There are two approaches, labelled “MtM” and “Off”, respectively corresponding to “mark to market” and “off market” (formerly called smoothing).
MtM Assumption The initial interest rate is the yield on either longterm conventional gilts (nominal payments) or the yield on long indexlinked gilts (indexed payments). While simplistic, it is not only simple but also not that far away from what broadly tends to be assumed.
Off Assumption For whichever assets portfolio is being used, the expected return is estimated as a multiple of the initial yield. Using random numbers and past experience, the multiples have been arbitrarily set at either 1.13 or 1.25 for conventional gilts and either 2.81 or 3.00 for equities. Such a simple multiple approach just doesn’t work for ILGs and I have chosen “yield + expected longterm inflation + 1%” (taken from ukrpi.com).
Although these are based upon past actual experience means, we don’t need to use scalars.
