Steering pension funds on a 'one point' Coverage Ratio is like trying to proof global warming on a hot summer day...... It's useless.
First of all the complete pension fund balance sheet is based on market value.
As there is no substantial market for pension liabilities, this implies that pension liabilities have to be valued on basis of some kind of arbitrary (artificial) method.
In the U.S. this has led to the (irresponsible) high discount rate of 8% for state pension funds based on the 'expected' long term return without a kind of correction (subtraction) for 'risk'.
In de Dutch market, pension funds have to rate their liabilities on basis of a maturity dependable risk free interest rate, the ‘Nominal interest Rate Term Structure’ (RTS), as ordered by DNB (the Dutch Regulator).
Here's the outcome of this risk free interest rate (RTS) over the past 10 years, including the 10-y average RTS...
Ever since DNB ordered this 'artificial discounting method', pension fund board members didn't get a good night sleep. As the RTS juggles on a daily basis, every morning pension members wake up with the latest 'RTS news surprise of the day'.
You can play the RTS juggle (worm) here:
As coverage ratios are based on the RTS, they shuttle hither and thither as well and executing a long term pension fund strategy becomes more or less like riding the famous (market) bull in a rodeo show.
On a Dutch IPE congress, Angelien Kemna - chief investment officer of the €270bn asset manager APG - warned that the current swap-curve discount criterion forces pension funds to take unwise "significant long-term measures".
Kemna favors an average yield curve or a more straightened version of the current one for discounting liabilities.
The new Dutch Pensions Agreement foresees that pension funds can choose their own discount rate, as pensions are no longer guaranteed!
Indeed, it's time to stop this complex discount circus. But it's also time to stop 'one point estimate' Coverage Ratio steering.
A new look
Let's take a look at a characteristic discount rate dependence of a traditional pension fund like ABP.
Valuing ABP at an (derived average) RTS of 2.69% (September 2011), ABP's discounted assets fail to meet the discounted liabilities, leading to a coverage ratio of around 90%.
However this kind of risk free valuing is - for sure - too conservative, as ABP's aims at an underpinned strategic expected return of 6,1% on the long term and has a convincing track record of 5 and 10-year moving average returns:
As long as a pension fund (like ABP) continues to perform (on 5 or 10-years moving average) rates that outperform the (derived average) risk free discount rate, it's seems ridiculous to force such a pension fund to discount at a 'risk free rate', as this obliges the fund to change his strategic asset mix to a less risky mix and an suboptimal return.
In turn, these suboptimal returns will lead to an asset shortage. With a vicious cycle of decreasing risk as a fatal result in the end.
Sustainable Discount Rates
In an excellent discussion paper (2006) Jürg Tobler-Oswald proves that the optimal discount rate lies between the risk free rate (RFR) and the investment strategy’s expected return (ER) depending on how good the hedge against the fund’s cash flow provided by its investments is:
Another - more simple and practible - discount rate could be defined as the average between the free discount rate and the X-year (e.g. X=5, or 10) Moving Average Return of the last X-Years (MAR(X)).
As long as MAR(10), MAR(5) and ER stay larger than the interest rate that matches a coverage ratio of 100%, discounting by means of one of the new sustainable discount methods seems sound and safe......
Whats left is that the average (geometric) risk premiums during the last 10 years have turned out negative:
This implies (moreover) that it is important that the discounting rate of a pension fund should be based on a sustainable sound weighted mix of:
(1) proven historical performance
(2) a 'save' risk free rate
(3) realistic future return assumptions
Related Links/ Sources
- Kemna IPE article (2011)
- An investment based valuation approach for pension fund cash flows (2006)
- Ignoring the risk in risk premium in State Pensions(2011)
- DB: What went wrong? (2011)
- Actuary.org: Pension Fund Valuation and Market Values (2000)
- Aswath Damodaran: Equity-risk-premiums-2011-edition
- Dutch: ABP coverage ratio
Why?
First of all the complete pension fund balance sheet is based on market value.
As there is no substantial market for pension liabilities, this implies that pension liabilities have to be valued on basis of some kind of arbitrary (artificial) method.
In the U.S. this has led to the (irresponsible) high discount rate of 8% for state pension funds based on the 'expected' long term return without a kind of correction (subtraction) for 'risk'.
In de Dutch market, pension funds have to rate their liabilities on basis of a maturity dependable risk free interest rate, the ‘Nominal interest Rate Term Structure’ (RTS), as ordered by DNB (the Dutch Regulator).
Here's the outcome of this risk free interest rate (RTS) over the past 10 years, including the 10-y average RTS...
Ever since DNB ordered this 'artificial discounting method', pension fund board members didn't get a good night sleep. As the RTS juggles on a daily basis, every morning pension members wake up with the latest 'RTS news surprise of the day'.
You can play the RTS juggle (worm) here:
On a Dutch IPE congress, Angelien Kemna - chief investment officer of the €270bn asset manager APG - warned that the current swap-curve discount criterion forces pension funds to take unwise "significant long-term measures".
Kemna favors an average yield curve or a more straightened version of the current one for discounting liabilities.
The new Dutch Pensions Agreement foresees that pension funds can choose their own discount rate, as pensions are no longer guaranteed!
Indeed, it's time to stop this complex discount circus. But it's also time to stop 'one point estimate' Coverage Ratio steering.
A new look
Let's take a look at a characteristic discount rate dependence of a traditional pension fund like ABP.
Valuing ABP at an (derived average) RTS of 2.69% (September 2011), ABP's discounted assets fail to meet the discounted liabilities, leading to a coverage ratio of around 90%.
However this kind of risk free valuing is - for sure - too conservative, as ABP's aims at an underpinned strategic expected return of 6,1% on the long term and has a convincing track record of 5 and 10-year moving average returns:
| Returns (%) Pension Fund ABP 2993-2010 | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Year | 1993 | 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
| Yearly Return | 16.5 | -1.0 | 16.4 | 11.8 | 11.9 | 12.9 | 10.0 | 3.2 | -0.7 | -7.2 | 11.0 | 11.5 | 12.8 | 9.5 | 3.8 | -20.2 | 20.2 | 13.5 |
5Y MA Return | 10.9 | 10.2 | 12.6 | 9.9 | 7.3 | 3.4 | 3.0 | 3.3 | 5.2 | 7.2 | 9.7 | 2.7 | 4.2 | 4.4 | ||||
10Y MA Return | 7.1 | 6.6 | 7.8 | 7.5 | 7.3 | 6.5 | 2.9 | 3.8 | 4.8 | |||||||||
Or in Graphics:
As long as a pension fund (like ABP) continues to perform (on 5 or 10-years moving average) rates that outperform the (derived average) risk free discount rate, it's seems ridiculous to force such a pension fund to discount at a 'risk free rate', as this obliges the fund to change his strategic asset mix to a less risky mix and an suboptimal return.
In turn, these suboptimal returns will lead to an asset shortage. With a vicious cycle of decreasing risk as a fatal result in the end.
Sustainable Discount Rates
In an excellent discussion paper (2006) Jürg Tobler-Oswald proves that the optimal discount rate lies between the risk free rate (RFR) and the investment strategy’s expected return (ER) depending on how good the hedge against the fund’s cash flow provided by its investments is:
Discount Rate1 = RFR + FCash Flow(RFR-ER)
Another - more simple and practible - discount rate could be defined as the average between the free discount rate and the X-year (e.g. X=5, or 10) Moving Average Return of the last X-Years (MAR(X)).
Discount Rate2 = [ RFR + MAR(X) ] /2
As long as MAR(10), MAR(5) and ER stay larger than the interest rate that matches a coverage ratio of 100%, discounting by means of one of the new sustainable discount methods seems sound and safe......
Whats left is that the average (geometric) risk premiums during the last 10 years have turned out negative:
| Historical Equity Risk Premiums (ERP) | ||||
|---|---|---|---|---|
| ERP: Stocks minus T.Bills | ERP: Stocks minus T.Bonds | |||
| Period | Arithmetic | Geometric | Arithmetic | Geometric |
| 1928-2010 | 7.62% | 5.67% | 6.03% | 4.31% |
| 1960-2010 | 5.83% | 4.44% | 4.13% | 3.09% |
| 2000-2010 | 1.37% | -0.79% | -2.26% | -4.11% |
This implies (moreover) that it is important that the discounting rate of a pension fund should be based on a sustainable sound weighted mix of:
(1) proven historical performance
(2) a 'save' risk free rate
(3) realistic future return assumptions
Related Links/ Sources
- Kemna IPE article (2011)
- An investment based valuation approach for pension fund cash flows (2006)
- Ignoring the risk in risk premium in State Pensions(2011)
- DB: What went wrong? (2011)
- Actuary.org: Pension Fund Valuation and Market Values (2000)
- Aswath Damodaran: Equity-risk-premiums-2011-edition
- Dutch: ABP coverage ratio
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