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Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
September 2004
Subject 424 SA Fellowship Pensions
Paper One
MARKING SCHEDULE
Faculty of Actuaries
4/3/04 Institute of Actuaries
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
1 (i) Investment risk passes from the company to the members. []
The DB fund could come to have a poor funding position, eg due to
mismatching and fall in market value of investments, []
concerns about financial impact of Surplus Act on DB schemes (minimumbenefits, minimum pension increases, surplus apportionment). [1]
giving rise to an increase in, and uncertain, funding requirements, []
and possibly requiring large lump sum inputs in the short term, []
Demographic risks eliminated under DC. []
Some DB expenses would not necessarily be incurred under DC, e.g. cost of
actuarial advisers, but such savings might be offset by increased expenses in
other areas. []
Implementing AC116 (or foreign accounting requirements) gives rise to
volatile impact on company accounts for DB schemes. []
Which in case of offshore parents can be aggravated by extreme movements in
exchange rate. []
Consistent with the actions of competitor firms. []
DC fund perceived to be fairer for early leavers. []
And possibly easier to explain to potential members. []
Eliminates potentially generous and expensive options built into DB rules, e.g.
for early retirements []
DC fund perceived to eliminate so-called cross subsidies. []
Concerns about the possible impact of future legislative requirements on DB
schemes. []
Easier to tie in with the provision of cafeteria (or cost to company) style
of benefit provision overall. []
[8 out of 5]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
(ii) Advantages:
Strong likelihood of improvement in value of benefits for very early leavers,
[]
especially those at very young ages, []
because minimum benefits require inclusion of 100% of company
contributions used for savings element under DC for early leavers, []
but improvement could be contingent on actual investment returns not being
very low or negative. []
Members gain benefit of good investment performance, []
if smoothed approach not adopted. []
Possibility of individual member choice in investment medium. []
Option to decide how much investment risk to take. []
Possibility of living annuities and creation of an estate. []
Possibility of other annuity that fits members circumstances better than
provisions of DB fund. []
Disadvantages:
Loss of DB guarantees. []
Loss of needs based benefit provision, especially on death in service and on
ill-health retirement, []
which often replaced with very inappropriate risk benefit provision. []
Strong likelihood of lower benefit package overall, []
particularly for those who stay in service to retirement. []
Which can actually make change to DC very expensive in medium term
because of need to give guarantees (as consequence of reduction in package).
[]
Likely poorer benefit in case of early retirement (often loss of generous
provisions that give rise to early retirement subsidies). []
Likely less generous provisions in case of ill-health retirement (especially
where ill-health pension was based on potential service). []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Any associated separate disability scheme benefits subject to conditions of
acceptance of insurer (which usually far more onerous). []
Generally a surviving in service spouse or children must make own
arrangements in respect of lump sum death benefit, []
and lump sum often inadequate, especially at younger ages. []
So-called cross subsidies not necessarily eliminated, []
especially on cost of risk benefits, []
and allocation of expenses (usually debited to members on per cent salary
basis). []
Members commonly bear risks of escalating risk benefit costs, []
particularly as consequence of AIDS or deteriorating experience of insurer for
reasons not associated with Fund but other schemes. []
Problem is that under DC there is no self-insurance in SA as general rule and
funds pay price set by insurers. []
Members bear cost (through lower benefits) of use in most cases of insurance
products (expenses, commissions, margins and profit loadings). []
Members bear cost in medium and smaller funds of no credibility attributed
by insurers to good in service mortality experiences. []
Members bear risks of poor investment performance, []
and might additionally bear consequences of a smoothed returns policy. []
Members bear risks of the terms on which the fund account is converted into
pension at retirement, [
including longevity risks in case of living annuities, []
or including use of guaranteed, or no, escalations in normal annuities. []
Members most often bear full investment and administration costs. []
Generally no possibility of discretionary increases in course of payment []
[18 out of 5]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
2 (i) Segregated fund advantages:
Full control over choice of mix of assets between various sectors. []
And choice of individual assets within each sector. []
Full benefit of good investment performance. []
Costs of managing own pool of assets is cost effective for large schemes. []
Generally good liquidity, excluding any part in property. []
Can arrange asset/liability modelling and matching exercises on pensioner
assets and liabilities. []
Possibility of investing in index-linked bonds. []
Segregated fund disadvantages:
Costs of managing own pool of assets may not be cost effective for small
schemes. []
No investment guarantees. [
Possibly more onerous risk controls and governance structures. []
Insurance company pooled managed fund advantages:
Direct exposure to investment markets without the necessity to invest in
individual stocks. []
Gain benefits of diversification, again without holding actual stocks. []
Generally, with certain provisos, reasonable liquidity conditions exist or can
be negotiated.
Explicit scale of investment expenses. []
Insurance company pooled managed fund disadvantages:
No investment guarantees. []
Income reinvested, so not available for cashflow without disinvestment of
assets. []
Investment expenses may be higher than for a segregated fund, especially for alarge fund. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Can be liquidity conditions on disinvestment, []
especially in regard to any part of managed fund invested in property. []
At present time no suitable fixed interest funds available in SA for matchingpensioner profile. []
Guaranteed Fund advantages:
Generally smoother investment returns. []
Provision of certain investment guarantees. []
Possible arbitrage opportunity. []
Guaranteed Fund disadvantages:
Will not gain immediate benefit of good investment performance. []
In falling markets, some adjustment to any unvested account balance is
possible. []
Any capital guarantees must obviously come at a cost, []
which it should be assumed can be substantial, especially if full guarantee. []
Possible loss of any unvested account balance on surrender or transfer to
alternative investment medium. []
When ongoing cashflow insufficient, benefit payments sometimes made from
vested account only, thereby causing increase in proportion of assets in
unvested account. []
Over time the unvested component (or the equivalent in a fund with full
guarantees) will in any event increase from zero initially to as much as 30% ormore of total assets, adding to liquidity disadvantage. []
Often a delay in implementing a transfer to alternative investment medium,
especially if markets have fallen. []
Possible penalty if a transfer of members to another pension fund or if
alternative investment medium. []
Can be onerous conditions regarding time-period over which payments spread
on disinvestment. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Income / dividends from underlying assets reinvested, so not available for
cashflow. []
Charges implicit and may be disproportionately high, especially for a large
fund []
Lack oftransparency. []
Actions in respecttransparency (including effect of other funds in guaranteed
pool could adversely affect returns (that is, arbitrage aspect).pool). []
[19[18 out of 7]
(ii) Investment objectives of Fund and level of risk that is acceptable to trustees.
[]
Assets available (after any penalties) on surrender or transfer. []
Factors affecting future returns. []
Enhancements available if assets switched to managed fund with same insurer.
[]
Compare discounted value of assets, allowing for expected future returns, with
the surrender value offered. []
Guarantees available under guaranteed fund contract []
[3 out of 3]
3 (i) The provisions of the rules in regard to individual transfer values. []
Reason for the emergence of shortfall benefit improvements, experience
losses or change of basis. []
Steps being taken to address the shortfall. []
Level of transfer activity. []
Legislative as an ongoing fund, the fund is within the 12-month window
period before minimum benefits become obligatory. []
Rules, in particular any priority order for preferential liabilities. []
Acting in the interests of all members. []
Is fund likely to wind-up shortly? []
Members reasonable benefit expectations. []
[4out of 4]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
(ii) Minimum Benefit Valuation Balance Sheet
R 000s
Assets: 120 000
Liabilities:Pensioners: 60 611
Deferreds: 40 004(1.00515) = 37 120
Actives: 49 995(1.01520) = 37 120
Total 134 851 []
(a) Overall funding level
= 120 000 / 134 851 = 89% []
One possible reduction = (100 89)% = 11% []
(b) Treating Pensioners as a priority category and stripping them out.
Assets: 120 000 60 611 = 59 389 []
Liabs: DP: 37 120
Actives: 37 120
Total 74 240 []
Funding Level = 59 389 / 74 240 = 80% []
Another possible reduction = (100 80)% = 20% []Other assumptions: Expenses of paying/calculating transfer values are
ignored (or included within the financial assumptions) []
Final salary is the annual rate on the date of the valuation with salary
reviews once a year on 1 January. []
Average term to NRD is not distorted when weighted by the relevant
liability. []
[3 out of 3]
(iii) Stating reduction percentage []
Suggest when 100% transfer values likely to be restored. []
Detail steps being taken to rectify situation e.g. increased contributions. []
Why reduction necessary e.g. protection of non-transferring members rights.
[]
[2 out of 2]
[9 out of 9]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
4 (i) Trustees investment objectives should represent best judgement to meetliabilities given likely pattern of future contributions, []
taking account of attitude to risk, including that of employer as sponsor. []
Strategic asset allocation should reflect contribution towards achieving fundsinvestment objectives. []
Consider full range of investment opportunities. []
Asset allocation should reflects funds own characteristics. []
Trustees should adopt a clear investment policy, giving a mandate to
investment managers on objectives, risk parameters and benchmarks. [1]
Statements from A, B and C, respectively, cover specific risks, but do not
cover all prospective beneficiaries or all issues. []
And expose the fund to the possibility of shedding its property investments at
prices that might be unattractive, []
without any consideration of the suitability of this action or the time
constraints of implementation. []
A: Return on index-linked bonds depends on the market value at particular
points in time,
which will be affected by supply and demand, []
and any changes in the real rate of return over time. []
Hence return does not necessarily match inflation unless held for full term. []
And hence may not match the funds liabilities related to price inflation. []
Especially after taking into account retirement funds tax in regard to liabilities
in respect of any deferred pensioners. []
And is unlikely to match salary inflation. []
Although it has grown, the market in index-linked bonds is very small, []
with consequent liquidity and trading issues, []
and potential matching issues, even for pensioner liabilities. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
B: Suitable for matching liabilities fixed in monetary terms, []
but not salary related liabilities, []
or liabilities related to pension increases consequent upon inflation. []
Possible return is subject to consideration of credit risk. []
This trustee appears to have been influenced by accounting requirements and
not the specific liability requirements of the fund. []
C: Investment in equities with main operations in SA is suitable over long
term for meeting liabilities related to salary. []
But not liabilities fixed in monetary terms current level of pensions. []
And not best hedge for pension increases related to price inflation. []
Investment in SA equities with earnings totally or mainly in US Dollars leads
to currency risk, []
and risk associated with precious metal prices, oil and commodity prices,
which can be quite volatile. []
Currency risk will remain if the Rand does not stabilise in value against
Dollar, []
and in any event it would be too speculative to base an investment policy on
premise of stability of exchange rate. []
However, some investment in SA equities with earnings mainly in US Dollars
has attractions given that exclusion of such companies severely limits
investment opportunities. [1]
Also such investment provides hedge in event of a Rand that depreciates
against the Dollar,. []
and hence against that element of inflation that is a consequence thereof. []
An overall equity allocation of 75% is at maximum level per Regulation 28 .
[]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Balance in selection of bonds with small residual in cash provides
diversification, []
and helps to ensure that fund meets requirements of Regulation 28, []
with potential for some matching of current level of pensions. [][20 out of 8]
(ii) The trustees should consider the following asset classes, subject to overall
investment objectives and risks. [1]
SA equities including equities with offshore earnings (but not exclusively
those with major part in offshore earnings); []
that is include equities with generalised foreign earnings as risk spread. []
To match salary related liabilities []
Reasonable range, 30%50%, say []
Overseas equities: []
As diversification. []
To match salary related liabilities, but with a currency risk. []
Reasonable range, 0% up to maximum allowed of 15%. []
SA property: []
As diversification. []
To match salary related liabilities. []
Reasonable range, 0% to 15%, say. []
Fixed interest: Reasonable range, 15% to 30%, possibly double if index-linked
bonds not obtainable in desired quantities or duration at fair price. []
To assist in matching fixed liabilities to extent required duration
obtainable, []
and to assist in matching benefits that increase according to a
price index.
and to provide diversification for liabilities of active members. []
Corporate bonds to sweeten yield, but suggest small exposure. []
as for RSA bonds, but with a credit risk. []
Index-linked bonds (to extent obtainable at fair price, bearing in mindminute market): []
Assist in matching benefits that increase according to a price index. []
Holding up to say 36% (ratio of pensioner to total liabilities). []
Cash, % as required []
To meet immediate liabilities []
e.g. admin costs, transfer values, withdrawal & other lump sums. []
[Total 13 out of 7]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
5 Specify the problem(s)
He has benefits currently of value R10.8m on a transfer basis; value may even be
higher on the statutory basis for valuing benefits. []
Even if no future accrual, these will increase in value as he approaches retirement
(DB) or with investment income (DC), and will exceed R12.0m. []
So he is likely to suffer some penal tax unless benefits can be banked []
..or there is a high level of indexation on the R12.0m. []
..or he can persuade his former scheme to settle the tax (unlikely?) []
So it is likely that he will receive less net income than he might otherwise have
expected [1]
Pension earned after the introduction of the limit will almost certainly all suffer
the penal tax []
...but he has an opportunity to try and negotiate a package with his new employer
that will leave him no worse off than if the limit didnt exist [1]
Decisions to be taken
Existing benefits
keep as DB or transfer to DC (assuming currently DB)? []
DC for simplicity of knowing where he stands relative to the limit []
DB for known gross benefits but uncertain tax charge/net benefits []
How should funds be invested if DC (select investments to match increases in
limit or still look to maximise returns, notwithstanding additional tax charge) [1]
Transfer to new employer or leave where they are? (if transfer, more likely that
new employer/scheme might cover the additional tax charge?) []
Future Accrual
Form and level of pension benefits from new employer
Retirement benefits []
Other related benefits traditionally provided in pension scheme (death
benefits, ill-health)
Possibility of maximising pension accrual before the date the limit is introduced if
funds over R12.0m can be banked [1]
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Information we need to find out.......
About the individual
Current circumstances
Whether he has dependants (spouse, partner, children) []
Other wealth (investments, property, share options etc.) []
Any other approved pension benefits? []
Current outgoings []
Future expectations
Likely changes in above []
Plans for retirement (when, desired standard of living) []
How long does he see himself in this job []
Knowing the above will help us understand
Constraints on flexibility to select benefit package [1]
or need to provide protection benefits separately (e.g. if extra salary is substituted
for instead of pension) []
Need for diversification of investments []
Preference between long-term savings and immediate income []
Desire for security of benefits []
Also need to know more about existing pension
Is he already subject to some form of limit on tax-approved pension provision?
[]
If so, did previous employer provide unapproved pension benefits or cash/other benefits as compensation (or nothing)? []
..i.e. what is his expectation of approved/unapproved pension provision
(irrespective of introduction of the limit)? []
Were benefits DB or DC? []
Payable from what age? []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Any favourable early retirement terms not allowed for in the transfer value (can
increase benefits in value from R10.8m to significantly more than R12.0m) and
might create unexpected penal tax charge?) [1]
What did his contract promise? []
About the New Employer
Assume that the new employer wants the package to be attractive to the individual
[]
... but at an acceptable level of costs []
May have very specific objectives about how they want to structure the rewards
for this individual however? []
Long lock-in, or fully expects him/her to move on in 3-5 years []
How much of the package should be performance related? []
Will want to consider
Available tax concessions []
(one less now, may shift balance, create opportunity for increasing the
performance related element of the package pensions typically arent) [1]
Costs (admin & management time) []
Stability, durability and realism of costs (in cash and accounting terms) []
Requirement to disclose senior employees benefits packages []
Benefits provided to other senior employees (if compensates this individual
for penal tax charge, what about existing staff in similar situations) []
What should the individual contribute to the cost of providing benefits
(particularly if pension scheme was contributory but taking future benefits in a
different form) []
What does any draft contract promise in respect of pensions (particularly if
prepared before the limit was announced)? []
Existing practice for members affected by any limit on tax-approved benefits? []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
About how the limit will operate
Any grandfathering? []
How will it increase? []
Annual limit on future accrual? []
Who settles the tax and how (if DB)? []
Factors for valuing DB pensions? []
Any other restrictions being introduced e.g. on earliest age at which retirement
benefits can be taken []
Need to consider risks to member of switching to non-pension provision []
Salary-linkage of benefits at retirement lost []
Longevity risk transferred to individual []
Investment risks transferred to individual []
Security may be reduced (if alternatives are deferred, unfunded or linked to health
of employer) []
...so, should individual seek more than monetary equivalent of value of pension to
compensate (employer may argue that pension wasnt fully secure either?) [1]
[34 from 24]
6 (i) General / Constraints
Assumptions are the responsibility of the enterprise in terms of AC116
(hence they are responsibility of the directors). []
While not stated it follows that the directors should be seen to be taking
actuarial advice. []
The assumptions are an enterprises best estimates of the variables that will
determine the ultimate cost of providing benefits. []
The assumptions must be unbiased (neither imprudent nor excessively
conservative). []
The assumptions must be mutually compatible (inflation, salary increases,
investment return and discount rates). []
Where appropriate only, there should be consistency from year to year. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Financial
(a) Financial assumptions should be based on market expectations, at the
balance sheet date, for the period over which obligations are to be
settled. []
Discount rate set with regard to the yield on high quality corporate bonds,
or if no deep market in such bonds, then government bonds. []
Currency & term of bonds to be consistent with that of the liabilities.
[]
There should be no allowance for credit risk. []
Or actuarial or investment risk. []
There is a very limited range of bonds that are suitable by term. []
For example, only the government bonds R150 & R153, bothrelatively short, have a large turnover. []
And the R186, while more suitable from point of view of term, has
always been priced at a premium to other bonds, hence lower yield.
[]
But we can also be guided by yield curve. []
Hence there could be some scope for justifying a higher discount rate,
[]
than is shown to be suitable by market conditions. []
(b) Expected return on assets is a component of expense recognised in
income statement (& ultimately profit and loss a/c) but not the balance
sheet. []
Therefore presumably less of a concern to the FD, hence of less
significance. []
Should be a reasonable, long term expected, return for the appropriate
class of asset. []
Reduced by administration costs (all fees including investment). []
And by allowance for Retirement Fund Tax payable by fund. []
Some flexibility in initially setting this assumption. []
But any year on year change would have to be properly motivated. []
(c) Inflation actuary & directors might be guided by a market derived
basis. (Nominal bond yields vs. Index-linked bond yields), []
but AC116 does not prescribe a methodology. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
It requires recognition in salary increases, and pensions to extent there
is a history of increasing benefits to mitigate effects of inflation, []
hence some flexibility if a change properly motivated, []
but must have regard to the pension increase policy of Trustees in
terms of Pension Funds Second Amendment Act, []
and the minimum pension increase in terms of that act. []
(d) Salary increases on account of merit, productivity and supply &
demand fund specific and hence some flexibility []
represents realistic long term estimate and so unlikely to change much
year on year. []
Unless company remuneration structure and/or pensionable pay
definition changes. []
Would be in line with funding valuation. []
Demographic (already stated that these must be best estimates)
Would be guided in first instance by funding valuation. []
Experience should be analysed (use funding valuation analysis). []
Possibly some margin in pensioner mortality basis given that prudence would
have required actuary to allow for improvement. []
But caution to be exercised in removing such margin. []
Might be some scope for tweaking other assumptions, []
particularly if last funding valuation some years ago and recent experience
indicates a less cautious approach. []
[20 out of 15]
(ii) (a) Salary experience
Expected actives liability 31/3/2004
Accrued + 1 year liability + interest
(10.0 + 2.5) 1.10 = 1.375
Actual = 1.355
Gain = 0.020m []
Since no new entrants and no exits from actives (no benefit outgo in
respect of actives and no commutations) then all the gain must be from
salary experience. []
Estimated actual rate of salary increase
(1.355/1.375 1.087) 1 = 7.12% []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
(b) Expected fund at year end and gain/loss:
Determine ratio of pensioners liability to actuarial value of assets
to find approx tax-free component = 12 / 24 = 50% tax-free
Therefore taxable component = 50% []
Retirement Funds Tax (RFT) as a return:
Expected interest as return = 0.4 10.0% = 4.00%
Expected tax as return 50% 18% 4.0% = 0.36% []
Expected return = 0.4 10.0% + 0.6 12.0% = 11.20% gross []
RFT = 0.36%
Administration costs = 1.00%
Expected rate of return = 9.84% []
NCF = net cashflow NCF = (3.5 0.8) = 2.70m []
Assuming cashflows in middle of year, we have: []
Expected fund = 29 (1.0984) + 2.70 (1.0984) = 34.683m
Actual fund = 24.000m
Loss = 10.683m []
Estimated actual net rate of return
(24 29 2.7) / (29 + 0.5 2.7) = 25.4% []
(c) Administration costs:
Expected costs = (0.01 29 + 0.005 2.7) = 0.304
Actual costs = 0.330
Loss = 0.026m []
(d) Retirement Funds Tax:
Taxable component as before = 50%
Expected taxable income
10.0% 0.4 (29 + 0.5 2.7) = 1.214 []
Expected tax 50% 18% 1.214 = 0.109
Actual tax = 0.090
Gain = 0.019m []
[7 out of 5]
(iii) (a) Total liabilities were estimated as = 33.6m at 10%
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Therefore at 12.0%:
33.6 (1.10/1.12)14 = 26.109m []
Balance sheet:
Market Value of Assets = R24.000mPV of liabilities = R26.109m
Shortfall = R 2.109m []
(b) Total liabilities were taken as = 33.600m
Deferreds + Pensioners = 20.050m
Actives = 13.550m
If we let the mean term of the active members = N
then: (13.55 N + 20.05 10) / 33.6 = 14 [1]
so that mean term of the active members N = 19.9 as 20 []
Then revised value of liabilities of actives:
13.55 (1.10/1.12)20 (1.0725/1.087)
20 = 7.224m []
And revised deferreds & pensioners:
20.05 (1.10/1.12)10 = 16.744m []
So revised total = 23.968m
New balance sheet
Market Value of Assets = R24.000mPV of liabilities = R23.968m
Surplus = R 0.032m []
[4 out of 3]
(iv) Discount rate now 1.5% above yield curve vs. yield curve in prior year. []
Not consistent. []
Very large jump. []
Above likely to give rise to queries, from auditors. []
Likely to be at top end of range of corporate bond yields, or even over. []
Also matching of fixed component of liabilities difficult, maybe impossible.[]
Salary increase has been set (approx.) equal to actual rate in previous year. []
But rate should be long term. []
It is now very close to inflation, which evidence would suggest is imprudent /
unrealistic over the long term not enough allowance for merit etc.. []
Again no margin at all or scope for reduction in future years. []
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Subject 424 (SA Fellowship Pensions) September 2004, Paper 1 Marking Schedule
Basis is actuarially unsound as regards both interest and salary increases. []
[5 out of 4]
[37 out of 27]
END OF MARKING SCHEDULE
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