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Who determines the assumptions for pension plans?

How pension plans are valued impacts a plan sponsor’s cash contributions to the plan and the amount of pension expense reported in its financial statements.

Where costs are shared between members and employers, the valuation of a defined benefit (or target benefit) pension plan also impacts member contributions or benefits. So who determines the assumptions that are so critical in establishing the value of a pension plan?

There are three common valuation bases for pension plans. For the purpose of this article, we will concentrate on the going-concern basis.

In the past, assumption setting was almost exclusively the domain of the actuary. The actuary decided on the range of acceptable assumptions and often selected which assumptions to use for a given pension plan. These assumptions almost always included some conservatism, or what we now refer to as a margin for adverse deviations. Usually, the actuary discussed the range of acceptable assumptions with the plan sponsor since the plan sponsor would ultimately be required to make the resulting contributions. However, it was not a requirement for the actuary to seek formal instructions on which assumptions to use or which margins to reflect.

This process changed on December 31, 2010, when the Canadian Institute of Actuaries made changes to its Pension-Specific Standards of Practice. These changes included a requirement that plans be valued using best-estimate assumptions (with limited, but important, exceptions). In other words, the financial position of the plan and the plan sponsor’s minimum-required contributions need to be determined using assumptions that do not include any provision for adverse events. The use of best-estimate assumptions results in the plan achieving its assumed return on assets (i.e. discount rate) over the long term 50% of the time.

The exceptions to this change are that margins for adverse deviation can be included to the extent required by law or by the terms of an engagement. Therefore, the Standards do not permit an actuary to include any conservatism in their assumptions unless they have specific direction to do so from either the law or the entity that provides the actuary with their terms of engagement. But the question is: which entity is able to provide these terms of engagement?

The Canadian Association of Pension Supervisory Authorities (CAPSA) has partially addressed this question in its Pension Plan Funding Policy Guideline (Guideline No. 7, dated November 15, 2011). While they do not specifically address who can formally provide an actuary’s terms of engagement, they are very clear on the plan sponsor’s role in providing guidance on margins for adverse deviation:

“The plan sponsor can provide useful guidance to the plan actuary in selecting actuarial methods and assumptions that are appropriate for the plan sponsor’s risk management approach. This guidance can include the going concern actuarial cost method, desired margins or provision for adverse deviations and acceptable asset valuation methods and ranges. The plan administrator would provide information on data, investments, historical experience, etc. to assist the actuary in developing these assumptions. This combined input would normally be reflected in the actuary’s selection of methods and assumptions – in particular, the margins for adverse deviations – provided they do not lead to assumptions that deviate from accepted actuarial practice.” (emphasis added)

This Guideline could therefore be construed to indicate that margins for adverse deviation were within the purview of the plan sponsor. Consequently, it was quite surprising when the Régie des rentes du Québec released its Newsletter Express, in May 2012, in which they took the position that it is the plan administrator’s role to provide instructions on the margins for adverse deviation. In Quebec, the plan administrator is a pension committee as opposed to the plan sponsor (although the plan sponsor will usually have some representation on the committee) so this position is significant. The pension committee’s duties do not include an obligation to consider the plan sponsor’s tolerance for a level of pension contributions. It can therefore instruct the actuary to a large margin for adverse deviation in its assumptions, thereby potentially leading to contributions that are greater than the plan sponsor would have otherwise paid.

So, back to our original question: who determines the assumptions for pension plans? The answer is the actuary, but not only the actuary. The other players in the game will depend on the jurisdiction governing funding of the plan and the entity that provides the actuary with its terms of engagement with respect to margins.

Valuation Bases

 There are primarily three valuation bases for pension plans:

Accounting Basis

  • Requirement under accounting standards
  • Impacts an organization’s financial statements
  • Discount rate is established based on a prescribed methodology
  • Best-estimate assumptions are selected by management

Solvency Basis

  • Requirement of pension benefits legislation
  • Impacts cash contributions if the plan is in deficit on this basis (with some exceptions)
  • Assumes that the plan was wound up on the valuation date, with permissible adjustments allowed under legislation of different jurisdictions
  • Assumptions reflect market conditions as the valuation date

Going-Concern Basis

  • Requirement of pension legislation
  • Impacts the cash contributions in respect of normal cost (future service accruals)
  • Impacts cash contributions towards past service if  the plan is in deficit on this basis
  • The Plan is assumed to continue indefinitely; consequently, the assumptions generally reflect a long time horizon