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Ponds and Quix Table 1: Assumptions relating to return, risk and correlation: Short term and long term ...
Integral risk management by pension funds in a fair value framework Table 2: Excess return and misma...
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Integral risk management by pension funds in a fair value framework RA-RL ...
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Integral Riskmanagement for pension funds in a fair value framework

An old paper (10 years ago) about financial riskmanagement for pension funds in a fair value-context. The paper claims that the best way forward is to aim for a clear pension deal: ex ante it is clear who will benefit from the surplus and who will pay in time of shortages. Hopefully we will get to this clear pension deal in the next 2-to-3 years. Getting to a new pension deal is a wicked problem that takes time!
Published on: Mar 4, 2016
Published in: Economy & Finance      
Source: www.slideshare.net


Transcripts - Integral Riskmanagement for pension funds in a fair value framework

  • 1. "1... ~c I nt eg ral risk management by pension funds in a fair value framework Received(in revised10nTl): 12th November,2002 Eduard H. M. Ponds works lor ABP Pension Fund in the Netherlands, in the Risk Policy Department. He is responsible lor assaI and liability management. He also teaches actuarial science at the University ol Amsterdam, Department ol Economics and Econometrics. He has a PhD in economics trom University ol Tilburg. His main areas ol interest are delined benelit schemes and intergenerational risksharing. Fons Quix also works lor ABP Pension Fund in the Netherlands, in the Risk Policy Department. He is responsible lor risk measurement and risk control on the level of the pension fund. Abstract Pension funds worldwide, for instance in the UK and the Netherlands, wil I increasingly adopt the fair value approach. The aim of this paper is to derive an integral risk management framework for pension funds, based on fair value principles. The point of reference is a typical defined benefit plan with indexed liabilities, where the main sources of risk are the long-term fluctuations in prices driving the value of the plans assets and the fluctuations in the discount and inflation rates that determine the value of the liabilities. Mismatch risk is identified as the central risk measure for integral risk management. The fair value approach contributes in clarifying the long-term advantages of a pension fund scheme; however, the approach also contributes in revealing its main weakness: a high exposure to mismatch risk and hence a large risk of underfunding in the short term. A typical pension fund usually fails to be explicit on the issue of risk bearing. Therefore, it is not clear which of the stakeholders has to meet up a funding shortage. Three options to handle short-term risk are discussed. First, creating a floor by investing substantially in index-linked bonds. Secondly, holding a high solvency margin to absorb a fall in asset prices. The third option, preferred by the authors, is to state the so-called pension deal so that it is clear which of the stakeholders is participating in the risk of underfunding as weil as overfunding, and to what extent. Such a deal will assist in preventing potential conflicts between the stakeholders about the allocation of benefits and casts. The pension fund management and its stakeholders wil I only obtain good insight into the benefits and casts if the pension fund contract is a transparent and complete contract. Fair value principles contribute to these goals of transparency and completeness. Keywords: pension funds; risk management; ALM; fair value; pension deal; mismatch risk EduardH. M. Ponds ABP, Box4874, PO . 6401 JP Heerlen, IntroductIon and summary radical break with the actuarial approach. The Netherlands. Pension funds worldwide currently are Traditionally, the actuarial approach is Tel: +31 455797574; switchin g or considerin g switching to fair based on baak value principles and rules Fax: +31 45 5797258; E-mail: e.ponds@abp.nl value principles. This switch imp lies a of thumb, such as a fIXed 4 per cent 222 Pensions Vol. 8, 3, 222-234 @ Henry Stewart Publications 1478-5315 (2003)
  • 2. Integral risk management by pension funds in a fair value frameworkactuarial discount rate. Risk is ignored or The long-run benefits in riskdisguised. Actually, the actuarial approach reduction and risk sharing stimulateleads to a self-constructed picture of the pension funds to aim for long-termfmancial solidity of a pension fund objectives in their investment policy.without any link to fmancial markets. However, risk management in the short The fair value approach implies term remains important. A pension fundmarket-based valuation of assetsand may always get involved in a situation ofliabilities so the balance sheet reHects discontinuity, which can be the result fortrue economic values. Furthermore, instance of bankruptcy of the sponsoringinformation on fmancial markets is used company, or of mergers and takeovers.to arrive at an explicit analysis of the risk Also the generational perspective is ofposition of a pension fund. It also importance. A fund with a seriousenables short-term and long-term policy funding shortage will not be attractive toquestions to be analysed within one rOting workers, because they know insingle framework. In other words, the advance that the scheme will harm theirfair value approach enables integral risk net lifetime income. A serious fundingmanagement. gap bas to be solved by high The concept of mismatch risk is the contributions over a long period, so thecentral risk measure in the fair value present value of contributions to be paidapproach. Mismatch risk is defmed as the will be in excess of present value ofstandard deviation of the so-called excess benefits to be received.return. By excess return is meant the This paper will discussthree options todifference between the return on assets handle the high exposure to risk of shortand the return on the liabilities. There is term underfunding. First, creating a Hoora trade-off between excess return and by investing substantially in index-linkedmismatch risk. A higher expected excess bonds. The importance of inflation-linkedreturn can only be realised by accepting honds for pension fund risk managementmore mismatch risk. The authors put is demonstrated. However, there is a veryforward that mismatch risk in the long limited supply of these kinds of bonds.run is lower than in the short run. There Hence, govemments in Europe andare two reasons for this. First, stocks elsewhere should be encouraged to issuehave been characterised by mean (more) index-linked bonds. A second warreversion. Mean reversion implies that is to hold a high solvency margin in orderthe average risk on an annual basis to absorb a fall in assetprices. However, itdecreaseswhen the investment period is is very difficult to restore a surplusextended. Secondly, in the long run a position when the pension fund bas beenpositive correlation can be observed hit by a severe fall in assetprices. Thisbetween return on assetsand return on will imply high costs in terrns ofliabilities. In the short term there is no additional contributions by the sponsorsuch correlation. and/or a reduction in defmed benefits. A pension fund bas a very long The third war is to frame an explicitinvestment horizon (in fact indefmite) contract between stakeholders on theand is therefore in an excellent position issue: which of the stakeholders, and toto benefit from a decline of the what extent, are participating in the riskmismatch risk in time. An important of underfunding as well as overfunding? aspect of Dutch pension funds is Such a contract is called a pension deal. risk-sharing between generations, so they The preferences ofthose stakeholders whoare able to spread risk in time. are ultimately hearing the funding risk @ Henry Stewart Publications 1478-5315 (2003) Vol. 8, 3. 222-234 Pensions 223 I
  • 3. Ponds and Quix determine the exposure of mismatch risk entirely of indexed bonds. The and the degree of funding of the scheme. characteristics of this mix are that the The structure of this paper is as expected rate of return on assetsis foilows. It flrst looks at the concept of always equal to the rate of return on mismatch risk. Next it discusses liabilities, so that the excess return, as return-risk trade-offs, which occur in the weil as the mismatch risk, is nil. capital market, with a distinction being Addition of regular honds and stocks to made between the short-run and the the portfolio results in an increase of the long-run. Taking a simple case as an expected return on investment, so that it example, it is shown that the long-run is to be expected that a lower orientation of the investment policy leads contribution level wiil become possible, to an improvement of the trade-off but at a higher mismatch risk. between return and mismatch risk in comparison with the short-run. The long-run benefits stimulate pension funds Return and risk in the short and to aim for long-term objectives in their the long run investment policy. However, risk Risk analysesand ALM studies management in the short term remains performed by pension funds are aften important. Fina11y, three options are based on the assumptions of constant discussed to control the short-term expected returns, constant risks and solvency position. constant correlations. An important implication of these assumptions is that the optimal mix for a one-year period is Trade-off between excess return equal to the optimal mix taken for a and mismatch risk multi-year period. In other words, the The fmancing of pensions is based on optimal asset a11ocationis the same for funding. Pension pro mises to the the short and long term. participants have to be fulfilled by building up sufficient capital Erom contributions and investment returns. Return Higher returns imply less contribution, Ample literature bas by now become and the other war round. available in which, in the authors The primary objective of a pension opinion, it is convincingly demonstrated fund is to fulfill the pension promises at that return levels which vary in time and the lowest possible contribution rate with which, given a sufficiendy long horizon, an acceptable level of risk. In fact this are predictabie to a certain extent on the involves a trade-off between the basis of valuation ratios, must be dealt expected excess return on the one hand with.1 and the exposure to mismatch risk on the other hand. Excess return is defined simply as the difference between the Risk return on assetsand the return on The length of the horizon is a significant liabilities. Mismatch risk is defmed as the factor for the risk profile of the various uncertainty around the excess return. assetcategories. The risk attaching to a The fund may decide to construct the one-year horizon need not be equal to so-ca11edperfect hedge portfolio. In the the annualised risk attaching to a case of index-linked pension rights this multi-year horizon. perfect hedge portfolio will be made up The results of empirical studies ,224 Pensions Vol. 8, 3. 222-234 @ Henry Stewart Publications 1478-5315 (2003) I
  • 4. t.I,if.f Integralrisk managementby pension funds i~Qba valueframework fair ; indicate that long-tenn returns on volatility of inflation, which makes it f investments in equities are characterised difficult to test for correlation between! by mean reversion. With mean reversion stock returns and inflation. In addition,, ,. the annual returns on equity investments there is the problem that in the past the fluctuate -with a certain degree of inflation process has manifested itself as a correlation (serial correlation) -around series of inflation regimes which all have a long-tenn average. This means that the their own average level and volatility. annualised risk in the case of equity However, if persistence in the inflation investments can be assessed be lower to process is assumed and taken into whenever a langer investment horizon is account, then the correlation between opted faro However, there are also inflation and shares in the long tenn doesI economists and actuaries who state that become clearer. The higher the inflation I the evidence on mean reversion depends persistence, the better the performance ofI very much on the chosen time period stocks as a hedge against inflation.2I and the markets under consideration. With respect to nominal bands and I. In ~he case of in:v~s~ent in in~e~ed liabilities, a po~itiv~ corre~tion .I fixed-Income secuntIes lt appears, by Wlthin a long-tenn settIng IS plauslble as , I. contrast, that the annualised long-tenn weil. Movements in the real rate ofI, risk is higher than the short-tenn risk. interest will affect bath bands and I. This phenomenon is referred to as liabilities. This is in particular the case inI mean-averting. The increase in time of a low-inflation environment.I the risk on fIXed-income securities is to Market-based valuation of indexed , be attributed to the risk attached to pension rights is clone on the basis of theI reinvestment of interest and principal. real rate of interest. The nominal rate ofI The recognition of time-variation in risk interest is composed of the expected realI should be reflected in time-variation of rate of interest and the expected rate of I optimal portfolios. inflation. The positive correlation r between the nominal and the real rate of ! r Interest willb e more pronounce d . an . In r Correlation econoinic regime with a low level ofI The correlation between changes in the inflation than in an environment with aI value of assetsand changes in the value high level of inflation. In a high-inflation t. of liabilities is of much significance to environment the effect of the inflationI.. the mismatch risk for a pension fund. volatility will be .dominant in relation to Where the long tenn is concerned, a the real interest rate effect. , positive correlation is plausible. First of For the short tenn, any relationship t. all, stocks will provide a long-tenn between stocks and nominal wageI! hedge for (wage) inflation. The future growth will be absent. Bonds still may stream of nominal dividends is one of provide a hedge in a low-inflation ~ the driving farces of stock valuation. The environment, due to the co-movementI growth of the liabilities as a result of in the real and nominal rate ofI indexation will then in the long tenn be interest. A pension fund with a heavy partially matched by the upward investment in bands will be very revaluation of stocks. Empirically, the vulnerable for a switch from a inflation hedge qualities of shares in the low-inflation to a high-inflation long tenn are difficult to prove. Two environment. The inflation expectations reasons can be given for this. Volatility of go up, nominal rate of interest will rise stock returns is much higher than the and so there is a low or even negative @ Henry Stewart Publications 1478-5315 (2003) Vol. 8. 3, 222-234 Pensions 225
  • 5. Ponds and Quix Table 1: Assumptions relating to return, risk and correlation: Short term and long term (Iow-inflation environment) Correlation Matrix Bonds Short term Mean stocks long Liabilities Stocks 1 Long-term bonds 0,2 Liabilities return 0 Wage inflation Price inflation . Cotf$.lation ~atrix Bond$ Long term Mean;;". Risk stocks long Liabilities Stocks 8.0 12.0 1 Long-term bands 5.0 10.0 0.2 1 Liabilities return 6.0 9.0 0.3 0.3 1 Wage inflation P.. ti . 3.0 2.0 --+ rlce In atlon 20 15c + total rate of return on bonds. The case. This case is a highly stylised outline value of indexed liabilities will go up of the reality in order to highlight the because of higher indexation. major points. A higher degree of reality is possible of course, but this would only make the case more complex, without Conclusion leading to fundamentally different In short, Erom the above the authors insights. conclude flrst that the optimal equity Assume that a specmc pension fund allocation for a long-term investor such has formulated its expectations for the as a pension fund will be higher than for future, as has been set out in Table 1. a short-term investor. Stocks do These assumptions reflect the current mean-revert whereas bands mean-avert. environment for pension funds. A The longer the horizon, the more stocks distinction is made between the short becorne less risky, whereas bonds will and the long term and the shading in becorne more risky. the table indicates the changes for the Furthermore, in the long term a long term in comparison with the positive correlation between assetsand short term. liabilities can be expected. This leads to a reduction of the annualised mismatch risk and tros reduction increases with the Expected values horizon. As aresult, the trade-off A low-inflation environment is assumed. between excess return and, respectively, The expected wage and price inflation contribution rate on the one hand and are 3 per cent and 2 per cent, mismatch risk on the other, will improve respectively. Return on long-term bands in the longer run. These flIldings will be is set at 5 per cent. The expected return illustrated in the following with a simple on equity is 8 per cent, so the equity risk premium is equal to 3 per cent.3 Liabilities, L, have an expected growth rate RL of 6 per cent, which is based on Strategic investment portfolio an expected wage inflation rate of 3 per What bas been put forward in the cent and an expected real rate of interest foregoing can be illustrated with a simple of 3 per cent.226 Pensions Vol. 8, 3,222-234 @ Henry Stewart Publications 1478-5315 (2003)
  • 6. Integral risk management by pension funds in a fair value framework Table 2: Excess return and mismatch risk in the short and the long term J Mismatch risk M.ismatch risk I. Mixbonds/stocks RA tRL RA- RI. short term long term c! 100/0 5.0 6.0 -1.0 12..0 11.3 ( 90/10 5.3 6.0 -0.7 11:8 10.8 I 80/20 5.6 6.0 -0.4 11.8 10.5 ~ 70/30 5.9 6.0 -0.1 12.0 10.4 ti 60/40 6.2 6.0 0.2 12.3 10.3 I 50/50 6.5 6.0 0.5 12.9 10.4 I 40/60 6.8 6.0 0.8 13.6 10.6 , 30/70 7..1 6.0 1.1 14.4 10.9I1 20/80 7.4 6.0 1.4 15.3 11.4 10/90 7.7 6.0 1..7 16.4 12.0 0/100 8.0 6.0 2.0 17.5 12.7 " Risk has here been put at 9 per cent.4 The risk per category is given in temlS It should be noted that for the shortI , of standard deviations. For the asset categoriesof a higherrisk brings return. prospect a higher expected the teml a low correlation is assumed between a bands and liabilities, reflecting that in low-inflation environment A distinction has been made between bands and liabilities are bath affected , equity risk in the short and in the by movements in the rea! rate ofI lon~ te~. The .annualised risk on inter~st. For the long teml: stocks .Co equ1ty 1Slower m the long teml than proVlde a hedge for wage-mdexed in the short teml because of mean liabilities. reversion. The risk on equity in the Table 2 below shows the relation .~ long teml is assumed to be equa! to between the asset mix, the level of ;thf 12 per cent, while in the short teml it returns on invested capita! RA, the is 18 per cent. The reinvestment risk liability return RL and the excess of bands results in an increase of the return (RA -RL), and mismatch risk in risk in the long teml fiom 8 per cent the short and in the long teml. Figure to 10 per cent. 1 shows the trade-offs (efficient sets) The volatility of the liabilities can be between excess return and mismatch traced back to the volatility of the rea! risk for the short teml and for the rate of interest and the wage inflation. long teml. From tms figure it can be The pension liabilities may relate to seen at a glance that a long-teml benefits that win become payable in orientation of the investment policy the distant future (say within the results in an improvement of the period of the next 80 years). The trade-off between return on the one weighted average duration of the hand and mismatch risk on the other. pension rights in the case of a typica! It may be noted that a pension fund pension fund is of the order of 15 to has a huge exposure to mismatch risk, 20 years. That is why relatively small even with a 100 per cent mix of movements in the rea! rate of interest nomina! bonds. Furthemlore, this simple and wage inflation may have a case with realistic assumptions shows very relatively heavy impact on the clearly that a pension fund with indexed provision for pension liabilities. The benefits needs to invest quite heavily in standard deviation of this liability return equities (at least 40 per cent) to have a is consequendy relatively high and it prospect of a positive excess return. @ HenryStewartPublications 1478-5315 (2003) Vol. 8, 3, 222-234Pensions 227
  • 7. "c". """Pondsand Quix 2.5 2.0 1.5 1.0 ..I ~ I 0.5 ~ -1.0 -1.5 Mismatch risk 1- short tenn -.-long tennl Figure 1: Trade-off between return and rnisrnatch risk Solvency improve considerably the risk A pension fund cannot avoid mismatch management practice of pension funds. risk and is therefore exposed to solvency These bands provide a hedge for the risk that may lead to a situation of indexed pension liabilities, so they serious underfunding. Traditionally, in the reduce the mismatch risk of the fund. Netherlands the pension laws and the Figure 2 shows the potential of ILB regulating authorities have focused on for pension fund risk management. the short-term solvency position.5 A fund Two types of ILB are distinguished, the is seen as solvent if its capital is at all so-called wage-indexed bands and the times sufficient to allow a transfer of the price-indexed bonds. The return on liabilities to a third party, for instance to price-indexed bands is the sum of the another pension fund in the event of a real coupon plus the actual merger or a takeover, or to an insurance price-infiation. It is assumed that the (or reinsurance) company. The solvency expected return on price-indexed bands situation may be controUed by investing is equal to the expected retum on substantially in index-linked bands or by regular bonds. Also the expected retum aiming at holding a large funding surplus on wage-indexed bands also is set position. However, these two solutions equal to the expected retum on regular are hampered by serious problems. bonds. Wage growth can be Therefore the framing of an explicit decomposed in real growth plus pension deal is proposed as a third war. price-inflation. Therefore, the real coupon of the wage-indexed bands bas to be lower than the real coupon of Option I: Index-linked bonds price-indexed bands in order to Index-linked bands (ILB) were not warrant that the expected nominal included in the preceding analysis. It is returns on the different types of bands a weU known result that a large are all equal. A very important availability of index-linked bands wi11 characteristic of wage-indexed bands is228 Pensions Vol. 8, 3, 222-234 @ Henry Stewart Publications 1478-5315 (2003)
  • 8. Integral risk management by pension funds in a fair value framework RA-RL 1100% equities I A -4--1 Efficient setlong ten» I CTmismatch ~00% wage- 100% price- I 100%regular I mdexed bonds indexed bonds I bonds IFigure 2: Efficient setsthat the offered return matches the wage-indexed honds and equities arereturn on wage-indexed liabilities, so a superior to combinations ofpension fund with an asset mix price-indexed honds and equities andcomposed of 100 per cent also superior to combinations of regularwage-indexed honds is free of honds and equities.mismatch risk. When the asset mix is The risk-reducing capacity of indexcomposed of price-indexed honds, then linked honds (ILB) clarifies howmismatch risk wil1 also be reduced important it is that more of these assetsconsiderably, but not completely are issued. This wil1 contribute to thebecause these honds provide no hedge sustainability of funded defined benefitagainst rea! wage growth volatility. plans. In many countries in Europe,Apart Erom the efficient set consisting governments consider the transition Eromof regular honds and equities, we can pay-as-you-go pensions to fundeddistinguish an efficient set with pensions, primarily defmed contributionprice-indexed honds and equities and plans. ILB wil1 also be of considerablean efficient set with wage-indexed significance for defined contributionshonds and equities. It is plausible to plans in order to reduce the investmentassume that the objective function of a risk in the retirement period and thepension fund is positively related to the pre-retirement plans.term excess return and negatively to However, the world market ofthe term mismatch risk. Figure 2 then index-linked assetsis too small to be ofshows that combinations of rea! interest for pension plans. Table 3 ; @ Henry Stewart Publications 1478-5315 (2003) Vol. 8, 3. 222-234 Pensions 229
  • 9. Ponds and Quix Table 3: Comparison assets pension funds and large inflation-indexed bands markets Inflation-indexed markets ($USbn) Pension fund capital ($USbn) .. Canada 11 Netherlands 440 France 19 UK 1261 Sweden 12 USA 8078 UK 103 Canada 607 US 133 Japan 1926 Total 278 February 2002 Ultimo 2000 Source: Barclays Capital Source: Pensions & Investments shows that the world marker size of myopic investment policy will entail inflation-indexed bands amounts to more negative effects. So far in this paper it or less US$270bn in May 2001. The size has been shown that pension funds have of the pension funds in the Netherlands to accept high exposure of mismatch risk already amount to more than US$400bn in order to realise at least a positive in spring 2002. excess return. This is a necessary condition for the growth rare of assersto ..keep pace with the growth rare of Optlon 11: High surplus liabilities. So the switch to a more A second way to control short-term risk conservative assermix is not a durable of underfunding is to hold a minimum solution. It may be of help for the short surplus position in order to absorb a fall term, but it will undermine the in asserprices so that the funding ratio long-term solvency position. will remain above 100 per cent. The Higher contributions may also close Appendix sets out how a minimum the solvency gap. However, this will margin can be determined. Al1 Dutch imply very high additional contributions; pension funds follow this route to toa high to be of help in real life. To control solvency risk. The Dutch restore a 1 per cent-point fall in the supervisor also advocates this approach. funding ratio requires for a typical Dutch However, the authors have serious fund 3 per cent-point to 5 per doubts about this approach, because it cent-point additional contributions. The may harm the long-term durability of recent decline in funding ratio of Dutch the Dutch pension scheme. The main funds range Erom 20-40 per cent. Hence, problem is how to restore an empty a short-term recovering of the solvency buffer after the fund has been hit by a position by additional contributions is serious fall in asserprices or by a high not feasible. increase in indexation burden due to Sa, whenever a pension fund high wage increases. encounters a situation of a severe funding One way to restore an insufficient gap, then recovery will be difficult. A solvency position is to limit the exposure situation with a problematic solvency to mismatch risk because this will lower position will cause lots of difficulties. the required minimum size of the First, the supervisor will force the solvency margin. For instance, a switch pension fund to take measures to restore Erom a risky assermix to a more solvency. Secondly, conflicts may arise conservative assermix will result in between stakeholders as to the issue: lower solvency requirements. Such a who has to fin the funding gap?230 Pensions Vol. 8. 3. 222-234 @ Henry Stewart Publications 1478-5315 (2003)
  • 10. "1 ii~~ Integral risk management by pension funds in a fair value frameworkTherefore it is better to admit in advince at all, and it may lead to a decrease inthat a pension fund is not able to accrued benefits. A high funding ratioguarantee that the funding ratio wi1l wi1l lead to compensating indexation orremain above 100 per cent. The aim of even additional indexation. Thishaving a sufficiendy high funding ratio risk-hearing alternative implies a changecan be replaced by an explicit pension from a defmed benefit scheme to adeal.. This is the third solution. collective defin~d contribution scheme. In real practice, it is more likely that the risk-sharing rules are somewhereOption 111:Towards an explicit between these two extremes.pension deal Almost all Dutch pension funds lackA pension deal is explicit when there is such an explicit pension deal. Usually thefu11clarity on the three aspectsbelow: contract on risk hearing is implicit of nature. This may easily lead towards1 Pensionplan: What is the defmed asymmetry in the pension fund policy in promise? relation to the funding position. In the2 Funding: What are the aims in the late 1990s, pension funds experienced process of funding, ie what is the huge surpluses that have been used for aimed return on investments, the shortages in contributions and aimed contribution rate and what is improvements of the pension benefits. the tolerated level of mismatch risk? After the dramatic fall in stock prices in3 Risk: Which of the stakeholders and recent years, most Dutch pension funds to what extent take part in hearing are struggling with underfunding. The risk? supervisor insists on a recovery of the solvency situation in the short term;As to the third aspect, two extreme however, stakeholders disagree on whosituations can be distinguished. has to par. The implicit nature of the .contract may be hannful to theContributions continuity of the contract.The sponsors bear all risk, whereas the However, the current situation can beindexation of a<;crued benefits and the regarded as a challenge to reach a morebuild-up of new benefits take place explicIt contract of risk-sharing. Such anaccording to the conditions of the explicit pension deal wi1l prevent policypension plan. This is a defmed benefit inettia and conflicts betweenscheme in its pure farm. The participants stakeholders, because it is always clearhave fu11certainty as to their benefits. who has to par, when, and to whatThe contribution rate is uncertain extent, in a shortage situation. It shoulddepending on how the funding ratio is also be clear who also wi1l benefit,hit by economic risks (assetprices and when, and to what extent, in the case ofwage arid price inflation). a large overfunding.6 Furthermore, the autho~ advocate that the stakeholderIndexation who ultimately bears the funding risk -The contribution rate is fIXed at a certain this may be either the sponsor or thelevel (for example, the actuarial cast collectivity of participants or aprice). Risk is absorbed by adjusting the combination of them -has to decideindexation of the liabilities of the on the funding policy. The risk-hearingparticipants. A low funding ratio wi1l stakeholder is then able to relate theimply a low indexation or no indexation funding policy to rus preferences. @ Henry Stewart Publications 1478-5315 (2003) Vol. 8, 3. 222-234 Pensions 231 I
  • 11. Ponds and Quix Table 4: Seven critical questions tor an explicit pension deal? Assets Liabilities 5. What is the risk-tree asset mix that 1. What is the benetit promise? provide a perfect match with liabilities? 2. What is the value ot detined benetits? 6. Should pension fund undertake asset mix policy risk? 7. Should the plan undertake active management risk? Surplus 3. What is the target tunding ratio? 4. How are balance sheet surpluses and losses allocated between stakeholders? Who owns the surplus on termination? An explicit pension deal may also yean. The 3 per cent assumptionmay indeed be imply a completely different role for the see~as quite high.. However, ~ lower (or higher) eqwty premIum wiJl have no Impact on the SUpervISOr. Whenever an explicIt pensIon argument of the paper. deal is in force, the supervisor has to 4 This 9"/0is calculatedwith the following expression: check that the execution of the pension U!;.bili.", D* UW Uw...,.The term D represents = + the ...duration of the laibilities, the term Uwstandsfor the fund IS In accordance Wlth the content risk (standarddeviation) in the real rate of interst of the deal. There is no langer a need to and Uwage the risk in wage growth. The volatility for formulate criteria as to the minimum in the expected real rate of interest rate is quite low .." and it bas been set equal to 0.4 per cent. Let margIn. It IS the ulttmate nsk-bearer who duration be equal to 17.5 yean (this is more or less has to decide on the issue of aimed the duration of a typical Dutch pension fund with funding ratio. indexed liabilities. The volatily in wage growth is set Anib h h d E 7 equal to 2 per cent. This leads to a volatility in ac ts eer an zra suggest a liabilities of 9% (=17.5*0.4% + 2%). pro gramme of questions to arrive at an 5 The Dutch supervisoris currendy developing a explicit pension deal. Table 4 is a revisedframework. Fair value and risk analysisare representation of their proposal. These prominent features.of the new model. Elabor:ationof ..methods and techniques,as weIl as the def=g of questtons may be of help to clanfy the standards wiJl take place within the next few yean. main topics in the pension fund The supervisor,the Pensioen- & Verzekeringskamer arrangement. If a pension fund is going (pensionsand insurancesupervisoryauthority of the .Netherlands) basrecendy published the basic to create value for lts stakeholders, the principles for this new framework, named: the fiduciary of the fund must actually be Financial TestingFramework. See clear as to what the pension promise is http://www.pvk.nl/engels/index~eneral.html. an d w 0 h th . k b e ns -earers are. 6 The deal rnay also be important to check -at least . on an ex antebasIS -that the advantages of participation are on balancehigher than the Acknowledgment disadvantages. Then the participation of the various We thank Keith Ambachtsheer, Jean Frijns and Luis stakeholders ensured,as it is in the interest of all is Viceira for comments on an earlier version. of them that the pension fund remains in existence. Main advantages participation are the prospect of of an insured wage-relatedpension, a low contribution References rate and low implementation casts. As main 1 See for instanceCampbell, J. y: and Viceira, L. M. disadvantages can distinguish volatile one (2002) Strategïc assetallocation: Portfolio choice for contribution rate, lack of fu11freedom of choice and long-term investors, Oxford University Press, ex-post income transfersbetween the parties Oxford. involved. 2 See Schotrnan,P. C. and Schweitzer,M. (2000) 7 Ambachtsheer, P. and Ezra, D. D. (1998) Pension K. Horizon Sensitivity of the Inflation Hedge of Fund Excellence,Creating Value for Stakeholders, Stocks,Joumal ofEmpirical Finance, Vol. 7, pp. John Wiley & Sans, New York. 301-315. 8 Or a variant of the probability of underfunding, for 3 We acknowledge that currendy a debate is going on instancethe size-weighted probability of as to the size of the equity premium for the coming underfunding or the downside deviation risk.232 Pensions Vol. 8. 3, 222-234 @ HenryStewartPublications 1478-5315(2003) I
  • 12. ,E:.i_ttt_~iftN,:;Njj I Integral risk management by pension funds in a fair value framework ~ I lniti~l ratioI ~dingFigure 3: Probability distributionfunding ratio end of year T9 This fonnu1a doesnot takeinto account effect the shortfall risk8 a after a period of T years of the increment the fundingratio due to the t d of turn .. tI al funding tl-- 100." . bI . IS acce pta e as a maX1mum. Thi h . s c olce expec exces e re : llU ra 0 -7. + margin-/- increment excessof return. However, is detemrinative of the initial funding the Jatter tenn canbe takento be zero,for two ratio or the required solvency margin. h --_ in reasons: case actualfundingratio is equalto the Th . ti al fu din ti. b . th th - t e llUtI funding ratio, en e mcrement te. al 0 f h elm n g ra 0 can e . fundingratio is fxeelyavailable canfor instance and detenmned by means of the followmg be usedfor premiumreductionor pension formula,9 where the volatility in the improvement. funding ratio increases in time proportionally to the square root of theA d " M "" I forecast period T: ppen IX: Immum so vencymargin I .. al fu din mtI n g ratio .This paper has discussed the holding of a = 100% + marginminimum solvency margin as one war to = 100% + VT*a *z mrn acontrol short term risk of underfunding.Here me minimum solvency margin in a where:fair value context is derived. The funding ratio T years Erom now T = forecast periodis uncertain and can be described on the <Tmrn mismatch risk (=standard =basis of a probability distribution. In the deviation of extra returnshort term the probability distribution relative to the liabilities)can be characterised as a normal Za = number of standard deviationsdistribution. The spread in the away Erom the average, givendistribution is mainly detemrined by the the accepted shortfall risk amismatch risk. The mismatch risk is nil ifall the resources of a given fund are The above can be illustrated by Figure 3.invested in indexed bonds. The addition Now, with alternative values taken forof regular honds and shares results in T, a and <Tmrnthe size of the requiredmore excess return, but at the same time margin can be detemrined for thein a higher mismatch risk as well. The pension fund presented in the case studycrucial issue now is the question which above. @ Henry Stewart Publications 1478-5315 (2003) Vol. 8, 3, 222-234 Pensions 233 I
  • 13. Ponds and Quix Table 5: Minimumsolvencymarginfor different combinationsof horizon(T) and probabilityof underfunding a, for a given mix of 50% sharesand 50% long-termbonds Margin Period T Probability a (.%) Mismatch risk r,- 16..41 10 12.9 21.2 1 5 12.9 29.9 1 12.9 38.8 0.1 12.9 28.5 10;0 12,9 36.7 3 5 12.9 51.9 3 1 12.9 672 .. 301 .. 129 " 36.8 5 10 12.9 47.4 5 5 12.9 66.9 5 1 12.9 86.8 5 0.1 12.9 Table 6: Minimum solvency margin for different mixes, with a horizon of three years and a 5% probability of underfunding Margin ; Period T; ; Probability a (%) Mismatch risk r,- Mix stocks/bonds 35.2 3 5 12.3 40/60 36.7 3 5 12.9 50/50 38.8 3 5 12.6 60/40 41.1 3 5 14.4 30nO Three variants as regards to the calculated, on the basis of an investment horizon are distinguished: portfolio, which is made up of 50 per cent equities and 50 per cent long-tenn T = 1 (in line with the new solvency bonds. This mix gives a short-tenn assessment of Pension and mismatch risk of 12.9 per cent. The Insurance Chamber); results of these calculations are presented T = 3 in Table 5. It can be seen that the T = 5 margin increases accordingly as the ...period becomes langer. This is due to For the probability of underfunding a, the accumulation of uncertainty as the 10 per cent, 5 per cent, 1 per cent and horizon is extended. The margin 0.1 per cent are chosen. On the basis of becomes larger as the allowable these values, the following values for z probability of underfunding becomes are obtained: smaller. Table 6 shows the effect of variants in a (%) Za the investment mix on the margin. The mix is determinative of the level of the 10 1.28 mismatch risk. The calculations have 5 1.65 been clone for a combination of a 1 2.33 horizon of three years and 5 per cent as 0.1 3.02 the acceptable probability of underfunding. The figures in Table 5 For the various combinations of T and a show the increase of the margin at a the required solvency margin is higher mismatch risk.234 Pensions Vol.8, 3, 222-234 @Henry Stewart Publications 1478-5315 (2003) " I

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