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The ‘issue’, if one can call it that, of increasing life expectancy is now highly significant when it comes to financial statements for companies with final salary pension schemes.

When one looks at what changes have been made and how it could affect specific schemes, however, one quickly hits a brick wall of jargon that only the most ardent FD or CFO will be able to decipher.

It is imperative there is a greater understanding and clarity around mortality assumptions used in pension disclosures, and so here is a guide to the jargon minefield.

Longevity vs mortality

These two terms are often used interchangeably but they are really opposites of each other. Longevity measures how long you might live whereas mortality assesses when you are likely to die.

If you have a 1 per cent chance of dying in the next year then you have a 99 per cent chance of surviving that year.

Pensions are paid by pension schemes to their retirees and the life expectancy of pensioners is a major determinant in the cost of pensions. 

This is true even for members who are years away from retirement because the offsetting effect of them dying before they reach retirement is really quite small.

Life expectancy for pensioners is calculated from the probabilities of them surviving in future years.

Base mortality

To set a mortality assumption for a pension scheme you first need to analyse the mortality experience of its pensioners. 

For the very largest schemes your actuary can construct a table of observed death rates, at different ages, for pensioners.

For smaller schemes the analysis is restricted to a broad comparison of the experience against mortality rates in published "standard" tables. 

From here the best fitting table needs to be selected.  Mortality tables selected in this way only provide a base because of the need to adjust for improvement factors and, in some case, for rating factors too.

Rating factors

Where a pension scheme is too small to have enough meaningful mortality data with which to construct mortality rates (or to adjust standard tables to ‘fit’ the data), your actuary may be able to do little more than select as a base an up-to-date standard published table of death rates.

Such published standard tables are typically constructed from large populations, e.g. national statistics or using data pooled by insurance companies.

Up to now there have been no standard tables for occupational pension schemes although a major study by the UK actuarial profession is nearing completion.

Even with this, however, it will be necessary to adjust the standard tables to reflect the specific circumstances of an individual pension scheme.

Relevant circumstances are factors such as industry sector, earnings levels, geographical region and such.

Most of these are proxies for the socio-economic make-up of the members which is believed to be the major factor in health and longevity.

Postcodes or amounts of pension are commonly used as the basis for rating factors for socio-economic class.

These rating factors are then used, building on further analysis, to adjust the base mortality tables.

For example, a scheme might use 110 per cent of the base mortality rates where death rates are observed (or judged) to be higher. 

Improvement factors

Evidence continues to show that people are living longer.

Therefore base tables selected with reference to the mortality experience of current pensioners are unlikely to accurately reflect the mortality of current workers when they retire.

Accordingly, mortality tables attempt in a number of ways to build in allowances for greater longevity in the future.

Improvement factors may be based on observed past improvements, but remain subjective.

Challenging mortality assumptions

Armed with this guide, what should finance directors do to challenge the mortality assumptions that you see in pensions disclosures? 

Here are some questions you might ask:

• When was a mortality study last carried out?
• What other evidence or judgement has been used instead?
• What base table has been used and why?
• What rating factors have been used and why?
• What improvement factors have been used and why?

There is a wealth of mortality information available to actuaries to advise on the setting of mortality assumptions.

Because of the financial significance of these assumptions, there should be plenty of debate about how mortality assumptions are selected and this should be fully disclosed in company accounts.

There is not a one-size-fits-all solution and we expect more not less differentiation in future.

This, however, needs to be backed up by scheme-specific analysis combined with sound judgement. 

As FD it falls on your shoulders to challenge your actuary and ensure that appropriate allowance is being made for longevity in your financial statements.

Martin Potter is a partner at consultants and actuaries Hymans Robertson.

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Related links

• Hymans Robertson