Sep 11, 2010

Coverage Ratio Solution Space

Dutch pension funds are in deep trouble. The average coverage ratio of many pension funds has fallen to a level well below 100% (underfunded). Some major Dutch pension funds with coverage levels around 90%, called Government to dissuade the planned pension rights cuts.

A delay in pension rights cuts seems justifiable. Key question is the reason for this requested delay. For reasons of reformulating new pension policies and ambitions, delay seems reasonable. With the intention to just 'buy time' in order to continue 'desperate hope' that the markets and low returns will recover, further delay could prove catastrophic.

Facing Reality
Pension funds have to cope with several hurricanes at the same time:
  1. Relatively low interest rates
  2. Underperforming stock market
  3. Underestimated longevity risks
  4. Need for higher confidence levels

Although low interest rates and underperforming stock markets could continue for several years, on the long term interest rates and stock markets will most likely recover, simply because economic growth imply higher returns on the long term.

Underestimating The Longevity Monster
One of the 'big' (?) surprises seems the recent development in longevity. For decades now, actuaries and researchers are structurally underestimating the effect of longevity.

Maggid's Longevity Forecast
Although longevity has been studied a lot, a decrease of the steady growth of the human lifespan in the coming decades will most likely turn out to be idle hope....

Lessons learned, we actuaries will seriously have to take into account that the linear increase of lifespan probably will continue until at least the age of 90 (Maggid forecast). This implies that we'll have to 'spice up' our mainly retrospective life expectancy models and corresponding forecasts with a healthy portion of common sense.

What about the 'risk free' discount rate?
More actu(ari)al trouble is caused by the fact of the low interest rates and sticky stock markets.
Pension funds face the substantial volatility and the low level of the so called "risk free discount rate" that drives the coverage ratio. Paradoxically we could state:

There's nothing more risky than a  'risk free' discount rate

The - artificial - low level risk free interest rate pulls down the coverage ratio of a pension fund.

At the same time it's necessary to level up the existing 97.5% confidence level of pension funds. A 97.5% confidence level implies that a pension fund will turn into default (underfunding) twice in an average person's lifespan.

Despite the fact that a 'twice in a life meltdown' is probably hard to explain to anyone, new upcoming Solvency demands for pension funds will be inevitable in order to create a level playing field on the financial market. Good governance, common sense and upcoming new regulatory initiatives will therefore certainly urge a higher pension fund confidence level like the 99,5% level in the insurance industry (Solvency II) or the 99,9% level in the banking industry (Basel II) .

Sitting Ducks
As is clear from the above image, successfully financing a pension-fund (portfolio) on the long term at the current ambition level, calls - in general - for high (unrealistic) interest rates. The 'solution space' for achieving the necessary  high coverage ratios that match the (new) capital requirements appears to be very narrow.

Therefore (there is no other way), most pension funds have to take time and redefine their (future) ambition instead of playing 'sitting ducks' and hoping for the best.

Used Sources, Links:

- Dutch life expectation 2010-2060
- Japanese life expectation: 86.5 years
- Dutch life expectation 2010-2060
- Japanese life expectation: 86.5 years
- Dutch - De risico's van het leven (risks of life) ...
- Will Life Expectancy Continue To Increase Or Level Off 

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