Showing posts with label embedded option. Show all posts
Showing posts with label embedded option. Show all posts

Aug 9, 2010

Pension Fund Development

Pension Funds....What originally started with well-meant intentions, has developed to one of the most complex risk management topics and will end in a nightmare if we don't change our risk management approach drastically and fast.

Pension Fund times have changed
Back in the second half of the twentieth century, Pension Funds were an excellent (HR)-instrument to stabilize employer-employee relationship and keep retention high. Since then, a lot has changed:
  • Employees became more flexible and international orientated
  • Permanent or Lifetime employment is nowadays no longer key
  • Increased social en technical complexity,  supervision, governance, etc., urge for an increasing professional approach.
  • Original Pension Fund advantages (economies of scale:cost, funding, risk) are at stake, due to the enormous (rising) costs  (administration, supervision, management [risk, asset, hedging] , funding, etc).

But there's more...  Surreptitiously, like the famous 'boiling frog', the (member) composition of a pension fond has fundamentally changed during the last decades.

Some decades ago, at the start of a Pension Fund, almost all participants where existing employees of the corresponding company (sponsor).  Today, the number of 'current employees' is often overshadowed by the number of 'pensioners' and the - until now - quiet force of  'deferred pensioners' (former employees, that left the company before retirement).

Managing Pension Fund Powers
All Pension Fund concerned parties, the three member-groups as well as the employer (sponsor), have different and sometimes opposite interests with regard to the financial policy of the Pension Fund. The tension between these parties with regard to what's best for the employer, the employees, pensioners and deferred pensioners, will therefore increase as the Pension Fund becomes more mature.

The first step to manage this tension is to redefine Pension Fund Governance in line with the changed balance of power. Skipping this governance step seems not wise, as this will undoubtedly lead to future financial claims of the concerning power-discriminated parties.

The second step is just as important.

Even with the right balanced governance in place, it will be an almost impossible task to manage a Pension Fund if the often implicit 'embedded options' between the defined member groups (including the sponsor) are not proactively recognized, defined, explicated and - above all - financially and organizational managed (settled).

Regain Pension Fund Risk Control
To regain Pension Fund Risk Control, governance principles have be transparently defined and every possible - likely or unlikely - future situation (scenario), has to be identified, described, valued, controlled and managed.

In this approach, a strong segmented, segregated or 'split up' framework, helps to keep oversight at board level and urges to define all possible 'embedded options' as clear as possible and to clear out possible sticky, fuzzy or unspoken arrangements, deals or intentions.

Pension Fund's Objectives
Of course this comprehensive operation makes only sense if the Pension Fund's objectives are (upfront) well defined and if all members agree upon those objectives. Main objectives among others are:

General (financial) PF objectives
  • Target Pension Benefit Level and volatility
  • Target Contribution Level and volatility
  • Target PF Growth Rate and volatility
  • Target Risk level and volatility
  • Target Coverage Ratio and volatility
  • Target Indexation level and volatility
  • Target Assets Returns and volatility
  • Target Cost Rates and volatility
  • Target AL-Mismatch and volatility
  • Target Mortality Rates and volatility

In so called Financial Member-Contracts (FMCs) has to be defined exactly what the explicit financial consequences are for every Pension Fund Member, each time the actual performance of one of the objectives scores (negative or positive) out of the defined expected 'volatility range' for a certain predefined period.

On top of, these FMCs have to give a clear upfront financial answer to other general or Pension Fund specific developments. Some examples:
  • Consequences of a sponsor's default or down- or upgrade.
  • Consequences of  possible exit of substantial employers, corporate split up, outsourcing, etc.  (upfront exit conditions, restructure consequences, etc.)
  • New upfront entering conditions and principles in case of future take-overs or new employers joining the Pension Fund
  • Defining upfront catch-up indexation rules in case the target indexation levels are not met.
  • Consequences, principles, methods and guide lines that will be used in case of possible future changes in (pension) legislation, supervisory, governance or value) accounting.

Sponsor Default Risk
Last but not least, let's take a look at an interesting risk element.
One of the most risky and underestimated elements in the Pension Fund's Risk Management Framework is the 'default risk' and correspondent creditworthiness of the sponsor.

The sponsoring employer’s ability to support Pension Fund volatility by providing additional funding if required, is defined in the so called 'Employer Covenant' or 'Corporate Covenant'

Although, with regard to the obligations of the sponsor, legislation  from country to country differs strongly, the Corporate Covenant and more explicitly, the capacity of the sponsoring employer to cover (incidental) losses in the event of poor investment outcomes or the guarantee of incidental or temporary underfunding, is crucial and impacts the valuation of the Pension Fund strongly.

That this 'sponsor default risk' is not negligible, is well illustrated by the next table of Global Corporate Cumulative Average Default Rates by Standard & Poor.

Moreover the importance of the sponsor's default risk is in general essential if you take into account that the majority of companies is rated as BB an B, as is clear from the next 2003 and 2009 Corporate Ratings Distributions by S&P:

Valuing Corporate Covenant
If you're interested....In an excellent article called 'Corporate Covenant and Other Embedded Options in Pension Funds', Theo Kocken explains, how various contingent claims in a pension fund, such as the Corporate Covenant or Conditional Indexation, can be valued with the same techniques that are used to value options on stocks.

However, there's one slight problem.......

Vicious Value Circle
Future IASB proposals will  gradually move towards 'plain fair value' in case of Pension Funds. The new 2010 IASB draft versions make a first step by proposing - as AON calls it - a "third way" (between buffering and mark-to-market in combination with asset smoothing) .

As Pension Funds become more and more mature and the volatility of pension Funds is more and more reflected in the sponsoring employer's balance sheet and P&L, the question of valuing the Pension Fund becomes a kind of vicious circle.

On the one hand the value of the Pension Fund depends on the default risk and credibility of the sponsor. On the other hand the credibility and default risk of the sponsor depends strongly on the volatility of the Pension Fund.

This dependency implies that if either the sponsor or the Pension Fund gets into serious financial trouble, revaluing forces will pull the value of both institutions into a negative spiral towards a default situation, leaving the Corporate Covenant as a paper farce.

It's clear: Risk Management of Pension Funds is challenging and urges actuaries to keep eyes open.

Related links:
- Corporate Covenant and Other Embedded Options in Pension Funds
- Mercer: Assessing Employer Covenant (2009)
- S&P:Global Corporate Average Cumulative Default Rates (1981-2009)
- S&P:Global Short-Term Ratings and Default Analysis (1981-2009)
- AON: IASB Releases Exposure Draft on DB Accounting
- AAA:Pension Accounting and Financial Reporting by Employers