What is a valuation and why is it needed?

11 Sep 2018 By

Independent pensions writer Sally Ling explains.

An actuarial valuation is an assessment of a pension scheme’s financial health. It is a legal requirement for all defined benefit (DB) pension schemes to carry out a valuation at least once every three years.

To understand why valuations are necessary, it helps to take a brief look at how DB pensions work. DB schemes pay a set retirement income to members based on their earnings and years of membership. This pension ‘promise’ stretches many decades into the future – payments continue no matter how long members live for and, when a member dies, their dependants may also be entitled to receive a pension.

DB schemes are managed by boards of trustees, who have a legal duty to make sure that members receive their pensions – now and in the future. The majority of UK DB schemes do this by collecting contributions from members and the employer, and investing them to build up a fund. A valuation is a regular check to make sure that the trustees’ funding plan remains on track.

What happens in a valuation?

A valuation is carried out for a specified date and is conducted on behalf of the trustees by the scheme actuary (a specialist in risk and probability). The first step is to calculate the monetary value of members’ pensions ‘earned’ up to the valuation date, and compare this to the value of the investments in the fund. There are three possible outcomes:

  • Cost of benefits equals value of investments – scheme is ‘fully funded’
  • Cost of benefits is less than value of investments – scheme is ‘in surplus’
  • Cost of benefits is more than value of investments – scheme is ‘in deficit’

If the scheme has a deficit, additional contributions will be needed to get the funding back on track.

The next step is to assess the cost of providing scheme benefits for future service to make sure that contributions are set at the right level.

To carry out a valuation, predictions – or ‘assumptions’ – are made about a range of future events, such as how long members will live, likely investment returns and salary and price inflation. The trustees need to understand how each assumption will affect the valuation outcome and must take account of the employer’s ability to continue to support the scheme financially if the assumptions prove to be too optimistic.

Valuations must be completed within 15 months. If a scheme has a deficit and the trustees can’t reach an agreement with the employer on increased contributions, it might be necessary to consider reducing, or even ceasing, benefits for future service, to make the scheme affordable. Members’ pensions built up before the valuation date are protected by law and won’t be affected by any changes.

Finally, trustees must submit their valuation report, including an agreed recovery plan if necessary, to the Pensions Regulator. The Regulator can get involved in the valuation process at any stage if it has any concerns and has a number of powers – such as enforcing payments – that it can invoke to make sure that schemes are adequately funded.

All views expressed are those of the author and not Universities UK.