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).

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.

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:

• 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:


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

Let's compare driving your car with managing a Pension Fund. Are you ready?

You, the Car Driver Suppose you plan a trip from New York to Washington, about 200 miles, in a tight time schedule of four hours . You're know your car's average fuel consumption is on average about 25 miles per gallon and your dashboard computer tells you, you've got 10 gallons left in the tank. Simple mental arithmetic shows you'll finish in Washington without any major 'out of gas'  problem if you keep your average fuel consumption above a rough 20 miles per gallon. You tell your partner, who's next to you in the car, you're quite sure (97.5%) there's enough gas left for Washington. Suddenly - your half way climbing a small hill - your Miles Per Gallons (MPG) Meter drops from 25 to 13. A bit worried you take a look at the Average MPG Trip Meter on your dash board computer that shows an average of 35 miles per gallon on the first 100 miles. You conclude there's no problem or real gas shortage issue to be expected and decide to keep checking your dashboard every 5 minutes to find out how the Average MPG develops. Your partner, who's not familiar with driving a car or arithmetic exercises, tells you to stop at a gas station immediately and to end this silly arithmetic game. You - quietly - explain that there's no need to go to a gas station and if you would go to a gas station, the two of you will be late on your appointment in Washington. You tell her that you'll take no direct measures and have decided to look for a gas station if your average GPM meter shows a 25 gallons per mile. Your partner is satisfied and you continue your trip. Problem solved.

You, Pension Fund CEO Suppose you run a 30 year old Pension Fund and your target is to keep a save coverage ratio of 125% on the long run. The outcome of intense and professional Risk Modeling, ALM studies, VaR analyses, FIRM approach and other sound risk techniques, has concluded in an agreed asset mix, implicating that daily coverage ratio's may vary (97.5% CI) between  65% and 185%, corresponding with an average long term coverage ratio of 125%. Suddenly, exactly at the Pension Funds 30th  birthday, interest rates collapse.... Your Dashboard's Daily 'Pension Fund  Coverage Ratio' (PFCR) meter shows a surprising meltdown to 65%! All pension board members look worried. They take a look at the '5 years Average Pension Fund Coverage Rate Meter' at their Dashboard. This meter  shows a trustful 132%. You and your board conclude there is no urgent or substantial problem of  shortage on the long run. Problem solved!, one would think. Unfortunately: No!. At this point the Supervisor starts interfering. The Supervisor is worried and orders the Pension Board to develop a recovery plan outlining measures on how the pension fund will restore minimum funding requirements within a five-year time frame. This Recovery Plan (RP) was not included or part of the original  strategic risk management plan as foreseen. The extra costs of executing this RP and the effects of reallocating the assets to a lower risk position, result in a lower return of the pension fund on the long run with a lower coverage ratio than the original 125% objective average. The pension fund was forced to improve the short term (daily)  coverage ratio a little bit at the cost of substantially lowering the coverage ratio on the long run. Congratulations!

Conclusions...
It's clear that ...

• Pension Funds shouldn't be managed just on daily coverage ratio's, but more on 5 or 10  years average coverage ratios.
  
  
• Demanding recovery plans after a disappointing 'two year coverage ratio' is not wise and damages the long term objectives and financial results of the pension fund.
   
• In case of  long term (more than 5 years) failing coverage ratios, there's enough time to take measures to redefine the Pension Fund's strategy and funding policy. The same applies for interest rates, returns and other Dash Board parameters, excluding liquidity scores.
   
• Much more than banks, Pension Funds are financial institutions with mainly long term obligations and should therefore mainly be managed, controlled and supervised by "long term" score card parameters.

Therefore, Supervisors should change their Risk Management philosophy as well as their control policy on this subject. Supervisors should redefine dash board parameters and only demand recovery plans in case of more than five year consequently failing coverage ratio's.

Related Links
- GN26: Pension Fund Terminology (pdf)
- Coverage ratio Dutch pension funds.png
- ABP assets up, but funding ratio down
- Fuel Convert
- New York Senate passes gallons per mile bill
- GPM psychology

- Volvo Penta (Meter)

The essence of a DB pension fund's risk strategy can be captured in a single graph:


Key issue is that the portfolio duration of a DB-plan's Liabilities varies between 12 and 14 years, whereas the duration of the DB plan’s Assets is generally much shorter, 4.5 to 5 years (Moore 2007).

Secondly, 2008, 2009 and 2010 have proven that investment statistics and models have failed. Sustainable models are nearby dead.

All this implies that, despite all (developed) models, risk strategies, derivatives and experts, ultimately, a Pension Board has to take a decision without a reasonable amount of certainty. In other words they have to gamble.... And to brighten up your day, it's your responsibility as an actuary to advice this pension board!

Read more about this fundamental pension challenge in:


Links:
-Public Pension Funds Gamble With Risky Investments
-The Prudent Man Standard

What is a 'good' return on investment?

Dutch Pension Fund ABP, the industry-wide pension fund for employers and employees ( 2.8 million participants) in government and educational institutions in the Netherlands and the world’s third largest pension fund, reported a 20.2% return on investment in 2009.

In the 2nd half 2009 Press Release, ABP qualifies it's own performance as a 'Good Rate of Return'.
Now theologists as well as actuaries are familiar with the risk of calling something 'Good' ....

ABP ROI Stress Test
Let's put the ABP investment strategy to the test.

In the same Press Release,  ABP publishes the long-term rate of return from 1993 to 2009. ABP's average annual rate of return over this period of 17 years is 6.7%.

ABP's 'Signs of Hope Strategy'
To achieve this phenomenal return, ABP has developed a spectacular - every three years changing - Investment Strategy Plan (latest plan is confidently called: 'Signs of Hope') with a strong diversified 'winning' (?)  investment mix in combination with zero transparency or accountability information with regard to 'investment costs'.

Alternative T-Bond Strategy
Alternatively, ABP would have been better of if it would have applied a no-risky defensive European (10 years) Treasury Bond Strategy from the start. In this case the yearly average 1993-2009 ROI would have been around 6.9%.

Take a look at the next chart and decide for yourself. What pension fund would you prefer, Red or Blue?


ABP stated in their objectives that, in order to keep pensions affordable in the future, the return on investments must attain an average of 7% per year. It's clear that this objective will never be met on basis of the developed investment strategies in the past.

ABP's Future perspective?
Let's 'hope' that, after the recent step down of Ed Nijpels, ABP's new to be appointed chairman will have enough power, (pension) experience and time available to resist and combat the opportunistic and risky plans of the headstrong APG investment specialists.
Anyhow, the new chairman should be at least someone who knows how to spell the word 'Risk Management' and is experienced in (ac)counting from 1 to 10.... maybe an actuary?

Solution
Perhaps the best thing to do is to:

• turn the ABP scheme into a "pay as you go system",
  
• transfer the ABP administration to the efficient Dutch Social Insurance Bank,
  
• fire most of the ABP Asset Management Department (APG) (as they are confused about time and cannot tell the difference between Tomorrow and Today anyway) and finally,
  
• use the € 208 billion on assets to reduce most of the Dutch National Debt ( € 375 billion)

Good Luck ABP!

Links
- Top 10 largest pension funds in the world
- ABP Press release 2nd half 2009
- APG: Tomorrow is Today 
- Joshua Maggid: Excel ABP (.xls) 

Is Market Valuation (MV) the right tool for pension funds?

Mid 2009, the new appointed ABP chairman Nijpels and - previously - the ABP CFO ten Damme (picture on the right), stated that the relatively new method of MV is inadequate for pension funds.

Both think that valuation of pension funds could be better based on a (seven year) moving average interest rate.
Nijpels en Ten Damme are supported in their view by Albert Röell, Chairman of KAS BANK, who advises the Dutch regulator DNB to reassess its policy.

Nevertheless DNB doesn't seem to respond.
Neither Roëll nor the world's third-biggest pension fund gets an answer. Is ABP crying over spilt milk?

Why MV?
At first sight, there seems nothing wrong in calculating the value of a pension fund, on MV basis. Market (consistent) valuation implies that the value of an asset or liability is defined by it's market price. If the market is too thin, a mark-to-model approach can be used....

Clearly MV increased the transparency and accountability of pension funds. However, 2008/2009 show that MV, based on the actual term structure of interest rates, leads to excessive volatility in funding ratios.

Is MV the best method?
Of course MV can be a best practice method in helping to define the pension fund value in case of a merger, a takeover or with regard to managing assets. But is MV also the best method for managing the pension fund as a whole, from a board, regulator or 'pension fund member' perspective?

• Future certainty
  The first fundamental question is :
  
  
  can we define the value of long-term
  ( 60 years or more) cash flows at all?
  
  
  The answer is: No, we can't!. Just take a look at an average CFO, who's proud to present his next quarterly company result with 60% certainty. What would be the certainty of the long-term company result of - let's say - 20 years ahead. Exactly: Almost zero.
  
  It's impossible for anyone, no Nostradamus Actuary included, to predict the compound and correlated long term effects of interest rate, stock market, derivates, inflation, salary increases, mortality, disability, longevity and costs. Therefore, if it's not possible....., don't pretent you can.
  
  
• Pension fund: Not for Sale
  Second important subject for consideration is that a pension fund (in general) is not listed on the stock market. Also, in general, it is not for sale on the market. Therefore, the hourly, daily or monthly calculated MV is only of limited interest with regard to the pension fund's strategy, policy or control.
  
  Neither is MV the right base for monthly adjusting of the contribution rates, funding rates or indexation capacity.

Principles
Simply stated, it's important that a pension fund:

1. can meet its obligations "on the long-term"
2. is sufficiently liquid to pay his annuities "on the short-term"

Moving average
The first statement implies that if you take the funding ratio as steering/testing parameter (there are more!), there is - given the mentioned long term uncertainty - no other option than to base the valuation on a more (term dependent) 'moving average' of interest rates in combination with the moving average value development of other asset classes. The choice of the moving average period is critical.

Dead Money
Even more, if the pension fund is forced to act on basis of MV, it has to keep extra (non-volatile) buffers to withstand the possible effects of non-relevant short-term market fluctuations. On top of this many pension funds tried to downplay their indexation ambition.

The consequence of all this is that MV generates a substantial amount of structural "dead" capital into the balance sheet. "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.

Paradoxical measures
In case - due to market developments - the MV goes down , short-term prudential constraints (as enforced or stimulated by the regulator) will moreover endanger the long-term objectives of pension funds. Consequently leading pension funds from the frying-pan into the fire.

There's another interesting aspect that pleads against MV. In general (Dutch) pension funds cannot go bankrupt, as they are allowed to cut back on the participants’ entitlements in extreme (emergency) situations. So the key question is what kind of minimum security level we enforce upon ourselves. Just an example to illustrate this:

Example
What would you prefer:

1. 100% of the yearly pension that you have been promised, on basis of a 125% funding ratio
2. 125% of the yearly pension that you have been originally promised, at a 100% funding ratio target

Remember there is no ultimate warranty whatsoever in either situation.

The only difference is that in scenario A the chance that your entitlements will be cut down is slightly smaller than in scenario B. But this last situation is as hypothetic as it can be, as contributions will be raised first, before any cut down scenarios will be considered.

So its better to use the funding ratio surplus for legalized controlled indexation and pension benefits improvement than as 'dead' money.

A final argument in the war against MV for pension funds is the next illustration .....

ParaDox
Let's take a look at a company called ParaDox.... ParaDox produces parasols (sunshades) for the high season.

In winter, ParaDox produces at full speed in order to achieve a top level inventory at the start of the summer.

In winter, however, hardly any parasols are sold. During this cold season the price of the parasols on the market (in the shops) drops to about 50% of the summer price. Even more, parasols sales go 80% down in winter (cf. long-term investment market).

If ParaDox would apply MV based techniques, it would have to depreciate their current stock to 50% of the (summer)value. Surely ParaDox would go bankrupt. No, every sensible human being, including actuaries, would decide that in this situation it's best to value the stock of ParaDox on basis of the 'moving average' (realized) sales price over one or more recent years.
N.B. Even if ParaDox would have one or two 'bad summers', deprecation would not be considered.

If in this ParaDox case it's clear that market valuation (i.c. deprecation) is unwise, the more it must be clear that in a company with long-term obligations and high uncertainties , like a pension fund is, it's naive to operate and steer on basis of MV.

Moving Average Period
Now that's illustrated that the Moving Average Method (MAM) is preferable above the MV method (MVM) for pension funds, there's still one thing to decide: the 'MAM period'.

If the MAM period is chosen too short, it will suffer the same disadvantages as the MVM.

If it's chosen too long, there's the risk of not being able to adapt fast enough to realistic contribution levels, if needed. In this situation there's also the risk of unintentional intergenerational financial effects. However, these effects can be yearly calculated and translated into a sound policy.

From this perspective it seems reasonable to fix the MAM periode to the average duration of nominal pension liabilities, which is (in The Netherlands) about fifteen years (in real terms, it is even longer).

Hope
Let's trust that DNB listens to ABP and KAS BANK, so that 'pension funds' and 'pension fun' become one again!

Related links:
- P&I/Watson Wyatt World 300 Largest Pension Funds
- Market-consistent valuation of pension liabilities (must read!)

In a very simplified model (Pensions Dynamics, PPT), professor of investment strategy, Alan White, concludes that defined benefit pension plans probably cannot succeed on the long term.

Death Spiral
White shows that every pension fund with a non risk-free asset approach, will eventually encounter a “Death Spiral” which will lead to the collapse of the fund. The only solutions are:

• Raising contribution rates
• Lowering promised pension benefits.

Assumptions
All conclusions are based on the next summarized main assumptions:

• Compensation growth: 2% per year
• Pension contribution: 15% of yearly compensation
• Yearly retirement income objective: 70% of his final salary
• Risk-free rate of interest is 3%;Risk premium on the risky assets: 3%
• Annual volatility of the risky assets: 15%
• Time horizon: 100-year
• Risky Assets investment part : 60% of the portfolio
• Corresponding final pay pension defined as 20 year annuity
• Required minimum average Pension Fund asset value in steady state
  - at 3% return: €/$ 47,200
  - at 6% return: €/$ 23,600

Frequency Distribution Outcome
One of the most striking outcomes of this study is the fact that as we look farther in to the future of the simulated pension fund, the amplitude of the frequency distribution of asset values appears to be dropping to zero. The chance that (average) asset values will be between $10,000 and $100,000 gets smaller and smaller.

The reason for this is that the probability of very high asset values and the probability of entering a collapsed state (the collapsed funds are not shown in the next figure) both increase as we expand out time horizon. As a result the probability that assets remain in the intermediate interval, is reduced.

Another interesting facts are:

• Asset values appear to become more sustainable as the part 'risky assets' increases
• Collapse rates for growing pension funds are, (almost) independently of the asset mix, negligible.
• Collapse rates for more mature (steady state) pension funds are substantial and increase to deadly percentages as the time horizon increases from 50 to 100 years.

Remarks
Although Whites model is perhaps oversimplified and can be easily criticized, it clearly shows the essential principles of running a pension fund.

In a commentary, Rob Bauer (ABP, University of Maastricht) argues White's conclusions. Nevertheless, interesting stuff, that stimulates actuarial insight.

Links
Interesting corresponding links:

• Longer Horizons Can Handle Riskier Holdings
• Stochastic Interest rate models (2008)
• The calculus of retirement income

As experienced actuaries you'll probably know that 'De Nederlandsche Bank' (DNB) is the Dutch supervisor on banks, pension funds, insurers and mutual funds.

Recently DNB reported about the effects of the credit crisis.

You may find the report in the recently published:



Main articles in this interesting bulletin discuss the following topics:

• Capital market financing more difficult and more expensive in 2008
• Dutch banks scaled down foreign activities
• Dutch pension funds fail in realizing indexation ambitions in 2009

The bulletin also includes a description of the fully revised statistics of investment funds.

Indexation
The Dutch save massively for their pensions. To supplement their future state old age pension, nearly 6 million employees save for a pension at a pension fund. At end-2007, over 2.5 million persons received a pension benefit.

These savings have accumulated into a collective nest egg of around EUR 575 billion, i.e. nearly EUR 80,000 per Dutch household (end-2008).

For many households, pension savings are by far their largest financial asset. As a result of the credit crisis, pension funds saw their financial position deteriorate. In 2008, the pension funds’ average nominal funding ratio dropped from 144% to 95%

According to a survey among the largest 25 pension funds, the pension sector, too, is being impacted by the credit crisis.

Following catch-up indexation last year, pension benefits will probably be indexed on average at a mere 0.2% this year. This means a loss of purchasing power for pensioners, even though the price level has fallen since the summer of 2008. Many pension entitlements accrued by employees, too, are not being indexed.

In 2009, pension contributions will rise, especially those of employers with an independent company pension fund. Employees, too, will be paying higher contributions.

Interested? More info at DNB

SOURCE