Defined Benefit  

FRC warns of errors in DB scheme audits

FRC warns of errors in DB scheme audits

In almost half of the defined benefit (DB) pension audits inspected by the Financial Reporting Council (FRC) improvement was needed in at least one aspect of the work, a report has shown.

The accounting watchdog published a report entitled The audit of defined benefit pension obligations yesterday (26 July), which focused on the quality of the audits of pension balances and related disclosures in 51 of its audit inspections.

In half of the audits reviewed by the FRC, the valuation of the DB obligation was identified as being at 'significant risk of material misstatement'.

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Valuing liabilities allows the scheme to calculate how much money it should have set aside today to be able pay benefits in the future.

According to the Pensions Policy Institute, it is a complex calculation involving many assumptions about future economic prospects, inflation, interest rates, investment returns and the longevity and other demographic experience of the scheme members and their beneficiaries.

There is no single correct answer on how to calculate these, and the potential impact of getting them wrong is that the pension fund won’t have enough money to pay out pensions in the future.

The FRC report stated that in many of the cases analysed, the key assumptions applied in the valuation were where the risk of 'material misstatement' was most likely to arise.

The regulator gave as an example a case study of a final salary scheme with a net liability of £100bn at the year-end.

The pension note showed an increase in the mortality rate assumptions by one year would increase the obligation by £83m. Materiality was £8m.

But the mortality rate assumptions had been adjusted to account for the actual experience of the scheme when compared to standard mortality tables, increasing the level of judgment involved in setting the assumption.

The audit team did not say why they didn’t consider the mortality rate assumptions to be a significant risk.

The FRC stated "key assumptions used in calculating the pension obligations are subjective and involve significant judgement.

"Audit teams should therefore assess the risk for the more sensitive assumptions appropriately and plan and perform appropriate procedures in order to conclude on the valuation of the DB obligation."

The watchdog also stressed multiple pension arrangements or financial and risk management transactions, such as liability-driven investment strategies, partial buy-outs and longevity swaps, had made valuation judgements and their audit complex.

According to Melanie Hind, executive director, audit and actuarial regulation at the FRC, "auditors need to understand the work of actuaries inputting to their work and pay attention to assets as well as liabilities."

She added: "We hope to raise standards by highlighting good practice and areas for continuous improvement."

John Ralfe, an independent pension consultant, argued "the examples of bad practice the FRC gives are all small beer".

He said: "I'm afraid this has all the hallmarks of the FRC looking for things to do."