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IFoA SP4 practice questions

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Question 1Pension scheme design, benefits and types of scheme

A UK occupational pension scheme promises a benefit of 1/60 of final pensionable salary for each year of service, with no member contributions. How is this scheme best classified?

  1. Defined benefit, non-contributory Correct answer.
  2. Defined contribution, non-contributory
  3. Defined contribution, contributory
  4. Defined benefit, contributory

Explanation

The benefit formula fixes the pension by reference to salary and service, so the employer bears the investment and longevity risk: this is defined benefit. Because members pay nothing, the scheme is non-contributory. Contribution status is independent of the benefit basis, so both features must be identified separately.

Question 2Pension scheme design, benefits and types of scheme

In a defined contribution occupational pension scheme, which party principally bears the investment risk during the accumulation period?

  1. The scheme trustee board
  2. The scheme actuary
  3. The sponsoring employer
  4. The member Correct answer.

Explanation

In a defined contribution arrangement the contribution rate is fixed and the retirement fund depends on investment returns, so the investment risk falls on the member. The employer's obligation is limited to paying the agreed contributions. Trustees and actuaries administer and advise but do not absorb the risk.

Question 3Pension scheme design, benefits and types of scheme

Which feature distinguishes a defined benefit scheme from a defined contribution scheme from the member's perspective?

  1. The scheme must be contracted out of the State Second Pension
  2. The scheme must invest only in bonds
  3. The member's benefit is expressed as a promise related to salary or a specified amount Correct answer.
  4. The member's contributions are always lower

Explanation

The defining characteristic of defined benefit is a promise of a specified benefit, typically linked to salary and service or a fixed amount. Defined contribution benefits are whatever the accumulated fund will buy. Contribution levels and investment strategy vary independently of the benefit basis.

Question 4Pension scheme design, benefits and types of scheme

A scheme provides a pension of 1/80 of final salary per year of service plus a separate lump sum of 3/80 per year of service. Which term describes this structure?

  1. A cash balance arrangement
  2. A defined contribution arrangement with a protected rights lump sum
  3. A defined benefit arrangement with a separate lump sum Correct answer.
  4. A defined benefit arrangement with an integrated lump sum

Explanation

The pension and the lump sum are each calculated by separate fractions of final salary per year of service, which is the classic separate lump sum structure. It is a defined benefit promise because benefits depend on salary and service. A cash balance arrangement would instead credit a notional account.

Question 5Pension scheme design, benefits and types of scheme

In a final salary defined benefit scheme, which definition of pensionable salary is most likely to reduce the employer's cost relative to using basic salary alone?

  1. Basic salary plus regular overtime and bonuses
  2. The member's total earnings including one-off commissions
  3. Basic salary only Correct answer.
  4. Basic salary plus all taxable benefits in kind

Explanation

Restricting pensionable pay to basic salary excludes fluctuating elements such as overtime, bonuses and commissions, lowering the salary base and therefore the cost of accrued benefits. Broader definitions increase the pay on which benefits are calculated. The choice of definition is a significant cost lever in scheme design.

Question 6Pension scheme design, benefits and types of scheme

A defined benefit scheme changes its accrual rate from 1/60 to 1/80 for future service only. What is the principal effect on members and the employer?

  1. Both past and future benefits are reduced immediately
  2. Future benefit accrual is slower, while benefits already accrued are preserved Correct answer.
  3. The scheme becomes a defined contribution arrangement
  4. Past accrued benefits are reduced and future benefits are unchanged

Explanation

Changing the accrual rate for future service only slows the rate at which new benefits build up, while benefits already earned remain protected. This is a common way to reduce future cost without cutting accrued rights. It does not alter the fundamental defined benefit nature of the scheme.

Question 7Pension scheme design, benefits and types of scheme

What is the key characteristic of a cash balance (or defined benefit hybrid) arrangement?

  1. The member selects investments from a fund range and bears all risk
  2. The member's account is credited with a guaranteed rate of interest and benefits are expressed as a notional fund Correct answer.
  3. Benefits are paid solely from the state scheme
  4. The employer's contribution is fixed and the member bears longevity risk

Explanation

A cash balance plan credits each member with a notional account that grows at a guaranteed rate, often linked to salary or an index, and the resulting fund determines the benefit. The employer bears investment and often longevity risk, unlike defined contribution. It is therefore a defined benefit hybrid.

Question 8Pension scheme design, benefits and types of scheme

Which of the following best describes a career average revalued earnings (CARE) scheme?

  1. Benefits accrue each year on that year's salary and are revalued to retirement Correct answer.
  2. Benefits are a fixed lump sum independent of salary
  3. Benefits depend entirely on investment returns on member-selected funds
  4. Benefits are based only on the member's salary in the final three years

Explanation

In a CARE scheme each year's pension accrual is based on that year's pensionable pay and is then revalued, often in line with an index, up to retirement. This avoids the back-loading of final salary schemes while retaining a defined benefit promise. It is not a final salary or defined contribution design.

Question 9Pension scheme design, benefits and types of scheme

A scheme member is entitled to a pension of 1/80 of final salary per year of service and takes 25 years of service with a final salary of GBP 40,000. Ignoring any lump sum, what is the annual pension?

  1. GBP 20,000
  2. GBP 10,000
  3. GBP 16,000
  4. GBP 12,500 Correct answer.

Explanation

The pension equals the accrual fraction multiplied by final salary and service: 25/80 times GBP 40,000. That gives 0.3125 times GBP 40,000, which is GBP 12,500 a year. The calculation ignores early retirement reductions and any lump sum commutation.

Question 10Pension scheme design, benefits and types of scheme

Which statement about the role of member contributions in scheme design is correct?

  1. Non-contributory schemes cannot be defined benefit
  2. A contributory defined benefit scheme reduces the employer's net cost for a given benefit level compared with a non-contributory one Correct answer.
  3. Member contributions in a defined contribution scheme guarantee a minimum pension
  4. Contributory status determines whether a scheme is defined benefit or defined contribution

Explanation

Where members contribute, part of the cost of the promised benefit is met by members, reducing the employer's net outlay for the same benefit. Contribution status is a design lever independent of the benefit basis. It does not by itself guarantee outcomes or determine scheme type.

Question 11Pension scheme design, benefits and types of scheme

What is the primary purpose of a scheme's normal retirement age in benefit design?

  1. It defines when benefits become payable without early or late adjustment Correct answer.
  2. It determines the scheme's investment strategy
  3. It fixes the employer's contribution rate permanently
  4. It sets the age at which the member must stop working

Explanation

Normal retirement age is the reference age at which unreduced benefits are payable; retiring earlier or later typically triggers actuarial adjustment. It is a design parameter for benefit timing and cost, not a legal retirement bar. Investment strategy and contribution rates are set separately.

Question 12Pension scheme design, benefits and types of scheme

A defined benefit scheme offers members the option to commute part of their pension for a tax-free lump sum at retirement. What is the usual effect of exercising this option?

  1. The scheme's defined benefit status is lost
  2. The pension increases to compensate for the lost lump sum
  3. The member's contributions are refunded
  4. The remaining pension is reduced in exchange for the lump sum Correct answer.

Explanation

Commutation converts part of the pension entitlement into a lump sum, so the ongoing pension is reduced in line with the commutation basis. The member trades income for capital. The scheme remains defined benefit and contributions are not refunded.

Question 13Pension scheme design, benefits and types of scheme

Which of the following is a typical mechanism for sharing risk between employer and member in a hybrid pension arrangement?

  1. A scheme combining a defined benefit core with a defined contribution top-up Correct answer.
  2. A defined benefit scheme where the member bears all investment risk
  3. A state earnings-related pension
  4. A defined contribution scheme with no employer contribution

Explanation

Hybrid designs often combine a defined benefit core, which gives some certainty, with a defined contribution top-up where the member bears investment risk. This splits risk between the parties. A pure DC scheme with no employer contribution or a pure state pension is not a risk-sharing hybrid.

Question 14Pension scheme design, benefits and types of scheme

In a defined benefit scheme, what does the term 'accrued benefit' refer to?

  1. The total contributions paid by the member
  2. The benefit that has built up for service to date, based on current pensionable salary Correct answer.
  3. The scheme's surplus assets
  4. The benefit the member would receive if they worked to normal retirement age

Explanation

Accrued benefit is the benefit earned for service completed to the valuation date, usually calculated on current pensionable salary for final salary schemes. It is distinct from projected benefit at retirement. Contributions paid and scheme surplus are funding measures, not benefit entitlements.

Question 15Pension scheme design, benefits and types of scheme

A scheme's rules provide a pension of 1/60 of final salary per year of service, with a member contribution of 5% of pensionable pay. Which combination of design features does this describe?

  1. Defined contribution, non-contributory
  2. Defined benefit, contributory Correct answer.
  3. Defined benefit, non-contributory
  4. Defined contribution, contributory

Explanation

A salary-linked fraction per year of service is a defined benefit promise, and the 5% member contribution makes it contributory. The two features are independent: one describes the benefit basis, the other the funding split. Both must be read from the rule.

Question 16Pension scheme design, benefits and types of scheme

Which design feature is most likely to make a defined benefit scheme's cost more volatile for the employer?

  1. A defined contribution arrangement with a fixed employer rate
  2. A fixed accrual rate with benefits linked to final salary Correct answer.
  3. A career average scheme with revaluation capped at a low index
  4. A scheme paying a fixed nominal pension with no indexation

Explanation

Final salary linkage exposes the employer to salary growth and to investment and longevity risk on a benefit that is not capped, increasing cost volatility. Capped revaluation and fixed nominal pensions limit the employer's exposure. A fixed DC employer rate is by definition stable.

Question 17Pension scheme design, benefits and types of scheme

A member joins a scheme that provides a pension of 1/60 of final salary per year of service and also offers a separate lump sum of 3/80 per year of service. How would you characterise the total benefit package?

  1. A defined benefit package with both a pension and a separate lump sum Correct answer.
  2. A defined benefit package with only a pension and no lump sum
  3. A cash balance package with a notional account
  4. A defined contribution package with a protected lump sum

Explanation

Both elements are calculated by salary-linked fractions per year of service, so the package is defined benefit and includes a separate lump sum in addition to the pension. The two fractions operate independently. Nothing in the description suggests a notional account or a DC fund.

Question 18Pension scheme design, benefits and types of scheme

What is the main reason an employer might convert a final salary scheme to a career average scheme?

  1. To avoid having to fund the scheme at all
  2. To reduce cost and volatility while retaining a defined benefit promise Correct answer.
  3. To remove all employer risk from the scheme
  4. To transfer investment risk entirely to members

Explanation

CARE schemes typically cost less and are less volatile than final salary schemes because each year's accrual depends on that year's pay rather than final pay. They retain a defined benefit promise, so employer risk is reduced but not eliminated. They do not transfer all investment risk to members.

Question 19Pension scheme design, benefits and types of scheme

Which statement about the trustee's role in a defined benefit occupational scheme is correct?

  1. Trustees determine the member's state pension entitlement
  2. Trustees hold the scheme assets and act in members' interests Correct answer.
  3. Trustees set the employer's contribution rate unilaterally
  4. Trustees guarantee the scheme's investment returns

Explanation

Trustees hold the assets on trust and must act in the best interests of beneficiaries, including overseeing funding and investment. Contribution rates are agreed with the employer, often after actuarial advice. Trustees cannot guarantee returns or determine state benefits.

Question 20Pension scheme design, benefits and types of scheme

A defined benefit scheme offers a pension of 1/60 of final salary per year of service. A member with 30 years' service and final salary of GBP 45,000 also receives a separate lump sum of 3/80 per year of service. What is the lump sum?

  1. GBP 45,000
  2. GBP 22,500
  3. GBP 50,625 Correct answer.
  4. GBP 33,750

Explanation

The lump sum is 30 times 3/80 times GBP 45,000. That is 90/80 times GBP 45,000, equal to 1.125 times GBP 45,000, which is GBP 50,625. The pension is calculated separately and is not needed for this figure.

Question 21Pension scheme design, benefits and types of scheme

Which of the following best explains why defined benefit schemes expose the employer to longevity risk?

  1. The employer must pay a pension for as long as the member lives, however long that is Correct answer.
  2. The scheme is contracted out of the state scheme
  3. The member chooses the investment funds
  4. The employer's contribution rate is fixed in advance

Explanation

A defined benefit promise is a lifetime pension, so if members live longer than assumed the employer must fund the extra payments. Longevity risk therefore sits with the employer rather than the member. Fixed contribution rates and member investment choice describe defined contribution features.

Question 22Pension scheme design, benefits and types of scheme

What is the effect of a scheme providing a pension based on 'final pensionable salary' defined as the average of the best three consecutive years in the last ten?

  1. It reduces the benefit relative to using the very last year's salary if pay has risen steadily Correct answer.
  2. It makes the scheme a defined contribution arrangement
  3. It always increases the benefit compared with the last year's salary
  4. It removes salary from the benefit calculation

Explanation

Averaging the best three years smooths salary spikes and, where pay rises steadily, produces a lower figure than the final year alone. It is a common cost-control definition in final salary schemes. It does not change the defined benefit nature or remove the salary link.

Question 23Pension scheme design, benefits and types of scheme

Which statement about a group personal pension compared with a defined benefit occupational scheme is correct?

  1. The group personal pension promises a salary-related pension
  2. Both arrangements guarantee a fixed retirement income
  3. The group personal pension is a defined contribution arrangement where the member bears investment risk Correct answer.
  4. The defined benefit scheme places investment risk on the member

Explanation

A group personal pension is a defined contribution arrangement, so the member bears investment risk and the retirement income depends on the fund built up. A defined benefit scheme promises a salary-related benefit and places investment risk on the employer. Neither guarantees a fixed income in all cases.

Question 24Pension scheme design, benefits and types of scheme

A defined benefit scheme introduces a cap on pensionable pay increases used to calculate final salary benefits. What is the main design objective?

  1. To remove the need for actuarial valuations
  2. To limit the employer's exposure to salary growth Correct answer.
  3. To convert the scheme to defined contribution
  4. To increase the benefit for high earners

Explanation

Capping the pay increases used in the final salary calculation limits how much the employer's liability grows with salary inflation. It is a cost-control device rather than a benefit enhancement. It does not change the scheme type or remove the need for valuations.

Question 25Pension scheme design, benefits and types of scheme

Which of the following statements about the state pension relationship with occupational scheme design is correct?

  1. Contracted-out status determines whether a scheme is contributory
  2. The state pension replaces the need for occupational provision
  3. All occupational schemes must be contracted out
  4. Contracted-out occupational schemes historically provided a benefit in place of part of the state earnings-related pension Correct answer.

Explanation

Contracted-out salary-related schemes historically gave members a scheme benefit in place of the state earnings-related pension, with a reduction in National Insurance contributions. Contracting out was optional and is separate from contribution status. The state pension does not remove the need for occupational saving.

Question 26Pension scheme design, benefits and types of scheme

A UK occupational pension scheme promises each member a lump sum at retirement equal to a defined percentage of salary for each year of service, with interest credited at a rate linked to gilt yields. Which type of scheme is this?

  1. A defined contribution scheme
  2. A career average revalued earnings scheme
  3. A defined benefit scheme
  4. A cash balance scheme Correct answer.

Explanation

A cash balance scheme defines the benefit as a lump sum built up from salary-based credits and interest, rather than as a pension calculated by a formula. It is a defined benefit arrangement because the employer bears investment and longevity risk, but the benefit is expressed as a capital sum.

Question 27Pension scheme design, benefits and types of scheme

An employer is designing a new occupational pension scheme and wants to limit its exposure to investment and longevity risk while still providing a target level of retirement income for employees. Which design feature would best achieve this?

  1. A final salary defined benefit arrangement with a 1/60 accrual rate
  2. A defined benefit arrangement with a discretionary annual increase to pensions in payment
  3. A defined contribution arrangement with a default investment strategy and an employer contribution Correct answer.
  4. A cash balance arrangement with a guaranteed interest credit linked to RPI

Explanation

In a defined contribution arrangement the employer's contribution is fixed and the member bears investment and longevity risk, so the employer's exposure is limited. The other designs all leave the employer bearing some investment, inflation or longevity risk.

Question 28Pension scheme design, benefits and types of scheme

A UK defined benefit scheme provides a pension of 1/80 of final pensionable salary for each year of service, with no separate lump sum. A member with 20 years' service and final pensionable salary of £30,000 retires. What is the annual pension?

  1. £6,000
  2. £15,000
  3. £3,750
  4. £7,500 Correct answer.

Explanation

The pension is calculated as accrual rate × service × final pensionable salary: (1/80) × 20 × £30,000 = £7,500 per year. This is a straightforward application of the scheme formula.

Question 29Pension scheme design, benefits and types of scheme

A UK defined benefit scheme is considering changing its pension increase policy for pensions in payment from discretionary increases to a statutory requirement to increase pensions by at least the rise in the consumer prices index, subject to a cap. What is the main effect of this change on the scheme's risk profile?

  1. It transfers inflation risk from the employer to the members.
  2. It increases the scheme's exposure to inflation risk, although the cap limits the exposure. Correct answer.
  3. It removes inflation risk from the scheme entirely.
  4. It has no effect on the scheme's risk profile because increases were already paid.

Explanation

Moving from discretionary to statutory indexation makes future increases a legal obligation, so the scheme bears more inflation risk than before. The cap limits the increase in any year but does not eliminate the exposure.

Question 30Pension scheme design, benefits and types of scheme

A UK employer operates a defined benefit scheme with a normal pension age of 65. It is considering introducing a flexible retirement option allowing members to draw benefits from age 55 while continuing to work. Which statement best describes the main actuarial implication of this change?

  1. It will increase the scheme's liabilities because benefits are paid earlier and may be based on a lower salary, with the net effect depending on the early retirement terms. Correct answer.
  2. It will reduce the scheme's liabilities because benefits are paid earlier.
  3. It will reduce the scheme's liabilities because members will accrue less service after age 55.
  4. It will have no effect on the scheme's liabilities because the member continues to work.

Explanation

Paying benefits earlier generally increases the present value of liabilities, although the effect may be offset if the early retirement terms include an actuarial reduction and the member's salary at 55 is lower than it would have been at 65. The net effect therefore depends on the specific terms offered.

Question 31Funding, valuation and financing of pension schemes

Under a defined benefit occupational pension scheme, which party normally bears the investment risk of the scheme's assets relative to the promised benefits?

  1. The sponsoring employer, subject to the scheme's funding and statutory protections Correct answer.
  2. The scheme actuary, who guarantees the funding level
  3. The asset manager, who indemnifies the scheme against shortfalls
  4. The active members, through reductions to their accrued benefits

Explanation

In a defined benefit scheme the employer underwrites the promise, so adverse investment experience falls on the employer's contribution obligations rather than on members' accrued benefits. Members' benefits are defined by the rules and protected by statute. The actuary and asset manager provide advice and services but do not bear the funding risk.

Question 32Funding, valuation and financing of pension schemes

A defined contribution scheme member is closest to bearing which combination of risks?

  1. Neither risk, because the trustee guarantees a target replacement ratio
  2. Investment risk only, because longevity risk is always borne by the employer
  3. Longevity risk only, because investment risk sits with the trustee
  4. Investment risk and longevity risk in retirement, subject to how benefits are drawn Correct answer.

Explanation

In DC the member's accumulated fund depends on contributions and investment returns, and the adequacy of the eventual retirement income depends on how long the member lives and how the fund is drawn. The employer's obligation is normally limited to paying contributions. Trustees administer but do not guarantee outcomes.

Question 33Funding, valuation and financing of pension schemes

A UK defined benefit scheme holds assets of 940 million and has liabilities on the scheme funding basis of 1,000 million. Which statement best describes the funding position?

  1. A funding level of 106%, indicating a technical provisions surplus
  2. A deficit of 60 million that must be met immediately from the employer's balance sheet
  3. A surplus of 60 million available for contribution reductions
  4. A deficit of 60 million, which the schedule of contributions must address Correct answer.

Explanation

The funding level is 940/1,000 = 94%, so there is a shortfall of 60 million on the technical provisions basis. Under UK scheme funding the deficit is addressed through the recovery plan and schedule of contributions agreed with the trustees, not necessarily paid at once.

Question 34Funding, valuation and financing of pension schemes

In pension scheme terminology, what does the 'technical provisions' amount represent?

  1. The market value of the scheme's investment portfolio
  2. The actuarial value of liabilities calculated on the scheme's chosen funding basis Correct answer.
  3. The statutory minimum contribution rate set by the regulator
  4. The cost of buying out all benefits with an insurance company

Explanation

Technical provisions are the actuarial estimate of the amount needed to pay benefits as they fall due, calculated using the scheme-specific funding basis and assumptions agreed between trustees and actuary. They are not the same as a buy-out or solvency estimate, nor are they an asset value or a prescribed contribution rate.

Question 35Funding, valuation and financing of pension schemes

Which best describes 'longevity risk' as it applies to a defined benefit pension scheme?

  1. The risk that members live longer than assumed, increasing the cost of pensions Correct answer.
  2. The risk that the employer becomes insolvent
  3. The risk that the scheme's investments fall in value
  4. The risk that inflation reduces the real value of fixed pensions

Explanation

Longevity risk is the uncertainty in future mortality improvement and hence in how long pensions must be paid. It raises liabilities if members live longer than the assumptions embedded in the valuation. Investment, sponsor covenant and inflation risks are distinct risks.

Question 36Funding, valuation and financing of pension schemes

A scheme's liabilities are valued using a discount rate of 4% per annum. If the discount rate were lowered to 3% with all else unchanged, what happens to the present value of the liabilities?

  1. It stays the same, because the cash flows are unchanged
  2. It increases only if the liabilities are inflation-linked
  3. It increases, because future payments are discounted less heavily Correct answer.
  4. It decreases, because a lower rate implies lower benefit payments

Explanation

The present value of a fixed stream of payments rises when the discount rate falls, because each future payment is divided by a smaller compounding factor. The benefit cash flows themselves are unchanged; only their discounted value alters. The effect arises regardless of whether benefits are inflation-linked.

Question 37Funding, valuation and financing of pension schemes

Which funding vehicle involves the employer and trustee agreeing a formal schedule of contributions and a recovery plan to eliminate a deficit?

  1. A defined contribution trust scheme
  2. The statutory scheme funding regime for defined benefit schemes Correct answer.
  3. A workplace ISA savings plan
  4. A group personal pension arrangement

Explanation

Under the statutory funding regime for DB schemes, trustees must prepare technical provisions, a schedule of contributions and, where there is a deficit, a recovery plan. DC arrangements and personal pensions do not involve a recovery plan because no defined benefit promise exists.

Question 38Funding, valuation and financing of pension schemes

A pension scheme invests in a portfolio expected to return 6% per annum, while the discount rate used to value its liabilities is 4.5% per annum. Which statement is correct about the expected effect on the funding position over time, all else equal?

  1. The funding position should deteriorate, because the discount rate is lower than the return
  2. The funding position should improve, because assets are expected to grow faster than liabilities accrue Correct answer.
  3. The funding position is unaffected, because both figures are actuarial assumptions
  4. The funding position improves only if the return is guaranteed

Explanation

If assets are expected to earn more than the rate at which liabilities are discounted, the excess return reduces any deficit over time, all else equal. This is the basis of the 'expected return' or 'excess return' element in scheme funding projections. The relationship holds as an expectation and does not require a guarantee.

Question 39Funding, valuation and financing of pension schemes

In the context of scheme financing, what is a 'contingent asset' such as a parent company guarantee?

  1. An asset already included at market value in the scheme's investment portfolio
  2. A statutory levy collected from all schemes by the regulator
  3. A resource that may be used to reduce a deficit if a specified event occurs Correct answer.
  4. A reserve held by the scheme actuary for adverse experience

Explanation

A contingent asset is an arrangement, such as a guarantee or letter of credit, that gives the scheme recourse to additional funds on the occurrence of a defined event. It is not included as an ordinary invested asset but may be taken into account in funding negotiations and in assessing the employer's covenant.

Question 40Funding, valuation and financing of pension schemes

An employer wishes to reduce its defined benefit pension risk. Which action most directly transfers investment and longevity risk to a third party?

  1. Switching the scheme's growth assets into index-linked gilts
  2. Increasing the scheme's equity allocation to target higher returns
  3. A bulk annuity buy-in with an insurer covering a defined group of members Correct answer.
  4. Extending the recovery plan period for the deficit

Explanation

A bulk annuity buy-in insures the benefits of a defined group of members with an insurer, transferring the associated investment and longevity risk while the policy remains a scheme asset. Changing asset allocation or lengthening the recovery plan alters risk but does not transfer it to a third party.

Question 41Funding, valuation and financing of pension schemes

A scheme with liabilities of 500 million enters into a buy-in policy that exactly matches the insured benefits. Which statement best describes the immediate effect on the scheme's funding position?

  1. The scheme's assets fall by the premium but liabilities remain unchanged
  2. The scheme's liabilities fall to zero because the insurer now owes the benefits
  3. The scheme records an immediate surplus equal to the insurer's profit margin
  4. Total assets and liabilities are broadly unchanged, since the policy is an asset matching the insured liabilities Correct answer.

Explanation

In a buy-in the insurer's policy is held as a scheme asset and the corresponding liabilities remain in the scheme, so the overall funding position is broadly unchanged apart from pricing and basis differences. The members remain scheme members and the trustees retain responsibility. Assets and liabilities both continue to be recognised.

Question 42Funding, valuation and financing of pension schemes

A scheme actuary is choosing assumptions for the scheme-specific funding basis. Which approach is most consistent with a prudent technical provisions calculation?

  1. Using the insurer buy-out basis as the sole funding basis
  2. Using assumptions that are individually prudent, with margins reflecting the scheme's circumstances Correct answer.
  3. Selecting the assumptions that minimise the reported liabilities
  4. Adopting best-estimate assumptions with no margins at all

Explanation

Technical provisions must be calculated prudently, and the assumptions should reflect the scheme's own circumstances and demographics, with appropriate margins for adverse experience. Best-estimate assumptions without margins would not be prudent, and minimising liabilities is not a valid objective. The buy-out basis is a different, typically more conservative, measure.

Question 43Funding, valuation and financing of pension schemes

Which of the following best explains why a defined benefit scheme's funding level can fall sharply when interest rates rise?

  1. The discount rate may rise, but the scheme's assets may fall in value more than the liabilities Correct answer.
  2. The scheme actuary is required to increase the prudence margin automatically
  3. Liabilities always rise when interest rates rise
  4. Assets are unaffected by interest rates while liabilities fall

Explanation

Rising interest rates usually reduce the present value of liabilities, but they also depress the market value of bonds and other assets. If the asset fall outweighs the liability reduction, the funding level can deteriorate. The net effect depends on the scheme's asset-liability matching.

Question 44Funding, valuation and financing of pension schemes

An employer is considering paying a one-off deficit contribution into the scheme. Which factor is most relevant to whether this improves the employer's overall financial position?

  1. The length of the scheme's member booklet
  2. The scheme's number of deferred members
  3. The identity of the scheme's investment managers
  4. The tax treatment of the contribution and the reduction in future accrual of deficit Correct answer.

Explanation

A deficit contribution may attract tax relief for the employer and reduces future deficit repair costs and risk, so the net financial effect depends on these factors. Member counts, manager identity and document length are not directly relevant to the financial decision.

Question 45Funding, valuation and financing of pension schemes

In a scheme funding valuation, which item is normally treated as an asset of the scheme?

  1. The market value of the scheme's invested holdings plus any accrued income Correct answer.
  2. The employer's goodwill and brand value
  3. The present value of future employer contributions not yet due
  4. The expected future investment returns on the portfolio

Explanation

Scheme assets are the invested holdings valued at market value, together with accrued income and cash. Future contributions not yet due and expected future returns are not assets at the valuation date; they are future cash flows. The employer's goodwill is not a scheme asset.

Question 46Funding, valuation and financing of pension schemes

A trustee board is reviewing the employer covenant. Which of the following is the most direct indicator of the employer's ability to support the scheme?

  1. The employer's cash flow and balance sheet strength, including its ability to make deficit contributions Correct answer.
  2. The scheme's asset allocation to equities
  3. The level of the scheme's investment management fees
  4. The number of active members in the scheme

Explanation

The employer covenant is the employer's legal obligation and financial capacity to support the scheme, assessed through its cash flow, balance sheet and prospects. Asset allocation, membership numbers and fees relate to the scheme, not to the employer's ability to pay.

Question 47Funding, valuation and financing of pension schemes

A scheme has a deficit on its technical provisions basis but a larger deficit on a buy-out basis. Which statement is correct?

  1. The buy-out deficit is smaller because insurers benefit from economies of scale
  2. The buy-out deficit is larger because insurer pricing assumes lower returns and includes expenses and profit margins Correct answer.
  3. The technical provisions deficit is irrelevant once a buy-out estimate exists
  4. The two measures must always be equal by regulation

Explanation

A buy-out basis typically uses more conservative assumptions, such as lower discount rates and allowance for insurer expenses and profit, so it usually produces a larger liability value and deficit. The technical provisions basis remains the statutory funding measure and is not superseded by a buy-out estimate.

Question 48Funding, valuation and financing of pension schemes

Which statement best describes the role of the schedule of contributions in a UK defined benefit scheme?

  1. It documents the trustee's investment strategy and risk appetite
  2. It lists the scheme's investments and their market values
  3. It records the actuarial assumptions used in the valuation
  4. It sets out the contributions payable by the employer and members and the dates by which they must be paid Correct answer.

Explanation

The schedule of contributions is the formal document specifying the rates and due dates of employer and member contributions, certified by the actuary. Investment holdings are covered by the statement of investment principles, and assumptions are set out in the actuarial valuation report.

Question 49Funding, valuation and financing of pension schemes

An employer sponsors a scheme with a large deficit and limited cash. Which funding arrangement is most likely to be considered to give the scheme additional security without immediate cash payment?

  1. A reduction in the scheme's investment risk
  2. An increase in the scheme's equity allocation
  3. A shorter recovery plan requiring larger immediate contributions
  4. A parent company guarantee or other contingent asset Correct answer.

Explanation

A guarantee or other contingent asset can provide additional security to the scheme and support a longer recovery plan without requiring immediate cash. Reducing investment risk or increasing equity does not add employer security, and a shorter recovery plan demands more cash, which the employer lacks.

Question 50Funding, valuation and financing of pension schemes

Which of the following best describes 'sponsor covenant risk' in a defined benefit scheme?

  1. The risk that members live longer than assumed
  2. The risk that the employer cannot or will not provide the promised financial support Correct answer.
  3. The risk that inflation exceeds expectations
  4. The risk that the scheme's assets are misvalued

Explanation

Sponsor covenant risk is the risk that the employer's financial strength deteriorates or its commitment weakens, reducing the scheme's ability to rely on future contributions. Longevity, inflation and valuation risks are separate categories.