Valuing the liabilities of a DB pension fund

agent69

I have a deferred final salary pension entitlement with a previous employer and get the fund newsletter annually (albeit 12 months late).

The newsletter details the assets and liabilities of the scheme and as a layman I would have thought that the asset value is the summation of all the investments that the fund has made. Meanwhile the liabilities would mainly relate to the obligation to pay members their future pensions.

I can understand that the assets value may be volatile (given changing market conditions) but would have though that liabilities would be less so, assuming they are mainly affected by membership numbers, life expectancy, and the amount that is due to be paid annually (all of which should be reasonably predictable).

In the 12 months to March 15 the assets of the fund increased by 15% and the liabilities by 25%. When I asked how the liabilities could have increased by such a large amount I was advised 'liabilities are valued on a long term gilt yield basis'.

I am obviously misunderstanding the liability side of the equation.Can anyone explain how this works?

kidmugsy

Suppose they took the present value of each asset, and then projected what its future value would be by compounding at an interest rate equal to long-term gilt yields. Obviously the future value would be sensitive to what that interest rate is. So lower interest rates imply that you need more assets to meet any given future liability.

Now, what they actually do instead, which is logically equivalent but much more convenient, is the following. They calculate the present value of the future liabilities and compare that to the present value of the assets. Again, since the two calculations are logically equivalent, the answer is sensitive to gilt yields.

Lower gilt yields imply that you need more assets now to meet the future liabilities. It's simply that they report the actual value of the assets now versus the "present value" of those future liabilities.

Linton

Say you owe someone £110 payable in 5 years time. For accounting purposes what is the value of your debt now? Well, if you had £100 now and there was an ultra safe investment (eg UK gilts) that guarantees 2%/year interest you would be happy - you could invest your £100 and know you would have £110 (approx) in 5 years time to pay off the debt. So the debt must now be worth £100 (approx).

Now suppose interest rates drop from 2% to 1%. The value of the debt rises to £105 (approx) as that is what you would need now to pay off the debt in 5 years time. A DB pension fund must continualy monitor its current wealth to ensure that it has enough now to meet all of its future liabilities.

The same sort of calculation occurs with the futue return on investments. With gilt rates at 2% a profit of £110 in 5 years time is only worth £100 now.

These calculations are examples of Discounted Cash Flow (DCF). It can be used to compare the relative values of liabilities or assets arising at different times in the future.

LXdaddy

Don't confuse me with someone who knows anything about the subject - one of those is bound to be along soon.


My guess is that if you are trying to work out the value of all the payments that the scheme needs to pay in the future then you need some method of working out the present value of a stream of future sums. The calculation must involve some interest or discount rate percentage.


This is how net present value or internal rate of return is calculated when doing a capital investment valuation. Spending £10million today and getting a benefit of £1million per year in years 2 onwards... what is the rate of return on the project.


But for the pension fund you are working the other way round maybe - trying to calculate how big a pot of money I need to have now to meet those future payments - the key variable is what is the interest or discount rate that you are using to calculate the present value.


If the interest or discount rate changes from one calculation to another then the present value will change.


Edit...
Wouldn't you know it - two knowledgeable answers in less time than it took me to type my wild guess