Funding, valuation and financing of pension schemes
Funding is the process of setting contributions and investment strategy to meet DB promises as they fall due. The exam tests the statutory funding framework, prudent assumptions, the employer covenant, and how deficits are repaired.
The framework
Trustees must obtain an actuarial valuation at least every 15 months (with a 15-month signing window), set Technical Provisions, agree a Statement of Funding Principles, a Schedule of Contributions and, if there is a deficit, a Recovery Plan. TPR's DB Funding Code (twin-track Fast Track/Bespoke) requires a Funding and Investment Strategy linked to significant maturity. Assumptions must be prudent and employer-specific; the discount rate should reflect asset returns and covenant strength.
Worked example
A scheme has assets of £800m and Technical Provisions of £1,000m, a funding level of 80% and a deficit of £200m. If the employer pays £20m a year for 10 years and assets return 5%, the present value of those payments is 20 × [1 − 1.05^-10]/0.05 = £154.4m, leaving a shortfall. The payment needed to clear £200m over 10 years at 5% is 200 × 0.05/(1.05^10 − 1) = £15.9m a year, before expenses and before any allowance for future accrual.
Traps
Using a best-estimate rather than prudent discount rate; ignoring expenses and PPF levies; comparing ongoing funding with buy-out cost without explanation; not testing the recovery plan against the covenant; forgetting that contributions are paid in advance or in arrears, which changes the arithmetic slightly.