A scheme guide on how to set your discount rate

For example, in relation to a pension in payment of £10,000 a year with fixed 3 per cent increases, the expected cash flow in year 10 will be £13,439 (calculated as £10,000 x 1.03^10). This is then multiplied by the probability of the member still being alive at that point, which might result in a figure of, say, £11,000.

The second step is to determine how much money needs to be set aside now to meet this future liability, by discounting it back to the valuation date at a particular rate, called the discount rate.

For example, if this is set at 5 per cent a year, then the amount that needs to be set aside now to meet our individual cash flow in year 10 is £6,753 (calculated as £11,000 divided by 1.05^10). 

I have been careful to refer to “the amount that needs to be set aside now” rather than using the words “current value”.

This is because the discount rate incorporates notions of how likely it is that the sponsoring employer will be able to top up funds in the event the amount set aside is insufficient to meet the actual liability in the future.

When discount rates differ

Two employers holding the same assets might therefore put aside different amounts in respect of this liability, even though the current value is the same.

This idea is fundamental to the Pensions Regulator’s new code of practice on scheme funding, due to come into effect for valuations completed from July 2014. The regulator has focused on the integration of employer covenant, funding strategy, and investment strategy.

The discount rate itself is often derived from the expected investment returns on the assets held

Therefore, if an employer wishes to adopt a higher discount they must be able to demonstrate a strong covenant.

The funding and investment strategies must also be consistent with the rate proposed – for example, the funding strategy would need to reflect ongoing employer support as opposed to targeting self-sufficiency – and the investment strategy would need to incorporate a certain holding of growth assets.

For the purpose of scheme funding valuations, it is important to remember that the assumptions are set by the trustees, rather than the employer. The trustees are, however, required to agree their assumptions with the employer.

Depending on circumstances, the employer may benefit from writing to the trustees shortly after the valuation date setting out ranges of assumptions, particularly the discount rate, that it feels would be appropriate.

This is best achieved if the employer has access to a funding tracker, which will provide a good indication of the scheme funding level based on the current valuation method. The employer will therefore know the extent to which it may need to push for a tightening of assumptions.

Even if not specifying any ranges of assumptions, the employer should engage early with trustees to ensure its objectives are taken into account from the outset. 

The discount rate itself is often derived from the expected investment returns on the assets held, less a small margin to make it a prudent assumption.

It is a common strategy to hold growth assets in respect of pre-retirement liabilities and matching assets in respect of post-retirement liabilities.

The discount rate is therefore also commonly split between these two categories, resulting in pre-retirement and post-retirement rates.

The post-retirement rate will reflect a mixture of gilts and corporate bonds, while the pre-retirement rate will either be expressed as gilt yields plus some percentage – called the equity risk premium – or based on the agreed target return of funds held.

Depending on the term structure of the scheme’s expected cash flows, using the full gilt yield curve, rather than taking the gilt yield at a specific term, could increase or decrease the value placed on liabilities, so should be carefully considered. 

Malcolm Rochowski is a corporate actuary at consultancy Barnett Waddingham