Report of the dynamic discount rates working party: key considerations for pension scheme funding

Abstract This report explores key considerations in relation to adopting a dynamic discount rate funding approach and the impacts of doing so in a range of areas, including funding volatility, investment strategy and end game objectives. It considers the advantages and disadvantages of this approach from the perspective of a range of stakeholders and the challenges that need overcoming in order to fully implement and support the approach, for example data challenges and the new skills required in the industry. The report includes sample modelling to highlight the practical issues that arise when adopting this approach. It describes a step-by-step approach for assessing the risks to be considered when determining an appropriate level of assets to provide funding for a sample set of pension scheme cash flows, as summarised in the table below. Steps involved in determining the funding buffer and discount rate Step 1 Create an asset portfolio based on best estimate liability cash flows Step 2 Adjustment for investment costs Step 3 Buffer: allowance for asset-side risks Step 4 Buffer: allowance for asset-liability mismatch risk (reinvestment and disinvestment risk) Step 5 Buffer: allowance for liability-side risks Step 6 Buffer: consideration of risk diversification when determining the buffer It also considers how a dynamic discount rate approach fits within the proposed future funding regulations. Finally, the report puts forward recommendations for the IFoA, Scheme Actuaries and TPR. Consequences of schemes adopting a dynamic discount rate approach could include very different investment strategies with investment in a wider pool of assets, less use of leveraged Liability Driven Investment, fewer schemes targeting buy-out as their end game strategy and an increase in technical work for actuaries in advising on the optimisation of asset and liability cash flows.