What it means
A valuation has two sides. The liability side projects every future benefit payment using demographic and economic assumptions and discounts them back to a present value; the asset side simply takes the market value of the investments held.
Everything else in the exercise flows from comparing those two figures. Comparing the two produces the funded status.
A funded ratio above 100% means the scheme currently holds more than the present value of its promises, while a ratio below 100% signals a deficit that has to be made good over time. The valuation also sets the cost of the coming year.
The normal or service cost is the value of benefits employees earn in the year ahead, and any deficit is amortised over an agreed recovery period, with the two added together to give the employer contribution. Different valuations of the same scheme can produce very different answers, and this is not a contradiction.
An accounting valuation uses a discount rate based on high quality corporate bond yields, a funding valuation may use expected portfolio returns, and a solvency or wind-up valuation asks what an insurer would charge to take the liabilities away entirely. The practical nuance is timing.
Because a valuation is a snapshot at one date, a scheme can look healthy in March and stressed in September, so trustees increasingly monitor an approximate funded position monthly between formal valuations. A valuation is also a negotiation rather than a pure calculation.
Trustees generally favour prudent assumptions and a short recovery period, while the sponsoring employer wants to protect cash for the business, and the agreed answer usually sits somewhere between those positions. The actuary's role is to set out the range of defensible choices, not to hand down a single correct number.
In practice
Real-world examples
Example 1
A manufacturer receives its triennial valuation showing a funded ratio of 87.5%. The trustees and the company agree a ten year recovery plan adding $600,000 a year to the $1,800,000 service cost, and the board builds $2,400,000 into its cash forecast.
Example 2
A local authority scheme runs a valuation ahead of merging two employers' sections. The exercise establishes the assets and obligations attributable to each side so the merger terms can be negotiated on comparable figures.
Example 3
A company preparing to sell a division commissions a wind-up valuation of the related pension liabilities. The insurer buyout price comes in far above the accounting deficit, and the purchase price is renegotiated to reflect it.
Think of it
Imagine planning a massive family reunion that will happen in twenty years. You have to estimate how many relatives will show up, how much food they will eat, and how much your savings account will grow in the meantime to buy all the groceries on the big day.
Formula
Calculation
Funded Status = Plan Assets - Present Value of Obligations, Funded Ratio = Plan Assets / Present Value of Obligations, and Annual Contribution = Service Cost + Deficit Amortisation. A scheme's actuary values the present value of promised benefits at $48,000,000 and the plan assets at market value at $42,000,000. Funded status = $42,000,000 - $48,000,000 = -$6,000,000, a deficit of $6,000,000. Funded ratio = $42,000,000 / $48,000,000 = 87.5%. The trustees agree a 10 year recovery plan, so deficit amortisation = $6,000,000 / 10 = $600,000 a year. Service cost for benefits earned in the coming year is $1,800,000, so the employer contribution = $1,800,000 + $600,000 = $2,400,000.Case study
Seen in the real world
The following is an illustrative and fictional case. Loxbridge Tooling, an invented engineering group, was reassured by an accounting disclosure showing a pension deficit of $6,000,000 against obligations of $48,000,000, a funded ratio of 87.5%. Management treated the scheme as a manageable long-term item.
When the fictional group agreed to sell its largest division, the buyer insisted on a solvency valuation. Measured on the basis of what an insurer would charge to take the liabilities on, the obligations were valued at $62,000,000 rather than $48,000,000, turning the deficit from $6,000,000 into $20,000,000 and stalling the deal for six months.
The illustrative lesson is that a scheme has more than one true value, and the relevant one depends on the question being asked. Loxbridge began reporting both the accounting and estimated solvency positions to its board so that no future transaction would be blindsided.
Watch out
Common mistakes
- Assuming the accounting deficit is the amount needed to settle the scheme, when a buyout with an insurer typically costs considerably more.
- Reading a funded ratio as a permanent measure rather than a snapshot that moves with market values and discount rates.
- Budgeting only for service cost and forgetting the separate deficit recovery contributions agreed with the trustees.
Questions
People also ask
How often is an actuarial valuation performed?
Formal valuations are usually every one to three years depending on jurisdiction, with lighter interim updates in between.
What is the difference between funded status and funded ratio?
Funded status is the dollar surplus or deficit, while funded ratio expresses assets as a percentage of obligations.
Why do two valuations of the same scheme differ?
Because they use different discount rates and assumptions chosen for different purposes: accounting disclosure, cash funding or settlement with an insurer.