What it means
Assumptions fall into two broad families. Economic assumptions cover things like the discount rate, inflation, salary growth and investment returns; demographic assumptions cover mortality, staff turnover, retirement age, disability rates and how many members will take a lump sum instead of an income.
The discount rate usually does the heaviest lifting. It converts future payments into a present value, and because it is compounded over many years, a one percentage point difference can change a pension obligation by 15% to 25% for a typical scheme.
Assumptions are meant to be a best estimate, not a wish. Accounting standards generally require them to be unbiased and mutually consistent, so you cannot pair an optimistic investment return with a pessimistic inflation figure just because the combination flatters the numbers.
Assumptions are reviewed at each valuation, and the difference between what was assumed and what actually happened becomes an actuarial gain or loss. This feedback loop is why long-running schemes gradually converge on assumptions that reflect their own membership rather than generic averages.
The nuance worth remembering is that assumptions differ by purpose. The discount rate used for accounting disclosure is typically tied to high quality corporate bond yields, while the rate used to set cash funding may be based on the expected return of the actual investment portfolio, so two perfectly correct numbers for the same scheme can look very different.
Assumptions are a governance matter as much as a technical one. Because the same scheme can be presented as comfortably funded or badly stretched depending on the inputs chosen, boards are expected to know who set each assumption and on what evidence.
Auditors and regulators pay particular attention to any change that conveniently improves a reported position.
In practice
Real-world examples
Example 1
A company's actuary updates the mortality assumption to reflect longer life expectancy. The pension obligation rises by 3% and the finance director has to explain a worse funded position that has nothing to do with investment performance.
Example 2
A benefits manager modelling a redundancy programme adjusts the staff turnover assumption upward. Fewer members are now projected to reach full pension entitlement, which lowers the projected obligation and changes the cost of the restructure.
Example 3
An insurer pricing annuities revises its long-term interest rate assumption downward after a sustained fall in bond yields. Annuity rates offered to new customers drop, because each dollar of income now costs more to fund. The change is documented in the pricing basis so the board can see exactly which input moved.
Think of it
Imagine planning a major road trip across the country. You have to guess your average driving speed, how many fuel stops you will need, and what petrol prices will be along the way. Actuarial assumptions are simply the travel calculations businesses make for journeys that take decades.
Formula
Calculation
Present Value = Future Payment / (1 + discount rate) to the power of the number of years. A scheme expects to pay $1,000,000 to a group of members in 20 years. Using a 5% discount rate assumption, 1.05 to the power of 20 = 2.6533, so the present value = $1,000,000 / 2.6533 = $376,900 rounded. Now change only the discount rate assumption to 4%. 1.04 to the power of 20 = 2.1911, so the present value = $1,000,000 / 2.1911 = $456,400 rounded. Lowering the assumed discount rate by one percentage point raises the reported liability by about $79,500, roughly 21% more, without a single thing changing in the real world.Case study
Seen in the real world
This is a fictional, illustrative example. Delmore Ceramics, an invented manufacturer, reported a pension deficit of $2,400,000 one year and $6,800,000 the next, with no change in contributions and a positive investment year in between. The chief executive assumed something had gone badly wrong in the fund.
The explanation was a single assumption. Corporate bond yields had fallen, so the actuary reduced the discount rate from 5% to 4%, and because the scheme's payments averaged around 20 years out, the present value of the obligation jumped by roughly a fifth.
The illustrative lesson for Delmore's board was to ask for the deficit to be reported in two parts at every valuation: the change caused by actual experience, and the change caused purely by revised assumptions. Once split, the board could see that the underlying scheme was stable and stopped over-reacting to accounting movements.
Watch out
Common mistakes
- Treating a reported liability as a hard fact rather than a figure that depends entirely on the assumptions chosen.
- Mixing an optimistic assumption with a conservative one so the combined result looks acceptable, which breaks the requirement for internally consistent assumptions.
- Assuming the discount rate used for accounting disclosure is the same one used to set cash contributions, when the two often differ by design.
Questions
People also ask
Which assumption matters most?
For most pension schemes it is the discount rate, because it compounds over decades and moves the liability more than any other single input.
Who chooses the assumptions?
Management sets them for accounting purposes with actuarial advice, and trustees or regulators may set separate assumptions for funding purposes.
How often are assumptions reviewed?
They are reviewed at least at each formal valuation, and economic assumptions such as the discount rate are typically refreshed at every reporting date.