Response to consultation on the exposure draft of the SORP: Financial Reports of Pension Schemes

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1 Response to consultation on the exposure draft of the SORP: Financial Reports of Pension Schemes About First Actuarial This response is provided by First Actuarial LLP. First Actuarial is a consultancy providing pension scheme administration, actuarial and consultancy services to a wide range of clients across the UK. We advise a mixture of open and closed defined benefit schemes with our clients concentrated in the smaller end of the pension scheme market. Our clients range across a number of sectors including manufacturing, financial services, not for profit organisations and those providing services previously in the public sector. Our response has been prepared following internal discussion and consultation amongst interested parties within the firm. Our response focuses on one area, annuities. Response to consultation questions 1. Annuities - FRS 102 requires annuities to be reported at the amount of the related obligation. What practical issues do you see arising from this requirement? The Draft SORP envisages the annuity value will be based on the trustee perspective of the related obligation and therefore most likely determined by the Scheme Actuary. Do you agree with this approach? We have a number of concerns about this proposal. In your summary of the changes, you state: However, annuities held in the name of the trustees form part of the overall assets of a pension scheme and do not secure the pensions which they fund. For example, if a scheme enters the Pension Protection Fund (PPF), annuity income is redirected to the PPF who take over payment of pensions, which may be restricted to PPF limits. We have two points to make about this statement: Although the annuity policy forms part of the overall assets of the scheme, in many cases, the annuity policy provides an exact match to the benefit payable by the scheme to the member concerned. Effectively, the annuity does secure the pension payable from the fund. We recognise that should the scheme enter the PPF then the annuity policy may provide an additional asset, as the benefits under the policy may be greater than the compensation payable by the PPF. However, our understanding is that the accounts are prepared on an ongoing basis, so consideration of what may happen if an employer insolvency event were to occur is not relevant. The example of a scheme entering the PPF should not drive the decision to include the value of annuities in the accounts.

2 One of the fundamental reasons for requiring accounts is to reconcile all money paid into and out of the scheme, thereby helping to prevent fraud. We do not believe that requiring trustees to now include annuity policies, where the payments under the policy are intended to be a direct match to the benefits to be paid to the individual, serves any purpose at all. It merely creates additional disclosures. For example, not only will the annuity policy need to be valued at the beginning and end of the year, but in order to reconcile the change in asset value over the year, details of all benefit payments paid by the insurer will also need to be identified. In our experience, where the annuity policy provides a direct match for the benefits payable, the insurer will pay the member their pension directly; payments do not go via the Scheme. The trustees will need to seek this additional information from the insurer, who will be entitled to charge for the provision of that information. When carrying out a section 179 valuation to assess the PPF risk based levy, guidance recognises that it may not be possible to obtain information for policies taken out before 6 April Where any liabilities are covered by a relevant contract of insurance (as defined by the Act) which was taken out before 6 April 1997, but insufficient information now exists for the contract to be taken into account in a valuation, then the value of that contract (and the value of the corresponding liabilities) should not be included in a section 179 valuation. The legislation requires all reasonable steps to be made to obtain sufficient information regarding insurance policies to enable a valuation to be carried out before concluding that they should not be taken into account. Source: Guidance%20Version%20G5%20May% pdf, section 5.5 Our preference is that the value of annuities should be excluded from the accounts. But if this is not accepted, then as a minimum, the approach adopted by the scheme actuary for the PPF risk based levy valuations should be applied. Actuaries have had nearly 10 years to obtain the annuity information required for those valuations. Where annuity information is used for the PPF risk based levy valuation, that information will be readily available to use for valuing the annuity policy for the purposes of the pension scheme accounts. We do not think it should be necessary to spend any more time trying to track down annuity policies issued over 17 years ago. Otherwise additional costs will certainly be incurred and for no obvious purpose. Where the annuity policy is not a direct match for the benefits to be paid, typically the insurer will make payments to the scheme, with the scheme then paying the benefit due to the member. In this case, information relating to payments made under the policy and benefits paid to the members will be readily known by the scheme. We accept that in this situation it may be reasonable to include the annuities in the value of the scheme assets. How should annuities be valued for the purposes of the accounts? The next question is what value should the pension scheme place on the annuity policy and there are a number of options. In sections to , you consider a number of issues.

3 You could argue that the surrender value is the most appropriate value. That would be consistent with the approach adopted for valuing other assets, namely the market value. Although this may be theoretically correct, we would not support this approach being used. Given the volume of annuities held in the name of trustees, this would result in substantial work for the insurers, the costs of which would be passed onto pension schemes. And this approach would not meet the requirement of FRS102: (b) which requires the fair value of the asset is deemed to be the present value of the related obligation. The present value of the related obligation will depend on the actuarial basis used and you have recognised that different actuarial bases will result in different values being given to the same asset and this in itself will cause problems. For example, for pension cost accounting, the expected future cash flows will reflect a best estimate or neutral estimate and the discount rate will reflect the yields on good quality corporate bonds of appropriate currency and term. We agree that this approach is not appropriate for pension scheme accounts. As a result, FRS102 will result in a different asset value being placed on the same asset in company accounts and in pension scheme accounts. This SORP recommends that the basis adopted by the trustees for pension scheme financial statements reflects the circumstances and purpose of the annuity arrangements. For example, if the intention is to hold the annuities in the scheme for the long term then the scheme funding valuation basis would seem most appropriate. If the annuity has been purchased with a view to moving to a buy-out then the trustees may consider the buy-out basis more appropriate. This may not be as clear cut as it first appears. If the scheme has a plan to buyout all benefits in 20 years time (it may even be funding on that basis), any annuities it currently holds will be held for a long term but could also be thought of as a first step towards buyout. Which value should be used? If there is a shift in funding policy, how should the change in asset value be shown? The principles and assumptions used to derive a funding basis are set out in the Statement of Funding Principles. Legislation requires the Statement of Funding Principles to be reviewed and, if necessary, revised before any actuarial valuation. For the majority of schemes, the Statement is not revised between the triennial valuation dates. For those schemes, if this approach is used, it will be necessary for scheme actuaries to advise on changes to the Statement of Funding Principles to incorporate the principles and assumptions for valuing annuities. The Statement of Funding Principles must be agreed with the trustees and, depending on the Scheme rules, either the employer is consulted about the changes or agrees to the changes. This will incur additional cost. Further a funding basis uses prudent assumptions when determining the future cash flow and further when deriving a suitable discount rate. The basis will reflect the scheme s funding objective and the level of prudence will reflect the strength of the employer covenant, providing a buffer to cope with future adverse experience. None of this is relevant or appropriate when placing a value on the annuity policy for the scheme. Does it make sense that the same type of annuity contract could have different values attributed to it by different schemes, merely because of the different margins of prudence within a funding basis? Further, none of this information is relevant to the financing of the scheme. All risks and experience, adverse or otherwise, are underwritten by the insurer. We can see no benefit to including the value of annuities in the accounts.

4 You could argue that the current cost of buying out the annuities would provide the best measure of the value of the policy held. This would certainly ensure that the value of assets immediately before and immediately after the annuity is bought remains the same. If any other measure of asset were to be used, the annuity purchase would result in a (potentially large) change in the scheme s asset value, which would need to be accounted for somehow! The current cost of buying out annuities varies as a result of changes in market conditions, life expectancy, inflation etc. Further, the value varies due to changes in the supply of annuities and insurers appetite and willingness to write annuity business. Once business has been written, the change in the value of these elements is irrelevant. As part of the actuarial valuation, the Scheme Actuary is required to provide an estimate of the cost of buying out benefits for the active, deferred and non-insured pension members. The basis used will represent the Scheme Actuary s view of the buyout cost and will typically be based on information received by insurers. It could be argued that this estimated buyout value would be a suitable measure. If the value of annuities has to be included in the scheme accounts, then we do agree that it should be on the measure determined by the Scheme Actuary. Interaction with scheme funding legislation When presenting the actuarial valuation, the actuary also has to calculate a buyout solvency valuation, which shows the value of the liabilities assuming that all liabilities were discharged by purchase of annuities. Legislation requires that the value of assets to be used for the buyout solvency valuation to be the same as that adopted for the funding valuation. Regulation 3 of The Occupational Pension Schemes (Scheme Funding) Regulations 2005 states that when carrying out the actuarial valuation that the assets of the scheme are to be taken from the relevant accounts, excluding. (c) where is appears to the actuary that the circumstances are such that it is appropriate to exclude then, any rights under an insurance policy. When presenting the results of the actuarial valuation, we would expect actuaries to make use of the exclusion. Otherwise, if the value of the annuities on the funding basis were to be reflected in the accounts, that asset value would also have to be used in the buyout valuation. The expected cost of buying out the insured annuities would then be shown as that asset value (which doesn t reflect a buyout cost at all, rather an ongoing cost on the funding basis). This will just raise questions with trustees and members. The logical way around this is to exclude the value of annuities from the asset value and therefore from the liability value. Asset value in accounts Less value of insured annuities =Assets for purpose of scheme funding and buyout solvency valuation.

5 The liabilities in respect of those policies would also be excluded, ensuring consistency of treatment. The Report on Actuarial Liabilities which will be required alongside the accounts, would therefore show assets and technical provisions excluding annuities. Annual valuation required Additional work and cost will be incurred to derive a value of the annuities for the annual accounts. The asset value will be audited. The SORP needs to provide clear guidance on what level of approximation may be permitted. Is it necessary to obtain membership records from the insurer each year for a full valuation to be carried out, or can a more approximate valuation be used in the intervaluation years? Consequences of requirement to include annuities in accounts Where scheme rules permit trustees to assign buyout policies to members, we envisage that trustees will consider taking those steps, thereby removing the asset from the scheme and avoiding the need to pay unnecessary costs to value the policy for accounting purposes only.

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