‘Defined benefit’ pension schemes can be valued in a variety of different ways. Even if a scheme is in surplus on one basis, it could easily be in deficit on another. A common mistake is to rely too heavily on the employer’s statutory accounts. This can be dangerous! Company disclosures, generally speaking, over-state any surplus in a scheme or under-state any deficit – most important, they don’t reflect the actual cost of the pension scheme. The only reliable way of assessing the position is to use the pension scheme’s own actuarial valuations and reports.

There are various ways in which the funding level of a DB pension scheme can be assessed and a lot of jargon to contend with. There’s a risk in using the results of a valuation that was prepared on one basis, for a different purpose – so what are the different valuation bases, and what is each used for?

Ongoing basis (‘technical provisions’)

Every DB pension scheme is required by the Pensions Act 2004 to have a full actuarial valuation undertaken at least every three years and to produce an intermediate actuarial report in the intervening years. The results generally become available between 9 and 15 months after the effective date of the valuation or report.

These valuations are scheme-specific – legislation requires them to take account of a scheme’s particular membership and investments, as well as the employer covenant. They’re carried out on an ongoing basis, i.e. assuming that the scheme will continue to have a solvent employer into the future and that any necessary contributions into the scheme will continue to be made.

They’re not, by contrast, a reliable indicator of what the scheme’s funding position would be if the scheme were to be terminated and all benefits ‘bought out’ with an insurance company.

Alongside the valuation, the scheme will have a “schedule of contributions” which sets out what the employer has to pay and if there is a deficit on the ongoing basis, there will be a “recovery plan” which shows over what period the deficit is made good.

Although the Pensions Act 2004 generally allows an employer to cease contributing to a scheme that is in ‘technical provisions’ surplus, the Pensions Regulator’s “moral hazard” powers still apply and the contribution notice tests (including the ‘material detriment’ test) still apply. Even schemes that look well-funded need to be considered fully as part of any corporate activity to avoid regulatory risk.

Solvency basis (“buyout debt” or “section 75”)

When a DB scheme is terminated, or its employer becomes insolvent, a debt falls due from the employer(s) to the scheme under section 75 of the Pensions Act 1995. This is the scheme actuary’s best estimate of the cost of securing the scheme’s benefits under a buyout contract with a third-party insurer, net of the assets that the scheme actually holds. It will typically be included in the scheme’s full actuarial valuation (but not necessarily the annual updates).

This measure of funding is normally lower for a scheme than the ongoing basis described above. This is because insurers traditionally price pension liabilities conservatively by reference to gilt yields, and also incorporate a variety of ‘buffers’ to take account of things such as their capital headroom requirements and a margin for profit.

Because it relates to the price an insurer will require, any buyout or section 75 debt is only an estimate, unless and until an actual insurance quotation has been obtained (which in itself is an involved and time-consuming exercise).

Pension Protection Fund basis (‘section 179’)

A third valuation basis is that used by the Government’s pension lifeboat, the PPF. This values the compensation which the PPF would be required to provide to members of the schemes if it went into the PPF on employer insolvency. This is often not the scheme’s full set of benefits. A section 179 or PPF valuation will generally make a scheme look better-funded than it does on either its ‘technical provisions’ or its solvency basis, and should not be relied upon for any purposes other than those relating to PPF entry and the annual PPF levy.

Company financial accounts basis (IAS19, FRS102)

And what of disclosures in company accounts? These value pension schemes in an objective manner – their purpose is to allow comparison between the reported position of multiple schemes by readers of financial accounts on a consistent basis. By definition, therefore, they are not specific to the scheme in question and are not a reliable indicator of any scheme’s real funding position or the cost to the employer of operating the scheme.

Their main downside is that they will, as a general rule of thumb, under-state any deficit in a scheme or over-state any surplus – often considerably. While the accounting disclosures relating to a DB scheme are important for many reasons, they are not, unfortunately, a reliable way of assessing the actuarial funding position of a scheme or the likely employer costs associated with the scheme for M&A-related purposes.

Key takeaway

All pension schemes are different, and scheme-specific valuations are the only reliable way of assessing their financial health – use company accounts at your peril!