The Pensions Board of the Institute and Faculty of Actuaries is discussing with the DSS the terms of reference for a complete review of the Minimum Funding Requirement (MFR). The review follows on from the short-term action taken by the actuarial profession and the DSS last summer to deal with the effect on the MFR of falling dividend yields.
The details on how to calculate the MFR for any particular defined benefit scheme are set out in the actuarial guidance note GN27. Since GN27 is given its mandatory force by the legislation, any change to it must first be approved by the Secretary of State for Social Security. During the summer of 1998, the Pensions Board wrote to all pension scheme actuaries to announce that John Denham, the then Parliamentary Under-Secretary of State, had agreed a change to GN27 to provide an immediate solution to a serious problem that had emerged in the MFR. The change, which was effective from 15 June 1998, was widely described as a "short-term fix".
The calculation of the MFR for any defined benefit scheme depends on the use of specified long-term financial assumptions listed in Appendix 2 to GN27. For active members and deferred members who are at least ten years away from retirement, the actuarial liability is calculated using the long-term assumption for the rate of return from equities. GN27 sets the effective assumed rate of investment return on equities at 9.0% p.a.. But, in carrying out any MFR valuation, the scheme actuary must adjust the calculation to allow for current market conditions by applying a Market Value Adjustment (MVA). The equity MVA before the 15 June 1998 was:
4.25 per cent
gross dividend yield on the FT-SE Actuaries All-Share Index.
Since that date, the equity MVA has been changed to:
3.25 per cent
net dividend yield on the FT-SE Actuaries All-Share Index.
The reason for changing the denominator in the equity MVA from the gross dividend yield to the net dividend yield followed from the fact that pension funds now receive dividend payments net of tax. A change from a gross yield to a net yield would lead one to expect the numerator to be reduced from 4.25% by the same proportion that the net yield bears to the gross yield i.e. a reduction of 20% to 3.4%
However, when looking at the FT-SE All Share Index as a whole, this does not follow. At the time of the change the Index showed a gross dividend yield of 2.87% and a net yield of 2.41% a difference of just over 16% rather than 20%. The reason for this difference was that at the time significant amount of Foreign Income Dividends (FIDs) were being made and these are paid without a tax credit. A 16% reduction from 4.25% would have given a figure of 3.57% but the Minister agreed to a more severe reduction down to 3.25%.
The explanation for the further fall lies in a change in the dividend policy of UK companies that had taken place since the July 1997 Budget. Companies had started to move to methods of distributing earnings to shareholders other than just using dividends. In particular, there was a rapid growth in share buybacks. Given this breakdown in the traditional way of distributing profits, the DSS and the actuaries had to act to produce a "short-term fix" if many schemes were not to be found to be less than 100% funded at their first formal MFR valuation. If the equity MVA was to be used, it meant reducing the numerator significantly more than would be indicated simply to reflect the change from gross to net dividend yield in the denominator. The figure of 3.25% was chosen somewhat arbitrarily.
The effect of the change can be seen by looking at the gross and net yield figures given for the FT-SE All Share Index in each day's Financial Times. For example, on the day of writing, 16 October 1998, the gross yield on the FT-SE All-Share Index stood at 3.36% and the net yield at 2.85%. Applying these figures into the "old" and "new" formulae for calculating the equity MVA gives a figure of 1.265 (the "old" equity MVA) and 1.140 ("new" equity MVA). This means that if an MFR valuation were carried out with an effective date of 16 October 1998, the equity-based liabilities as calculated under the "new" basis would be some 9.9% lower than would have been the case under the "old" basis. The change has reduced the prescribed actuarial value of the scheme's liabilities and so improved the scheme's funding position.
However, the action taken last June can only provide a temporary easing of the pressure and it is the aim of the MFR review to come up with a more long-lasting solution. This could well involve abandoning the MFR altogether and replacing it with a central discontinuance fund, a concept currently being explored by an actuarial working party.
The Pensions Board is likely to be kept busy over the winter months. Apart from the MFR review, it currently is also considering the following issues:
For further information please contact Jane Marshall, e-mail: Click Contact Link , 7 Devonshire Square, Cutlers Gardens, London EC2M 4YH, UK, Tel: + 44 171 655 1000
This article was first published in the Winter 98/99 Hammond Suddards Pensions Newsletter
The information and opinions contained in this article are provided by Hammond Suddards. They should not be applied to any particular set of facts without appropriate legal or other professional advice.
The details on how to calculate the MFR for any particular defined benefit scheme are set out in the actuarial guidance note GN27. Since GN27 is given its mandatory force by the legislation, any change to it must first be approved by the Secretary of State for Social Security. During the summer of 1998, the Pensions Board wrote to all pension scheme actuaries to announce that John Denham, the then Parliamentary Under-Secretary of State, had agreed a change to GN27 to provide an immediate solution to a serious problem that had emerged in the MFR. The change, which was effective from 15 June 1998, was widely described as a "short-term fix".
The calculation of the MFR for any defined benefit scheme depends on the use of specified long-term financial assumptions listed in Appendix 2 to GN27. For active members and deferred members who are at least ten years away from retirement, the actuarial liability is calculated using the long-term assumption for the rate of return from equities. GN27 sets the effective assumed rate of investment return on equities at 9.0% p.a.. But, in carrying out any MFR valuation, the scheme actuary must adjust the calculation to allow for current market conditions by applying a Market Value Adjustment (MVA). The equity MVA before the 15 June 1998 was:
4.25 per cent
gross dividend yield on the FT-SE Actuaries All-Share Index.
Since that date, the equity MVA has been changed to:
3.25 per cent
net dividend yield on the FT-SE Actuaries All-Share Index.
The reason for changing the denominator in the equity MVA from the gross dividend yield to the net dividend yield followed from the fact that pension funds now receive dividend payments net of tax. A change from a gross yield to a net yield would lead one to expect the numerator to be reduced from 4.25% by the same proportion that the net yield bears to the gross yield i.e. a reduction of 20% to 3.4%
However, when looking at the FT-SE All Share Index as a whole, this does not follow. At the time of the change the Index showed a gross dividend yield of 2.87% and a net yield of 2.41% a difference of just over 16% rather than 20%. The reason for this difference was that at the time significant amount of Foreign Income Dividends (FIDs) were being made and these are paid without a tax credit. A 16% reduction from 4.25% would have given a figure of 3.57% but the Minister agreed to a more severe reduction down to 3.25%.
The explanation for the further fall lies in a change in the dividend policy of UK companies that had taken place since the July 1997 Budget. Companies had started to move to methods of distributing earnings to shareholders other than just using dividends. In particular, there was a rapid growth in share buybacks. Given this breakdown in the traditional way of distributing profits, the DSS and the actuaries had to act to produce a "short-term fix" if many schemes were not to be found to be less than 100% funded at their first formal MFR valuation. If the equity MVA was to be used, it meant reducing the numerator significantly more than would be indicated simply to reflect the change from gross to net dividend yield in the denominator. The figure of 3.25% was chosen somewhat arbitrarily.
The effect of the change can be seen by looking at the gross and net yield figures given for the FT-SE All Share Index in each day's Financial Times. For example, on the day of writing, 16 October 1998, the gross yield on the FT-SE All-Share Index stood at 3.36% and the net yield at 2.85%. Applying these figures into the "old" and "new" formulae for calculating the equity MVA gives a figure of 1.265 (the "old" equity MVA) and 1.140 ("new" equity MVA). This means that if an MFR valuation were carried out with an effective date of 16 October 1998, the equity-based liabilities as calculated under the "new" basis would be some 9.9% lower than would have been the case under the "old" basis. The change has reduced the prescribed actuarial value of the scheme's liabilities and so improved the scheme's funding position.
However, the action taken last June can only provide a temporary easing of the pressure and it is the aim of the MFR review to come up with a more long-lasting solution. This could well involve abandoning the MFR altogether and replacing it with a central discontinuance fund, a concept currently being explored by an actuarial working party.
The Pensions Board is likely to be kept busy over the winter months. Apart from the MFR review, it currently is also considering the following issues:
- whether to issue a guidance note on benefit projections for defined contributions schemes
- which version of guidance note GN27 should be used for the purposes of calculations under section 73 of the Pensions Act 1995 which deals with the priority order of benefits on winding up
- whether to amend guidance note GN29 to relieve the advising actuary of the requirement to whistle-blow where OPRA has already been notified of the reportable event and the advising actuary has nothing further to add to the report.
For further information please contact Jane Marshall, e-mail: Click Contact Link , 7 Devonshire Square, Cutlers Gardens, London EC2M 4YH, UK, Tel: + 44 171 655 1000
This article was first published in the Winter 98/99 Hammond Suddards Pensions Newsletter
The information and opinions contained in this article are provided by Hammond Suddards. They should not be applied to any particular set of facts without appropriate legal or other professional advice.
