Why do I have a pension asset? Laura Fallon lfallon@arlingclose.com

In the ten glorious years that I have been completing balance sheet analysis for clients what has stood out this year is that a number of authorities have a pension asset on their balance sheet rather than a pension liability. Other than suddenly having to stop and think about which line to put this in, what does this pension asset mean in practice and why has this started to occur now?

Local authorities have defined benefit schemes for their staff. This means that you pay a proportion of your salary into the scheme every year and on retirement you will get a set benefit as defined by the contractual arrangements of your pension: usually this is a percentage of your annual salary for each year you worked at the organisation, linked to inflation. Some staff may be members of a final salary scheme (where a proportion of your final salary is paid on retirement) or more common now is an average salary scheme (where a percentage of your average salary whilst working for the organisation is paid on retirement). This is in contrast to most private sector employees whose pensions are defined contribution: employees and employers pay a proportion of salary into a scheme every year and then receive whatever this is worth when they retire.

Defined benefit contribution schemes have liabilities: when you retire the scheme will have to keep paying you an amount of money until you die. How much they will end up having to pay you depends on your life expectancy, your salary whilst you were working, how high inflation is, and what the exact arrangements of the scheme are. These schemes also have assets: every year employees pay into the scheme as does the authority as the employer, this money is used to buy investments which will generate income and can also be sold at a later date. If the liabilities of the scheme are greater than the assets, the authority will have a pensions liability (also referred to as a pension deficit). If the assets of the scheme are greater than the liabilities, the authority will have a pensions asset (or pension surplus).

The assets and liabilities of the scheme depend on what will happen in the future: they thus cannot be know for certain and must be estimated. Life expectancy, inflation, future salary changes, and the future return and value of investment assets all have to be guessed at. Assumptions also need to be made for very long periods: you may be starting work when you are 18 and still claiming your pension when you are 90. Historically defined benefit schemes are habitually under water because life expectancy has increased dramatically over the last 100 years in a way that was not estimated accurately.

What has happened this year that has made the picture look more rosy? Fortunately this is not because life expectancy has suddenly plummeted. The Covid-19 pandemic aside life expectancy in Britain continues to rise, all be it at a much more stalled pace than it has in the past. There has also not been any sudden change to expectations of local authority salaries in the long term (strikes aside) or inflation (which is not expected to remain at the currently high levels for the next 50 years). What has changed this year is that there has been an about turn in interest rates and expectations about the future level of income return on the investments that the fund holds. Until recently Bank Rate was languishing well below 1% and many investors anticipated a ‘lower for ever’ outlook where returns would remain low for an extended period. This has all changed now: Bank Rate is 5.25% and although interest rates are expected to reduce from current levels a ‘new normal’ of between 3% and 5% is now the mainstay of opinion. This means that pension schemes will get more income and their outlook is better.  

Interestingly (for those that find actuarial calculations interesting), the way that this is specifically accounted for in the overall asset or liability calculation is that the discount rate used to discount the liabilities has increased as it is linked to interest rates. This means that the liabilities appear smaller (even though actually they are broadly the same) making the financial health of the scheme overall look better. Better investment returns cannot be reflected directly by increasing the value of assets held in the scheme because these are required to be held at their fair value which will be their market price at 31st March 2023. This will have generally decreased on previous years, as bond prices have reduced and equity and property markets are currently struggling. However, for many schemes the increased discount rate effect on the liability is greater than the effect of investment market price falling: hence the move to an asset position overall for some authorities.

Pensions assets, or lower pension deficits, are clearly a good thing for local authorities’ financial health overall. If pension investment assets are getting better returns then employer contributions can potentially be made lower saving the authority money (employee contributions could also be made lower, saving employees money!). However, worms can and do turn, and the long-term assumptions used in these schemes may well change again in future years. The population continues to age and funding defined benefit pensions schemes is likely to still be a challenge given this.

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