As the year-end approaches, I thought it was worth taking a back-to-basics look at the underlying actuarial assumptions used in FRS 17 calculations and what flexibility exists to change the results depending on the specific circumstances of each organisation.
So what is FRS17?
FRS17 is an accounting standard used to assess the balance sheet impact and pension costs associated with the operation of occupational pension schemes. For defined benefit arrangements (e.g. final salary pension schemes), the balance sheet asset or liability for the organisation is calculated as the surplus or deficit of the scheme assessed in accordance with assumptions appropriate for FRS 17. The pension cost is a combination of the cost to the organisation of providing benefits built up over the past year and an interest charge applied to the liabilities built up in the past, offset by a credit in respect of the expected return on the scheme’s assets. The elements of the pension cost are again calculated in accordance with assumptions appropriate for FRS 17. Some organisations who participate in multi-employer schemes retain an opt-out, whereby the pension cost is set equal to the amount of employer contributions and there is no balance sheet impact. This opt-out continues to be placed under serious scrutiny by company auditors and is looking increasing untenable.
The responsibility for the FRS17 assumptions adopted lies with the directors/trustees of each organisation. The agreement of the auditor is required, and the organisation should seek the advice of an actuary on the assumptions. There is a considerable degree of flexibility in setting these assumptions and the impact of small changes to the assumptions can be quite substantial (some examples are provided in the table below).
In many cases, the assumptions proposed by the actuary will be based on the “average” index values and mirror those assumptions used for the Trustees funding valuation and therefore may not be appropriate for the individual circumstances of each organisation. As the assumptions are the responsibility of the directors/trustees, they are entitled to request that the actuary carries out their calculations on alternative assumptions which they feel might be more appropriate.
It is important as early as possible in the process for each organisation to consider whether the assumptions proposed are appropriate and take suitable action if not. However, it is not appropriate to “cherry pick” assumptions on a year by year basis as directors/trustees need to ensure a consistent approach is used.
FRS17 requires a market-related approach, with assets being taken at their market value. Liabilities are valued using the ‘discount’ rate equivalent to that available on AA corporate bonds. The rate should be adjusted to make it appropriate for the maturity of the scheme’s liabilities (this will depend on the proportion of pensioner and active members in the scheme). Other assumptions (e.g. pension increases, mortality) are on a best estimate basis. The expected return on asset assumption is set independently of the liability discount rate. The assumptions should be mutually compatible and lead to best estimates of the future cash flows arising from the Scheme’s liabilities. The assumptions should also reflect market conditions at the reporting date.
How assumptions can change from organisation to organisation
As noted above, the impact of small changes to FRS 17 assumptions can have a significant impact on the organisation’s balance sheet asset/liability and pension costs. The main assumptions driving FRS 17 disclosures are the rate at which future values are discounted to “present day” terms (the discount rate), the expected rate of future price and salary inflation and the life expectancy of members. Taking a scheme with a total liability of £30 million, an indication of the impact of assumption changes on the balance sheet would be as follows:-
|Change||Reduction in liability|
|Discount rate increased 0.25% per annum*||£1.8 million|
|Salary inflation less 0.25% per annum (assuming 50% of members are active)||£0.5 million|
|Price inflation and salary inflation less 0.25% per annum||£1.8 million|
|Life expectancy reduced by 1 year||£0.8 million|
*- liabilities are reduced by increasing the discount rate and increased by reducing the discount rate.
There would be corresponding increases in the liability if the opposite changes occur (i.e. reduced discount rate, higher salary and price inflation and higher life expectancy). Therefore, it is clear that setting assumptions can have a material outcome on the organisation’s balance sheet. The impact on the pension costs are more difficult to quantify but pension costs are generally lower when liabilities are lower and assets are higher.
My earlier blog entitled “Throw your actuary a curve ball on FRS 17” discusses the impact of changing the underlying assumptions in further detail.
It is worth noting the potential move to using the Consumer Price Index (CPI) as the measure of price inflation for the purposes of regulating occupational pension schemes. Given that historically, on average, CPI has been around 0.5% per annum lower than RPI, this change places a lower current value on future pension payments and so reduces the liability of organisations in respect of pension benefits. Typically, this change could reduce overall pension liabilities by around 10%. If you have year end FRS 17 disclosures coming up, this point should be addressed with your advisor as soon as possible.
It is worth remembering that the assumptions used for FRS17 purposes are no more than assumptions – the assumptions used for the ongoing funding of each scheme will be different and give rise to different costs and liabilities and the costs and liabilities associated with a cessation valuation (the amount an organisation has to pay if it leaves a scheme) will be significantly higher.
If you are part of a multi-employer scheme which makes full FRS 17 disclosures (i.e. the opt-out does not apply), actuaries will provide participants with a briefing note outlining the assumptions they will base the calculations on and these will be carried out on a consistent basis for all participants and will therefore, in most circumstances, not reflect the specific circumstances of the participating organisation and may be more conservative than the organisation might deem to reflect a best estimate approach resulting in higher liabilities, and therefore higher disclosed deficits. Independent advice at an early stage will allow assumptions appropriate to each organisation to be set and ensure that the ultimate results need be run only once.