Showing posts with label negative indexation. Show all posts
Showing posts with label negative indexation. Show all posts

Mar 14, 2009

Pension Recovery: Yearly Negative Indexation

Hold your breath...
Since 2008, according to Milliman, the average funding ratio of the top 100 US (largest) Pension Funds has fallen from 99,6% to 71,7%.

Dutch pension funds developments are comparable.

One way of the other, pension funds have to plan their way out of this financial crisis.

On january 29, 2009, on a NETSPAR meeting, Theo Nijman, Professor Investment Theory of the Tilburg University, gave a presentation called Optimal design of recovery plans.

Nijman's recovery model
Summarized, Nijman shows several recovery options:
  1. Do nothing:
    Hope that financial markets will recover and the interest rates will rise

  2. Use control instruments:
    • Indexation cuts, or no indexation of entitlements
    • Recovery contributions (sponsor, employee)
    • Return on mismatch (gamble)
    • Reduction, if no recovery plan can satisfy the criteria:
      Reduction of guarantees

Recovery by Maggid
Although all kind of (IRS) regulations are in place, basically there's no reason for panic....
Everything in life is based on trust. So are our (ALM and VAR) models.

This implies that the only way out, is to stick to our models and their corresponding strategies as much as possible, which means in principle: Do nothing.

However, what we do need to do, is to (re)define and maintain our indexation strategy as follows:

Yearly negative indexation
This strategy implicates that for pension funds with funding ratio's of 80% or less, we'll have to apply "yearly negative indexation".

One off reduction of entitlements is not necessary in this situation and would be 'clumsy', unless the funding ratio would be less than 60% (you have to draw the line somewhere).

In fact this 'negative indexation' is not really new, it's just that we haven't been in this kind of situation before and because we didn't think we would end up in this scenario, we didn't develop any policy. Let's do it now!
Yearly negative indexation is in fact no more than the logical natural opposite of (positive) indexation.

In good times there's positive indexation en in bad times negative indexation, it's a simple as that. Books closed.

Redefine risk strategy?
Last but not least: if we never ever want to end up in a (crisis)situation like this again, we should redefine our risk strategy and select an asset mix that fits to a lower risk/return level.

The question is, when it's the the right time to reallocate, will you actually do it?