Increasing Deficits: A time to panic?

Barely a month goes by without one of the trade papers publishing the headline that the combined pension deficit of the U.K.s largest companies has shot up/dropped (delete as appropriate) by some incredibly large number. The sensationalism of the headline will directly correlate with the number. This month those headlines were augmented by comments from Mercer suggesting that the recent slowing down of life expectancy improvements had wiped £2.5bn off the combined deficit.
Hmmm. It's time to pause for a moment and reflect on all this excitement.Dont Panic.png

Every three years a scheme actuary will help its trustees to access the funding position of their scheme. They will do this by comparing the value of its assets against the value of its liabilities. The difference is either a surplus or, more commonly, a deficit.  

There are three numbers in this process: the asset value, the liability value and the difference between the two.

The asset value is a factual number (up to a point – there may be some assets where the value used is an assessed value (your house has a value but you don't know what it actually is until you sell it).

The liability value, however, is not a factual number. The cost of a pension scheme is a result of its experience. If inflation is high, benefits will increase more than if inflation had been low – as a result they will be more expensive, if someone lives to be 100 years old, they will receive more pension than someone who dies at 70 – as a result it will be more expensive. By definition, we can only know what this experience is once it is in the past and so, it follows, we cannot assess the factual cost of a pension scheme until all the benefits have been paid out.

In the meantime, however, we can come up with a non-factual estimate of the cost. We do this by making educated guesses at what the experience will be. If we assume a member will live to 80, the projected cost will be X. If we assume they live to 81 the cost will be X plus a bit more (approximately 3% more). These, however, are non-factual costs because we won’t know how long that member will live, until he or she stops living!

It follows from this that as the surplus or deficit is the difference between a factual number and a non-factual number, it must also be non-factual number.

So where does this leave us?

It leaves us recognising that there is a lot of noise about changes in non-factual cost not factual cost. Deficits may go up or down with dramatic swings on a daily basis, but, unless you change the benefits themselves, their actual factual cost will never change.

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