSQUEST SPECIALIST MEDIAEngaged Investor is published by Newsquest Specialist Media Ltd – a Gannett company.Newsquest Specialist Media Ltd is an international mediaorganisation providing specialist business-to-business andconsumer information for a diverse range of markets.www.engaged-investor.comEngaged Investor30 Cannon Street, London EC4M 6YJ, UKNewsquestSpecialist MediaLtd is a memberof the PPATRUSTEEXTRA www.engaged-investor/trusteesurvey ISSUE 3/2007

THE VOICE OF THE PROFESSIONALExperts give their views on the key actuarialassumptions to use when valuing your schemeWe spoke to leading actuaries and consultants and asked for their guidance on the kind of considerationspension scheme trustees should make when valuing their liabilities. Here, we take you through the key issuesMORTALITY RATESSenior consultant at Watson Wyatt, Graham Everness,recognised this as a hot topic. When trying toestimate how long people will live “standard mortalitypredicting tables are used as a starting point.”“One generally assumes there will be improvementsin life expectancy, but the extent of theallowance varies from table to table,” he explained.Actuary Richard Murphy of Lane Clark Peacockattributed variation in life expectancy to someadvances in technology: “Medicines have come along way in the last 20 years. Insurers are buildingit into their calculations and pensions regulators arealso considering factoring it in.”But the trend is far from straightforward to predict.“Mortality is a big unknown,’ said principleactuary at Aon, Paul McGlone. “Over the last tenyears there has been a massive improvement in lifeexpectancy. Looking back over the preceding 100years it had been a gradual increase. You can’t necessarilysay the past is a good guide to the future.”Murphy gave the crude example of how just asmall miscalculation of life expectancy could havelarge implications for a pension fund. “If on averageyour members live one year longer than expected,that is very significant. If you have, say, a £100mscheme with a deficit of £10m and scheme holderslive one year longer, then typically the scheme willrise by 3% – going up to £103m – and the deficitwill grow to £13m.”Whilst there are various mortality tables on whicha company can estimate members’ life expectancywith relative accuracy, the actuaries also recognisedthe value of schemes doing company-specific calculations.“If you have got a scheme which is bigenough to have its own experience, you don’t needthe standard mortality rate tables, you can rely heavilyon the statistics of the pension scheme. But forthis, you need thousands of members, not hundreds,”said independent trustee consultant Keith Parker, ofAlexander Forbes.When asked about the kind of factors influencingmortality rate; geography, industry and type ofpension played significant roles. Geographically, peopleliving in the north of England and Scotland arerecognised in national tables as having a lower lifeexpectancy than their counterparts in the south.Actuaries put this down to social diversity. Parkerof Alexander Forbes acknowledged that “differentindustries have different mortality experiences. HeavyISSUE 3/2007industry typically has a higher mortality, while officejobs traditionally have a lighter mortality.”Unfortunately, jargon is impossible to avoid, andso here the dreaded word “cohort” needs to be tackled.The ‘medium cohort’, is a term referring to aparticular type of mortality table, and is “designedto recognise that those born between the wars havehad a huge rate of increase in their life expectancy,”said Murphy of Lane Clark Peacock. The ‘long cohort’refers to a faster rate of improvement, as seen bypeople born after the Second World War. Ultimately,concluded, Graham Everness, senior consultantat Watson Wyatt “trustees do have to realise thereis huge uncertainty” and advised them to look attheir own circumstances when making assumptions.SALARY INCREASES AND INFLATIONHow do you predict future pay rises for scheme holders?“There is a historical link”, said independenttrustee advisor Keith Parker of Alexander Forbes,“between the salaries, the rate of inflation and therate of interest.”Murphy of Lane Clark Peacock added: “Lookingat general salary growth historically, it is usually priceinflation plus 1% or 2%.”But inflation isn’t the only factor driving salaryincreases – company-specific factors play an equallylarge role: “Across some companies, salaries haveincreased significantly. But in other companies – inmature industries – it may be that there is littleexpectation of salary increase.” It comes down tofactors like who is in your scheme and patterns ofpromotion: “If your scheme is dominated by seniorexecs, they may get promoted increasingly wellahead of inflation. Their numbers may be small, butlarge in their liabilities,” said Murphy. Talking furtherabout promotions, Murphy referred to the transparencyof company policy. “In some businesses,the path of promotion is visible. In other levels ofbusiness, you wouldn’t expect to see it all.” Referringto past predictions, Parker said: “you have tolook back to see if salaries have moved in line withpast expectations.”w w w. e n g a g e d - i n v e s t o r / t r u s t e e s u r v e yLONG-TERM INFLATIONThere are two standard inflationary measures: theRetail Price Index and Consumer Price Index. RPI isthe measure most commonly used by pensionschemes, and tends to be higher than CPI. Butalthough short-term inflationary measures are nearing5%, long-term indicators are much lower. TheBank of England’s published long-term expectationfor CPI is now 2%. To estimate the long-term RPI,actuaries compare the price of RPI or index-linkedGovernment bonds to normal Government bonds,suggesting a figure nearer 3%.DISCOUNT RATESWhat is a discount rate and how do you chose one?A discount rate is a calculation used to convert allyour estimated future pension payouts into a singlefigure, measured in today’s money.There are two ways to calculate a discount rate:1 The assumed return from scheme assets. I.e.on average, how much do you expect yourscheme assets to grow by each year?2 The market value of liabilities. If all your futurepayments were fixed-income bonds, how muchwould they cost at today’s market prices?The second measure is the most popular methodtoday, and the one that the Pensions Regulator seemsto prefer. This is because it is conservative, and anobjective estimate, based on the real price of assetsthat most closely resemble your future obligationsPaul McGlone, senior consultant at Watson Wyatt,said: “The discount rate for the most conservativeassessment of liabilities is whatever you can get onlong-term gilts. The other extreme is when you assumethe scheme will invest in a whole range of assets –including riskier ones – and assume you will get ahigher rate of return.”Due to the varying ways the discount rate can becalculated and the range of possible values, theFinancial Accounting Standards has created a setway of measuring it, known as the FRS17. It is there,according to actuary Richard Murphy at Lane ClarkPeacock, “for the Pensions Regulator to use as abenchmark to decide whether trustees are prudentenough.” FRS17 models the value of your liabilitiesbased on the price of corporate bonds – using the‘market value’ method.Real numbers can vary widely. Trustees seekinga conservative approach, based on the market valueof Government bonds, could go as low as 4%. Amiddle of the road FRS17 estimate could be 5.3%,and a confident scheme, 100% invested in equitiescould go as high as 7% under the “assumed returnfrom assets” model. But there are risks when calculatingthe discount rate. Trustees are advised thereforeto try to strike a balance. TXTRUSTEEXTRA

Will your assumptions secure the pensionpromise for your DB scheme members?Mark Wood, chief executive of Paternoster, outlines how, as a trustee, the assumptions you make about thepension scheme you are responsible for affect the value placed on the scheme liabilities, the assessment offuture funding requirements and crucially the security of your members.MARK WOOD, chief executive ofPaternosterASSUMPTIONNoun 1: a thing that isassumed to be true.Noun 2: the action ofassuming responsibilityor control.www.askoxford.comLife expectancy for aman aged 65, isincreasing at a rate offive hours per day.How many people willretire early?Who will defer theirretirement?How many will want totransfer benefits toanother scheme?The best case scenario is a fully funded solvent schemecapable of fulfilling the pension promise for years to come.The worst case (in the event of sponsor insolvency), meanssignificant shortfalls and a scaling back of benefits,meaning reduced or no pensions for some members. Not asituation any trustee wants to contemplate.The challenge for trustees is to answer the following questionsin order to provide the basis of calculation for determiningthe scheme’s liabilities:■ How long will people live?■ Is the investment strategy appropriate?■ What is likely to happen to inflation?■ What are the demographics?■ How will members behave?■ What are the administration costs?■ How strong is the sponsor covenant (today andtomorrow)?The exercise of well informed judgement in each of theseareas is crucial to make sure that the scheme is adequatelyfunded and can meet the promises made by the pensionscheme.The absence of a reliable benchmark makes assessmentof performance difficult, areas of concern open to conjectureand worse, inaction due to the absence of a reliable scoreboardagainst which trustees can compare their opinions.Our work with Engaged Investor is intended to fill this gapand provide an up-to-date guide to the consensus view onthe most crucial areas of assessment that trustees shouldfocus on.Life expectancy is perhaps the area of greatest concern.The view of current trends, even among the actuarialprofession, is extraordinarily diverse. Miscalculations andwrong conclusions have been drawn too often as a resultof the failure to incorporate the most recent life expectancyresearch in projecting future improvements. Life expectancyfor a man aged 65 is increasing at a rate of five hoursper day. According to the medium cohort projection thisrate of change will have slowed to just two hours per daywithin a decade. Even a casual analysis of current lifeexpectancy trends suggests that this is highly unlikely.The formulation of an investment strategy is defined byhow much risk trustees are prepared to take, both with theassets already in the fund and with the assets owed to thefund by the sponsor in respect of any deficit (against a measureof solvency). Trustees may chase yield by carrying investmentmismatch risk, investing in equities, alternative assetsor utilising derivatives to control or take risk; however thiscan only sensibly be done after a full risk assessment.By looking at the Consumer Price Index with its current relativelylow level of inflation, there may be a tendency to understateinflation risk. Liabilities are related to the more realistic,and currently higher, Retail Price Index (RPI). The issue ofinflation is further complicated, as RPI nudges its way towards5% (the cap for the vast majority of schemes), beyond whichmost pensions in payment lose their sensitivity to inflation.The demographics of a scheme are, one would havethought, a matter of fact. Trustees. however, have importantassumptions to make in relation to the proportion of individualswho will be married at death, the age of their widow orwidower and the number of children who will have a rightto claim pensions.As many schemes provide for some degree of choice inthe benefits they pay, the behaviours of the members becomean important factor in establishing what funding level isrequired. Decisions by members regarding when to drawbenefits, whether to take cash or not, or if to transfer, resultin very different liability values.There is a lot of data available to enable a straight costcomparison for individual components of administration.Although the sponsoring company will fund the administrationcosts, it is essential not to lose sight that this ongoingcommitment exists in monetary terms.Companies need to take into account the value at risk intheir pension scheme. This is best expressed as the reserveof capital created to protect against the risk. In an insurancecompany this is called ‘solvency capital’. TXThe results of the survey which will be published in September will enable you to plot your own views against that of yourpeers and objectively assess where assumptions might be most sensibly set.We are sure that the answers will not be without controversy and will stimulate debate. If they do this then our survey willhave achieved its goal.TRUSTEEXTRA w w w. e n g a g e d - i n v e s t o r / t r u s t e e s u r v e y ISSUE 3/2007