The Chairman (Mr A. H. Watson, F.F.A.): I will invite one of the authors of the paper, Jon Hatchett, to introduce it.

Dr J. P. L. Hatchett, F.I.A. (introducing the paper): The working party's original motivation was to describe how we feel pension liabilities should be measured. Yet what this turned into was a paper about communication and decision-making rather than one of measurement.

As far as we can tell, actuaries manage all the measurement complexity pretty well. Given a set of deterministic assumptions, projecting the cash flows and discounting them back, even as the assumptions get more and more complicated, is a more or less straightforward task given the technology we have today.

This is not a technical paper but tries to bring together much current industry discussion and what we think is best practice into a workable, practical framework. The reason that we thought this was worth writing is because so much time and energy is put into futile debate, trying very hard to answer the wrong question accurately, or to do work that just does not need to be done to tick boxes that do not really need to be ticked.

Where a much more interesting debate is to be had is: What is the right strategy for actually managing pension liabilities in the UK environment?

Risk management is the right lens through which to view this question, whether that is by trustees seeking to deliver the benefits, or companies seeking to protect shareholder value from legacy pension promises. Whatever the question, management information, or actuarial calculations, should be seeking to inform good decision-making. A model can help you make those good decisions. But however good the model, it cannot make those decisions for you.

Our first key point in the paper is that there is no right answer to measuring liabilities. It depends on the stakeholder. It depends on the stakeholder's objectives, and as consultants it is delivering that information in the way that those stakeholders will find useful for their decision-making.

We also attempted to be quite careful in the language we used, posing things in terms of the current value of assets and future value of assets rather than fixating on values of liabilities. We think that it is important to distinguish between those two crucial aspects of measurement and not confuse the two.

Taking advance credit for future expected asset outperformance, without allowing for risk, by reducing the value placed on scheme liabilities is at best confusing and at worst misleading. That is not to say that you should not seek to earn returns, but it is how you account for them and disclose them to trustees and companies that is important.

So our second key point is that the price of your asset portfolio today matters but so does the price of the asset portfolio that you would like to hold in future. For closed schemes seeking to de-risk that probably involves some matching of assets. We talk about the limitations of matching in our paper, but clearly some assets match pensions liabilities much more closely than others.

Both of the current asset portfolio and the desired future asset portfolio can go up and down in value. Funding volatility depends on how they move relative to each other and the money-weighted return of the asset portfolio in between. None of that is to say that markets are efficient or not efficient. That question is entirely irrelevant to the point.

Discounted values, with which we are all very familiar, are a powerful tool. But they really only tell you so much in setting this strategy. If you had to meet £100 liability in a year's time, using a typical equity risk premium maybe you would say you would need about £96 today to give yourself a 50–50 chance of meeting that liability. But does it mean it is prudent if you have £98 invested in equities today or even £100 invested in equities today? Perhaps prudence is in the eye of the beholder.

From a risk management perspective I think there are much better questions to ask yourself than whether we value the liabilities at £96 or £100 or something else. What is the range of outcomes that could happen with that strategy? Who gets the gain from any upside? Who suffers the pain from any downside?

The first step in valuing those liabilities ought to be to establish the stakeholder's objective. It will vary between different stakeholders. But trying to agree objectives between all stakeholders about what they would like to achieve in the real world, not with actuarial assumptions, would often lead to a mutually beneficial result.

So the third key point we would like to make is that there is more to pension scheme measurement than discount rates, and there is more to pension scheme management than measurement.

Some conclusions on the right combination of contributions into a pension scheme and investment risk and investment return will no doubt be subjective. But we think that is the nature of the beast. While we do not disagree with the concept of risk premia for equities, or perhaps even risk discount for gilts today, we think that it is a fallacy to believe that we can know exactly what those premia and discounts are, however sophisticated our analysis. So while it might well be appropriate to seek to earn those premia, or, in simple terms, to choose investments which are good value, it is important to understand how our uncertainty about our models, or in other words uncertainty about what we believe, could impact stakeholders.

Some of us are fairly sympathetic to the view that, from a shareholder's perspective, seeking to earn risk premia in a pension scheme is a rather circular and long-winded way to leak economic value. Shareholders can rebalance their portfolios by themselves and often have better tax outcomes from doing it for themselves. On the other hand, another reasonable point is that you are about as likely to meet a fully rational shareholder as you are a unicorn.

Our fourth key point is that actuaries should be clear on risk to those that they are advising. There are no certain bets out there, but we should be comfortable living with the ambiguity of the real world. It certainly keeps it interesting.

Poor information or too narrow or siloed a view can lead to poor decision-making. Schemes might take more risks than they need, exposing both members and companies to more downside risk than is necessary because they do not see all the upside available to them. As a very simplified example, if 30% in growth assets gives you a decent chance of paying the benefits in full, is it prudent to invest 60% in growth assets just because it increases the probability of a higher funding position? This is in the context of closed U.K. schemes. We call this reckless prudence. But really it is about siloed decision-making that misses the big picture, whether that is asset returns, asset values, or the link between the contributions that a sponsor pays and what covenant is left after it has paid that money into the scheme. But lots of these questions about risk focus on the investment strategy as much as they do on the contributions. So it is thinking all of that together in the context of the business that is having to support the scheme.

We see actuaries tying themselves in knots over what value to place on the liabilities. We certainly did not coin the term “flight path”. In our framework we have tried to suggest people think about having a certain amount of assets invested in a certain way today in order to reflect what the scheme is currently doing, and targeting having a different amount of assets invested a different way as some target in the future. A gilts plus x discount rate, where x only depends on the proportion of assets a scheme currently holds, simply does not capture the dynamics in these moving parts, and more importantly it does not capture the range of things that could happen. It focuses too much on that central outcome.

So, our fifth key point from the paper is that flight paths, supported by risk-based analytics, provide a helpful way for thinking and communicating about pension scheme strategy.

As a final example, it seems unfortunate to us that in pensions parlance self-sufficiency has lost some of its common English language meaning. Self-sufficiency, I feel, ought to mean something about having a scheme with a very good chance of paying the benefits without financial or any other recourse to a third party. In practice, some of the actuarial bases you see described as self-sufficient today seem to be something about having more assets than today, or having better matching assets than today. While that is a laudable target, it does not necessarily make a scheme self-sufficient.

So, the final key point we would like to make is that communicating in a way that helps our clients make well-informed decisions must be a good aim for us all to have.

Not all of this is new by any means. But, given our collective experience in the U.K. pension industry, we felt that it bears repeating and formulating in a way that helps stakeholders make better decisions in the context of U.K. defined benefit pension schemes.

Mr C. J. Hurry, F.F.A. (opening the discussion): Let me start by saying that I am delighted to be opening the discussion this evening for three main reasons. First, it is not a technical paper, rather one of approach, which always makes it a lot easier for me to follow and, I hope, should lead to a more wide-ranging discussion. Secondly, I think it is a clear and well-articulated paper, one for which the authors should be congratulated. Lastly, and possibly most importantly, it is because it proposes what, for some, is likely to be a pretty significant shift in what is essentially at the core of a lot of the work that we do as actuaries.

The authors acknowledge that it is about bringing together much that people have already been considering as schemes move towards their end game, and bringing this together in a shared framework. For example, consideration of a target strategy underlies what I understand is the funding approach of the Pensions Protection Fund (PPF) at the moment. The ideas of understanding and managing risk in philosophy are similar to those at the heart of Solvency II.

Essentially, the paper considers that a valuation is only truly helpful if we know where we are heading, we need some shared vision of the end game if we consider much more than discount rates. So we need to focus on real parameters such as cash, asset strategies and time frames, if we consider the risks and if the strategy helps to provide a framework for deciding what risks should be kept, and for managing those risks. Each of those I think is rather different from the traditional approach that we have been following up until the recent past at least, if not the present.

The first page of the paper contains the rather stark reminder that actuaries do not actually know the answer to whether a given holding of assets is going to be enough to meet some future pension promises. There is a clear suggestion that our “making financial sense of the future” mantra is not actually about a magic discount rate, compressing everything into a single value. It should be about helping people understand the risks and making informed decisions in the light of their attitude to those risks.

So I think it would be really useful to hear people's views this evening on whether they actually agree with that sentiment and whether the lengthy actuarial arm-wrestling debates, as they tend to be called, if we are being polite, on discount rates that we have seen in the recent past have actually added any value, added any true benefit, for the various stakeholders concerned.

Let me skim briefly through the various chapters in the paper and draw out some of the questions that occurred to me as I looked through it.

Chapter 2 considers the different purposes and stakeholders in the valuation process. One point that emerges from this is a suggestion that the consideration of the asset strategy really forms part of the valuation process. For some this will mean a rather different way of working, of looking at things. Traditionally, investment strategy is followed on from the valuation. I suspect if we are to consider risks in the way that the authors later contend, it may well mean asset liability modelling that has typically lived in the investment side of the house, has to move home and is more logically accommodated on the liability side, on the actuarial side. I would be interested to hear people's views on this and whether this is the sort of thing that is really happening in practice already.

Chapter 3 covers flight paths. In particular, it really requires, and is predicated on, all the stakeholders agreeing a target: where you are actually heading to. My experience on this is varied. It might be easier to agree on a target than it is to agree technical provisions, I think because people see it as an aspiration for tomorrow, something slightly removed from today's hard bargain of technical provisions. Or it might actually be harder because people see it as pushing even higher something that is already a fairly high hurdle for them to attain. Again, I should really like to hear from people whether they think this is an easier discussion or a rather more complicated one to work out what is that target. I should also like to know how many people already have a funding strategy that has a secondary objective, and then, for those who do, whether they actually link up what they are going to do at the end once they have reached their primary objective and think how they are then going to move onto the secondary objective.

There is also a question in people's minds about whether they actually need a longer-term target today: “Can't I just re-adjust my sights when I get to my technical provisions target, my primary objective?”

My experience is that a longer-term target can actually make a difference to decisions that you make today. For example, in deciding to keep more risky assets today in the hope of getting to a better funding place, a higher bar, in the future. I am interested to hear your views and your experiences, on those sorts of questions.

Chapter 4 looks at risks and uncertainties. This is a useful reminder that while we can expand, and probably should be expanding, our actuarial conversation to cover risk, we need to be clear that there are still uncertainties that abound. I should be interested to hear whether people feel comfortable about communicating risk while having to accept that there are uncertainties that we do not know.

Chapter 5 focuses on the discount rate and concludes that we should be far more explicit in disclosing the gap between what we expect to plug in terms of contributions and what we are actually hoping for in terms of future investment returns. This, for some, is possibly a rather chastening disclosure. But I should be interested to see if we agree that this is a very valuable disclosure. I know that it is a figure that, for example, when I present results, is definitely there. But I wonder whether my experience is typical in that trustees can actually be very relaxed about the assets’ ability to generate something which in some cases is a pretty significant chunk of additional return. I would be interested to hear whether others spend significant time focused on this aspect and this clearly vital piece of information. If they do not, do they envisage difficulty in either getting trustees to look at that or considering why it has not been one of their focuses before?

The paper is also useful, I suggest, in seeing a framework for incorporating views on things like yield reversion into a flight path or indeed a recovery plan.

As the authors note, making allowance for risk premia introduces risk. It is worth considering whether, as a group, we accept that our world has to change to one with a significantly greater emphasis on risk than in the past and thus on the asset liability analysis rather than the single point discounting or whether we can make financial sense of the future in some way without going to those sort of lengths.

Chapter 6 looks at what seems key, the communication of all of this. I would be interested in hearing others’ views on those two seemingly very logical metrics from the trustees’ perspective at least: the authors put forward the chance of paying full benefits and the consequences for members in adverse scenarios.

The authors proposed disclosures that would make the parties focus rather differently from today, thinking about the longer-term, thinking about those risk metrics than with comparable risk metrics for the corporate stakeholder. I would suggest that it is much more valuable than the BAS-inspired best estimate that we are supposed to be disclosing. Views on that are of course welcome.

Do we as a group agree that such a disclosure would actually lead to better decision-making since this is ultimately the point of this paper on both the asset and contributions sides and how they will work together?

I am also interested that the authors contend that the covenant should not actually affect the quoted scheme deficit for trustees but rather affects lots of other things that the trustees will do. It rather flies in the face of a scheme-specific funding regime, of course. But actually I am starting to see very little macro level evidence that a covenant informs the discount rate in the way that, perhaps, the Pensions Regulator might have hoped, and possibly a statement from the trustees to the regulator that covers why they are taking the risk – either the sponsor is good for it, for example, or they consider it to be a necessary evil – might be every bit as helpful for the regulator as well as it is for the trustees. I am also wondering, and without trying to refocus this evening's debate at all, if we see that sort of risk framework as useful for EIOPA compliance in the way that may well be coming over the hillside towards us.

Finally, this paper seems to hinge on the trustees and sponsor having a shared longer term objective, and from my perspective what I would really like to hear are your views on the best way to facilitate a discussion about what that longer-term objective might be.

Mr T. M. Ross, F.F.A.: I speak not as an adviser to pension funds, although I was one for many years, but as a recipient of actuarial advice as a trustee of a pension fund.

I should begin by saying that I think that this is a very useful paper. The framework that the authors have put forward for looking at pension scheme financing should prove helpful in the dialogue between trustees and sponsors.

I suggest that the central focus on risk and uncertainty is appropriate. Indeed, anything that reduces the emphasis put on discount rates and what the opener described as the arm-wrestling that has tended to go on between trustees and sponsors has to be a good thing.

But, to put this in context, the current regime has not been in place for long – seven or eight years as I recall. Thus far, I think that, generally, the relationship between trustees and sponsors has taken time to develop and it did not always start as constructively as it might have done. Perhaps trustees, with their new powers, felt obliged to flex their muscles, particularly in circumstances where they did not have those opportunities before. Equally, those of my vintage will remember that in many cases – though in fairness not all – the debate on those matters really was a closed debate where the trustees were presented more or less with a fait accompli. I exaggerate to make the point but, nevertheless, it was a bit like that. So it is not surprising that thus far it is has proved quite a challenge to introduce serious long-term thinking and the development of a shared view on a glide path towards fully securing the scheme's liabilities.

A further barrier to constructive long-term debate on progress towards an end game for many defined benefit pension funds is the concern on the part of the sponsors about the level of short-term contributions. I think that if we were experiencing less virulent conditions for pension funds it would be easier to have that debate. If, for example, you consider a pension fund that had a valuation in March 2009 and is due another in March 2012, its sponsor might be forgiven for thinking that it really had drawn the short straw, with results at each date being rather frighteningly bad, no matter what measurements are used. Thoughts of survival rather than of a long term glide path are likely to predominate.

There is a particular point that I would make on section 2, where there is a helpful analysis of the perspectives of different stakeholders in pension funds. I think that there is an important omission here and that is the interests of the senior executives of sponsoring companies. I suspect that the intention is that the interests of the senior executives are being grouped with the interests of the sponsor itself and shareholders. But I would venture to suggest that those interests are not always as aligned as they might appear to be. The reality is that executive incentives strongly encourage short-term thinking, and that can be a significant barrier to achieving a shared longer-term perspective on some of those pension fund financing issues. Perhaps one of the more important things to understand, therefore, is how executive incentive schemes operate. They are very short-term, particularly in the context of a pension scheme. They are also fiendishly complex these days. Indeed, I would go so far as to say that if you can get your mind around how some of those schemes work, then you will find that pension scheme finance is child's play

Having said that, I would repeat that the framework that is suggested in this paper will be helpful in facilitating a better dialogue between trustees and sponsors than there has been in the past in many cases.

Mr A. C. Martin, F.F.A.: While we are not going to be dominated by trustee considerations tonight, I think it is an important area where you take off your advisory hat, you do not worry about the three pages of caveats at the back of your report but when you put on your trustee hat and have to make a decision, you are responsible for it. That responsibility crops up early in the paper, in paragraph 2.1, where I do not “seek to represent” or “seek to find” prudent assumptions, I have to be prudent and I have to represent all members. It is an important element of responsibility.

In detail, I was absolutely delighted on section 1.3 of the paper to see an early mention of the crucial date of 11 June 2003 when the Government very firmly moved the (wind-up liability) goalposts for every solvent body. Other dates and other events, such as the compulsory indexation of pensions, might have been mentioned, changes in tax could also warrant a mention as well as the big reduction in interest rates around the turn of the century.

In terms of overall risk assessment, I suggest that there is one aspect which could have had much greater emphasis in the paper and that is the scheme cash flow. I regard the scheme cash flow as absolutely crucial. Having to disinvest to meet liabilities, you are much more vulnerable to incur or to crystallise investment losses. I think it warrants further analysis because when money is going out of the door in great amounts, your investment end result in risk terms changes quite drastically. Indeed, when you move from positive to negative cash flow, I think that is arguably as important as when you move from perhaps a pre- to post-retirement discount rate. Monitoring that cash flow is absolutely crucial.

While contingent assets of all types are correctly highlighted in the paper, I think greater emphasis should be placed on this particular area. It is probably familiar to everybody with a mortgage where you can borrow over 25 years, that you get significantly different terms when you put your house down as security. Vastly different terms are available compared with credit card borrowing, for example. This is I think a real win-win scenario. It does justify more heroic or optimistic investment assumptions in the technical provisions. It does justify a longer repayment period. I know one finance director who regularly quotes his personal secured 25 year mortgage recovery plan to the Pensions Regulator. I am afraid that it does not get him very far!

In section 2.1.6, buy-out, may I also, slightly cynically and flippantly, suggest that the cost of buy-out is a little less frightening if you do an accurate assessment of future expenses – that is the capitalised value of future administration expenses and the reasonable professional fees of running the pension scheme. Whether that multiple of last year's expenses is times 30, times 50 or times 150, depends on whether you look back to how those expenses have increased in recent years, and of course whether you want to extrapolate that increase for the future.

In paragraph 2.2.2, it is very important to differentiate between directors and shareholders. In small companies they may be one and the same, but director responsibilities are quite significant. Directors have to take into account the position of all creditors, secured and unsecured creditors, and of course in the capitalistic world we live in, paying your debts comes before paying your dividends. Never miss an opportunity to mention that.

I also think the employer covenant is the biggest risk and should be mentioned as many times as you possibly can. You only need to look back 20 years to see how many of the top 100 companies just do not exist any more. So it is perhaps with those risks in mind that it is not surprising that there are so few Defined Benefit (DB) schemes remaining open to new members and future accrual.

And, finally, in relation to section 6, communication, I should like to suggest that the schedule of contributions is extended to pick up the authors’ emphasis on risk by actually including the monetary “contribution” that comes from the non-guaranteed investment income. Actually having the monetary amount of contribution from the employer and the expected investment contribution in the one document I think would be very useful. It would, in fact, be instrumental in supplementing the employer covenant because you could look at those two figures, compare that with profits, or indeed turnover, and then you would know whether your pension fund is a highly geared investment trust that happens to have an operating subsidiary that is also the sponsoring employer.

The Chairman: On the communication point, I wonder how many members explicitly express the additional asset return in their schedule of contributions.

Prof. R. S. Clarkson, F.F.A.: To me, by far the most important paragraph is 2.3.2, relevance of the investment decision. Earlier speakers have referred to the importance of the long-term investment strategy. Section 3 I thought was excellent: it is written in very understandable language and there are very few technicalities or mathematics.

About 15 years ago, in the lecture theatre here, I made some theoretical criticisms of financial economics which the authors include in section 5. They stress the importance of financial economics in the current legislative structure.

I am not going to repeat my arguments tonight except to say that what happened with the world-wide banking catastrophe did not exist according to financial economics. That sort of scenario was impossible. So I am rather unhappy about how financial economics was brought in at the end of the paper. In particular, it comes down to the definition of risk: whether it is volatility in the short term or the suitability of the funding in the long-term.

In section 5.3, financial economics and the law of one price suggests that you do not obtain equilibrium other than, perhaps, in the very short term in financial markets. However, with quantitative easing and with governments here and in the U.S. trying to stop any further economic deterioration, you have government bond yields giving negative real returns. This is a serious distortion. I would be very interested if any of the authors would comment on the practical implications of this position.

A suggestion which has been made recently is that, perhaps because pension funds are long-term in nature, they could invest in infrastructure assets of some type or another, which might give a positive real rate of return in the long-term. I am very well aware of the volatilities of equity share prices, but I have the strongest suspicion that although the authors mention the importance of the long-term rates of return, they have not specifically spelled out the dangers of the valuation methods forcing you into fixed interest securities regardless of the return.

So my main question of the authors is: what recommendations would you make as to looking at the very long-term strategy of the pension fund, bearing in mind these very serious distortions from quantitative easing?

Mr R. K. Sloan, F.F.A.: I would like to focus on a few key points that I noted when looking through the paper.

There are several references to there being only one answer, or a single estimate, as if this was a deplorable thing to come up with. Likewise, deterministic models seem to be pooh-poohed ever so slightly. However, I would point out that the amount of money that gets paid into a pension scheme each year always ends up as being a single specific sum, as one cannot pay a range of probabilistic amounts into a pension scheme. So, after all the debate and discussions that are described very fully, one has to come down to one actual amount that goes into the pension fund that year.

In my own experience, back in the days when computers were first used some 30 years ago, my approach was to present perhaps three sets of deterministically-based results. Although the grid in the paper is interesting to actuaries, particularly those who can interpret such things, I find it better for trustees to see the practical effect on the balance sheet of, say, a 1% increase in the investment return, which could be the risk premium. Likewise, one can show the downside, and can then intuitively assign risk probabilities towards the chances of achieving that extra return or not. I find that trustees are better able to understand these sorts of figures. Moreover, one can choose how one wishes to direct the trustees by careful choice of the assumptions made and how the results are presented.

Next, the risk appetite. I fully understand that everybody has different views on all the various elements of risk involved, but when you say that you need to set a risk appetite on behalf of the membership, I am not quite sure what that actually means. It seems that you are trying to make things fit into the model, but that was perhaps just a quirk of the wording that was used.

As regards the scheme members, I wonder if allowance is made in your modelling for the difference between the scheme benefits and the PPF benefit underpin? I am not sure that I saw anything about the extent to which net benefits are actually lost by the members if the scheme goes under, and hence the PPF comes into play. Obviously, different categories of member will lose to a greater or lesser extent, but which I think needs to be factored in when speaking to the membership as one of the stakeholder parties, or to the trustees on their behalf.

I was slightly surprised at one aspect of trustee involvement in scheme funding where it was suggested that trustees should be concerned about where the money going into a pension scheme was coming from – for example whether it was from dividend reduction, or not reducing debt, or not reinvesting in the company. This is evidently an important consideration, but I am not entirely sure whether this should be a trustee consideration rather than one for the employer.

Then there was mention of the recently coined expression “reckless prudence”, which the authors describe as being when stakeholders take undue short-term investment risk to compensate for an inappropriate flight path. That is not my understanding of the meaning of reckless prudence, which I take to mean apparently being overly cautious rather, than taking undue risks, and which I think first came into being in the Equitable Life situation. The term was coined in the Inquiry regarding Equitable Life's stance of assuming that all their policyholders would take their maximum tax-free cash lump sums and thereby not fully exercise their guaranteed annuity rate options, which were such a weighty liability. This contrasted with the reality that, once policyholders realised how valuable the guaranteed annuity rate (GAR) options were, they did not take their tax-free cash and instead exercised their GARs to the hilt. It was this, I think, that was termed “reckless prudence” by the investigator.

Clarity is the keynote, as was mentioned quite often in the paper, in which regard the authors suggest that many scheme members, and often even trustees, do not fully understand the meaning of ‘funding level’. However, I am not surprised in the slightest at that, and think it is up to actuaries to explain more clearly how funding operates and to improve how they present their findings.

Finally on a lighter note, that hackneyed word ‘holistic’ came up on a number of occasions. Holistic means simply ‘the whole’, looking at everything, taking all factors into account, which I would have thought we as actuaries have always done and is not a new approach. To my mind, the word ‘holistic’ conjures up notions of alternative therapists, and shady IFAs, who tend to use the term to suggest that their service is somehow rather more clever than it really is. So, I would urge caution in its use to describe the application of actuarial techniques.

Mr S. J. Makin, F.F.A., C.E.R.A.: I have a question which relates less to specific content of the paper and more to the wider topic addressed by it. My question relates to Solvency II. One of the currently open issues in Solvency II is whether or not the risks from the pension scheme should be included in the internal model SCR calculation. I wondered what your views were on this.

Dr Hatchett: I think to the extent that an insurance company is obliged to pay cash into a pension scheme, then the pension scheme must be a risk to the business. The way that the risks in the pension scheme are measured in the SCR ought to reflect the fact that it is not directly an on-balance sheet risk, but that there is a trust structure and negotiations to be had and everything else in between.

I should qualify this by saying that I see this from a pensions perspective rather than an insurance perspective. At a high level that would be my initial thought on the question. To ignore the pension scheme entirely when there is a risk that the company is going to have to pay cash into the scheme does not seem like the right answer.

But, treating pensioners as policyholders, given the current legislative framework, also does not seem the right answer. To me some half-way house would seem like a sensible, pragmatic approach.

Mr M.C.T. Hurd F.I.A.: I guess that there is a more generic point, which is about the changing of the game that has occurred over the years. So we can look back to 2003, when a major change for companies which sponsored pension funds was introduced, namely, indexation.

What companies effectively did is come up with an agreement with their members that they would award benefits if they were affordable. We can argue whether they made that clear or not at the time. But that was clearly different from the contractual agreement that insurance companies agreed with policyholders. So it seems a little bit unfair to me now to apply retrospectively a different set of legislation over a promise that was granted some time ago under different circumstances.

Mr Hurry: Is your perspective that insurers think that they will be able to ignore the drain in capital from their own staff pension scheme?

Mr Makin: I think that the issue is open at the moment and this is what my question relates to. I do not think anyone is disputing that these risks should be allowed for in Solvency II Pillar 2, that is in the Own Risk and Solvency Assessment calculation. The question is whether they should be allowed for in the regulatory calculation for internal model companies, that is in the Solvency II Pillar 1 SCR calculation. In mid-December 2011, the Association of British Insurers issued something to its Solvency II Committee which took the view that pension scheme obligation risk should not be allowed for in the internal model SCR. My personal view, contrary to the ABI's position, is that it should.

Mrs I. M. Paterson, F.F.A.: I thought the paper was very clear, as other speakers have said. A key point you are making which I think is well made is that it is not all about numbers, it is about communication, or to be more precise, it is about communication of the risk. I think the new IAS 19 accounting requirements from the IASB brought in in June last year focused on that message as well. It changed the disclosure requirements. For example it brought in the requirement to disclose the most significant assumptions and provide a sensitivity analysis around that effectively to communicate risk.

I just wondered if you had a view whether that aligned with your paper, whether you would, if you were advising the IASB, suggest another approach? I realise that is a rather open question.

Mr Hurd: I think that the first point is a very good one. IAS 19 was moving more towards communication. I think that has to be a good thing. Whether or not I personally would agree with the specifics of it and the things that are disclosed, is a separate point because I think pension funds are more about a long-term objective rather than a short-term accounting measure. But the challenge there is that the accounting measure itself is not designed for long-term funding so we have this arbitrary AA discount rate which is there to reflect other things, which does not include the long-term nature of the scheme. So arguably when we are disclosing sensitivities, and things like that, we are already assessing against the wrong measure.

However, I guess it is useful for shareholders to be able to see that kind of thing. I agree wholeheartedly that the framework is heading in the right direction.

We are laughing slightly because Dr Clacher wrote an excellent paper on accounting for pension costs for the National Association of Pension Funds but he had such a tough audience in the press that he vowed never to talk to the actuarial profession about pension accounting again!

Dr I. Clacher (Leeds University Business School): I feel I need to clarify that. The point I made in the paper was accounting for pensions focuses on the wrong thing. The IASB have an agenda of fair value accounting in general. This results in a lot of the short-term fluctuations that I personally think do not reflect a long-term accounting position, because the IASB take a balance sheet view. So you measure your assets and liabilities and everything flows through as a rounding error. They see this as the correct way of accounting for pensions as part of that overall ethos of fair value accounting. I do not. I think it is profit and loss and the income statement that should be the focus, so I am much more of a view that it is about revenue and expense.

The IASB did not really like it [the accounting for pensions report] because it goes against their fair value agenda. We purposely ignored it so we could all write this paper together.

Mr M. A. Potter, F.I.A.: I have a short point to make. It is really to pick on a point that Mr Martin, or one of the previous speakers, has already made, that our funding regime has only been with us since 2005, and it is quite correct to say that trustees’ and employers’ views have changed significantly – both their own views on what they are up to, and how they view defined benefit pension schemes at present compared to 2005.

The paper talks about agreeing flight paths. It strikes me there also needs to be perhaps a bit more of a discussion about striking flight paths but then monitoring them as well. We all know that flight paths can change, especially if you have ever tried to go into London City airport on a foggy day.

I just wondered whether that could get a little bit more attention, and also the challenge in agreeing mutual objectives. I suppose there is nothing worse than having a pilot and co-pilot disagreeing on where you are trying to get to. That possibly is not something that can always be agreed on in pension schemes, although perhaps you would hope so with an aeroplane.

Mr J. Hastings, F.F.A.: I come from an investment background but currently spend most effort in strategic work for pension schemes. I find that reconstituting the output of an actuarial valuation and presenting it in a slightly different fashion helps in explaining to trustees what is happening to their schemes.

I try and break the analysis into three components – the liabilities, the assets, and the contributions. Then I try and work out, as a triangle, how these three components are moving and, in particular, how the variability of the different elements interact. For valuing the liabilities, I just try to find the closest thing to risk-free, whether that is long gilts, long index-linked or any similar measure.

If you build the image in this way, the cash contributions, particularly in a closed scheme, may be largely deficit repair contributions that you can value on a fixed basis. What you tend to find with the assets and liabilities is that they operate like arms of a scissor which generally create most of the volatility, tending these days with risk-off/risk-on trades to be either moving apart or moving together at the same time.

By conducting some analysis of variance of these elements periodically with the trustees, we can show them how these three components are combining. You can work out the deficit that the scheme has to repair as the value of the assets less the value of the liabilities after adding back the value of the deficit contributions.

Instead of saying that the scheme is, say, 78% funded, it is easier to focus on the unrepaired deficit and the variability of that deficit. You can attribute that variation among the component parts.

I will quickly comment on financial economics. Pension funds, and defined benefit pension schemes in particular, are a metaphor for what is happening in Western economies. Over the course of the 1980s and the 1990s, we over-promised benefits on the basis that somehow the good times would last for ever making the cost affordable. One of the challenges that we face at the moment in pension funds and economies is accommodating those promises. We are finding in places like Greece and most of Europe, in the United States and probably in the U.K., the extent to which we have over-promised ourselves. It is going to be difficult and dangerous to repair that. That is a bigger problem than just pension funds.

The impact that repair is going to have on Western governments can be seen in what it is doing to bond yields and what it might do to asset values. This is going to catch final salary pension schemes in the mix. They are one of the casualties of a much deeper problem.

I think most of us here are probably being challenged these days as yields go much lower than we would have believed possible. This is way beyond our experience or even our wilder imaginings as to what could happen. What might now happen to equity PEs, for example? They could easily keep collapsing even if the companies are growing satisfactorily.

I think we have yet more challenges to face in the future, and one of the things financial economics tells us is that we should expect the unexpected in that area. We need to think about what the ramifications of pretty pessimistic outcomes could mean for pension schemes.

Mr B. J. Duffin, F.F.A.: My comments are not of a technical nature. Earlier comments mentioned the range of perspectives that are set out in the paper. One that occurred to me that should be included is the perspective of the regulator. The influence being exercised by the regulator is likely to increase. At the moment in my experience it is a little difficult to pin down exactly what the regulator finds acceptable or unacceptable. What is the range, for example, for a technical provisions basis or a recovery plan which is acceptable?

That is going to develop over time, and it all comes from the difficult position in which the regulator is placed. They have responsibilities both to try to protect the interests of scheme members but also to try to protect the position of the PPF. Even though there is some conflict in this situation, this is going to drive them towards a final position which will not be unfamiliar to those of us from a life office background.

As somebody mentioned earlier, the regulation of with-profits funds and the valuation procedures, and so on, which are now required, has driven us towards a position which is looking very like Solvency II in its present form. Although pension fund regulation is not yet at that position, that to me is quite a likely outcome at the end of the day, that there will be a common reporting standard for pension funds which will look very similar to Solvency II.

That will impose a lot of difficulties along the way and require a lot of adjustment. For example, the way in which recovery plans are currently discussed will have to change. There will be an enormous rumpus, particularly in the current economic environment, if we try to impose a 10 year position for schemes to move back to being fully funded on a Solvency II basis. Indeed, there may be a wider acceptance that being only 50% funded on a Solvency II basis is not the end of the world. It helps to put the assurance of delivery of benefits in a better context, both for members and for investors in the sponsoring company itself.

This future raises a further problem in my mind. We saw this in the life assurance world, particularly in the 2001–2002–2003 period, when investment decisions were being driven by the valuation procedures that were being required. Falling equity markets generated weaker fund valuations, which could only be managed by selling equities and therefore pushing the markets lower again.

If we see the same thing happening in the pension fund world, it will make for less stability in the financial markets. It introduces further problems, even though the changes will be introduced for the best of all possible reasons and the best of all intentions. If we get to the position that weakening markets drive both life companies and pension funds to disinvest from riskier assets, then this surely cannot be a helpful step towards having a sounder financial future for all of us.

Mr W. D. B. Anderson, F.I.A.: As I have been listening to the discussion tonight, one of the questions that I have been asking myself is if this had become the commonly-used language that we used at the beginning of my actuarial career in the late 1980s/early 1990s, would I have acted any differently then?

One of the acid tests which is relevant here is looking at the yields on index-linked gilts, which at that time were about $$$3\tfrac{1}{2}\% $$$ to 4%. Of course, today they are under $$$\tfrac{1}{2}\% $$$ , I think.

In the late 1980s/early 1990s, we were still in love with the equity market. There was a lot of herd mentality then. I should like to think that decision-making would have been different. It is only if you get a difference in decision-making that these ideas are of value.

I think, perhaps, people would have looked closer at the fact that they were fully funded on the price of index-linked gilts as they prevailed at that point, and maybe have been less inclined to put all their money in the equity basket.

I think there are a lot of good ideas here, particularly to do with cash, the use of cash flows, and getting that into your mentality rather than discounted values, thinking about the wider world in the context of not just the asset side of the balance sheet but also in terms of the employer covenant bit, encouraging a much wider thinking about risk in the context of both the pension fund and the employer covenant.

Mr C. Taylor, F.I.A. (closing the discussion): There were strong opening opinions tonight from Dr Hatchett, talking about taking advance credit for outperformance as being at best confusing, at least misleading: fairly strong words there. Poor decision making and reckless prudence was picked up by Mr Sloan.

Then Mr Hurry opened the discussion with some other interesting debates and points about mean reversion and BAS assumptions to confuse matters yet further. Scheme-specific funding, does the covenant of an employer really set the long-term funding target? Is that misleading as well? All were good debating points.

Then Mr Ross opened up with his new-found trustee muscle commending the paper with a comment on the barrier of short-term contributions and executive short-term pay structures. Individuals who have been here for 10–15 years have experienced that. Mr Martin backed the paper with some comments about liquidity, and he supposedly has a friend who keeps refinancing his 25-year mortgage.

Professor Clarkson came up and I thought he was bound to give me the opposite end of the spectrum, but he commended sections 2 and 3. It was not until section 4 or 5 that we started to get the debate criticising financial economics and the definition of risk. I think that is quite important in terms of understanding where both parties come from.

Mr Sloan spoke next and was followed by Mrs Paterson. There were unreconciled viewpoints of IAS 19: the debate goes on in that respect. I am keen to move away from confusion to clarity in this area. There was a lot of jargon about flight plans, journey plans, best estimates, etc. I think that the important thing is to bring both sets of individuals from those that do not like the financial economics or stripping it back.

Mr Hastings had a point about the gilts, risk-free – albeit clarity on what you mean by risk-free. But there was the investment actuary's perspective. He wants to know where the starting point is, where the measurement actually sits and then take value-judgements against that.

For example, if the actuary has made an adjustment for inflation, a premium, how does an investment actuary make a decision whether information is cheap or expensive, given he has one hand tied behind his back?

We had Mr Potter as well with the pilot and co-pilot thinking the same things. That is quite important.

I am very keen that we set objectives for our clients and the clients understand those objectives and that we measure the liabilities and assets properly and fully understand them. I use slightly different terminology, but it comes back to the same thing. Then we set a strategy, whether it be a contribution, investment, mean reversion of interest rates, reliance on the company covenant in between. The strategy to get from where you are just now to that long-term objective is very important, and understanding the scale back aspect of it just now.

Then the risk management plan of how you get from where you are to that long-term target. If you do not understand where you are just now, down to the bare bones, then it is very difficult to make those value decisions. I do not think that it changes anything about the points which have been made, for example, Professor Clarkson's point about negative yield yields being really low. Yes, they are really low. It is an investment decision whether you bet that investment returns will increase and when that might happen.

There was Mr Anderson's point about the historic context. That is very important. We have debated that many times in this forum about actuaries understanding economics and not just the last five or 10 years but the last 50, 100 and 150 years.

I thought that it was very helpful. My ask is that we continue to debate this and try to distil it down so the co-pilot and the pilot agree on more things and have better-informed decisions.

Mr Hurd (replying): Thank you very much, everyone, for feeding back your comments this evening. There have been many really good points and, with hindsight, a few things that we would have incorporated into the paper.

What I will try to do is to respond generically on the points raised.

One of the really good points that was drawn out a couple of times was the relationship between senior executives and the company and the importance they put on short term pressures, such as short-term contributions, against maybe long-term objectives in the company.

There is definitely a conflict. What we, as a profession, have to do is to help them manage that conflict to a certain extent. What I would say is the evidence so far of companies setting long-term objectives is that they do not necessarily conflict with their short-term objectives.

So you can have a long-term objective of reaching buy out but that does not necessarily mean you have to pay in greater short-term cash contributions. So there is not necessarily an inconsistency. What it may do is highlight any short-term actions that are inconsistent with the long-term objective.

If you realise that you are having to push out a time frame beyond a reasonable period, what it will do is highlight the short-term inconsistencies rather than give way to them.

One of the other points raised was around cash flows. I think cash flows are a really important part of setting the flight path and understanding what is happening.

I would say, though, that what we are focusing on here is decision making. So to the extent that cash flows aid decision-making, whether it is designing a matching portfolio or something like that, then, yes, it is to be encouraged. To the extent that they are not affecting the contribution or investment decision, then arguably they should not be relevant to the decision-making process. That might be slightly controversial. Somebody will probably try and pick me up on it later. For example, the idea that a scheme becomes cash flow negative and therefore there is a change in investment strategy because of liquidity reasons, clearly is not true in a scheme that has a 40–50 year time horizon. The extent to which it is relevant may be because assets need to be sold at a later date, and, yes, it ought to be a part of, but not the main driver of, the decision-making process.

There were a couple of comments about extending the schedule of contributions to include return from non-guaranteed returns, for example investment returns. I agree wholeheartedly that the disclosure ought to be there. Whether you would put it in the schedule of contributions I guess is a regulatory issue. Certainly – and this was half the purpose behind the paper – it would be helpful if trustees understood the sources of those returns to meet shortfalls and it ought to be disclosed.

Now, onto the big one, financial economics. It is interesting. Part of the paper was about bringing together the conflicting views of the financial economists and those – shall we just call them “other market analysts” which is the term referred to consistently in the paper?

What we have done is not back either side. It is interesting that a lot of the comments suggested that we had favoured financial economics. That was not the purpose of the paper at all. What we were saying is if your long-term target is to be, for the sake of argument, 100% gilt invested, critically, if that is your long-term target, then the price of that gilt portfolio today is relevant. Coming back to the more specific point that if the markets, for example interest rates, are too low, should you still be valuing them? Yes, because that is still your price today. To a certain extent it is irrelevant in that you do not need to make the transaction today. But explicitly allowing for future improvements and quantifying the risk of doing that has to be critical. So, what we are saying is measure it on today's interest rates, then highlight where you believe interest rates are going to be, to determine what the future price will be at the time you are about to do the transaction, and build that into your flight path.

So, yes, we may have the view that interest rates are currently artificially low; we may have the view that they are going to improve. Let us build that into the flight path.

We go one step further in the paper and actually say in fact not to do so is misleading because it is just as sensible to allow for future improvements in things like gilt yields as it is to allow for future equity returns in your recovery plan. That is where we came to the concept of reckless prudence, although it sounds like somebody else has already used it so we may have to change the name of it. The point there is to say that if you are expecting a source of return, in other words, that interest rates will improve, then you are better off allowing for it rather than taking undue short-term investment risk to try to make up that deficit in another way.

That is what we were trying to get across. Clearly, we need to go back and do some re-drafting to make that a little bit clearer.

There were a number of comments around single estimates. What we would say on that is this: there was something around sensitivities and the benefit of sensitivities to aid decision-making. The key thing here is to help stakeholders make decisions. If stochastic modelling and asset liability modelling does not help them make decisions, then we have to find a better way of doing it, whether that is sensitivity analysis or single estimates, or whatever it might be. Now we do have the computer power to do asset liability modelling and stochastic modelling, so it makes sense to use that. But ultimately, as a profession, I think it is important we choose the tools appropriate to our stakeholders to help them make better decisions.

There was a comment about holistic, meaning bunkum, rubbish, if you read the wrong line of the dictionary. Thankfully, we did not read the wrong line of the dictionary. We read “holistic” meaning trying to incorporate as much as possible. There was a good point there though. You can actually overcomplicate the issue. Going back to making more effective decisions again, in fact a lot of what our job is about is creating the choice architecture, i.e. putting forward all the relevant information to make the decision. Sometimes, as a profession, we can get carried away by knowing too much when a lot of what we do is not just giving more analysis but sometimes it is giving less, by focusing on the key decisions. Hence why the flight path framework we put forward focused on a few variables: the target; contributions; investment strategy; and time frame. To a certain extent the omissions which were mentioned, which were all very valid, and I will not go through them one by one, a lot of what we were doing was trying to seek clarity and creating that decision-making framework for the stakeholders.

Just one more specific point: the importance of monitoring. I think that was a really good point. We probably should have included something in the paper on monitoring. One of the key things is that once we have established the flight path, and once we have all our stakeholders pointing in one direction, of course things are not going to go according to expectation and that is part of the risk of uncertainty and the communication thereof on which we were trying to focus.

So, I think there is something about how we revisit flight paths, maintaining the same framework, remembering what we have agreed, revisiting those targets, and the circularity to make them consistent through time as well.

The Chairman: Thank you for that. It remains for me to express my own thanks, and, I am sure, the thanks of us all, to the authors, the opener, the closer and the various people who have contributed to this evening's discussion.