According to a report published by PwC, UK companies have overpaid £100 billion in defined benefit pension schemes after following exceedingly prudent actuarial norms.
The consultancy has said that actuarial valuations are a misnomer and called on for an effective reform of the way scheme funding is calculated arguing outdated calculations have trapped billions of pounds in unnecessary contributions.
“Inaccuracies in the traditional actuarial methodologies could easily amount to £100bn, which represents a huge drain on the economy”, said Raj Mody, chief actuary at PwC.
The traditional approach uses two discount rates to set scheme funding targets; a higher rate that takes in to account higher assts growth at the pre-retirement phase, and a lower rate based on returns on gilts or bonds for the post-retirement phase.
The lower discount rate fails to capture the true investment strategy of a post-retirement scheme, especially when there is provision for riskier asset allocation backed by strong sponsor covenant.
“The method implicitly assumes that if you have a scheme with only pensioners, you’d be 100 per cent invested in gilts or bonds and that is not what is happening in reality. The danger is a company over-contributes; the money is trapped in the pension scheme and is then virtually impossible to refund”, explained Mody.
Traditional methods of calculating scheme funding have distorted the situation where valuations are driving the risk management strategy rather than the other way out, pointed out the actuary.
“The traditional method distorts the decisions the sponsor and trustees might make about risk management transactions, so if they are framing decisions around the technical provisions then it is quite possible those decisions will be plain wrong”, said Mody.
An asset led approach where the discount rate is based on prudent investment returns to reflect the scheme’s changing investment strategy has been proposed by PwC.
“That would involve a slightly more complicated calculation because you are looking at different liabilities at various phases using a different discount rate, but in this day and age with computing power and sophistication it can be done”, observed Mody.