Pension Fund Coverage Ratio Analogy

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)