What's your Pension Fund Confidence Level?

In my last blog I discussed the relationship between 'Fund Ratio' (FR) and 'Confidence Level' (CL), mainly for Dutch pension funds.

Some bloggers asked me to visualize this FR-CL relationship also for some other important pension countries.

From a Tilburg University thesis (2010) we can make a comparison. Not for all pensioen funds, but at least for some major public sector pension funds.

Here it is!

Although Dutch pension funds are still discussing whether they should cut existing pension rights or not , US and UK public sector pension funds still believe that as bad dreams have become reality, miracles can also happen!

"No!", my English business friend answered me, "I don't believe in miracles, I rely on them!" .

  

It still sounds as in the good old days, it's just the view that differs.....

Relationship Confidence Level & Funding Ratio

Dutch Pension funds constantly keep their members informed about the development of the funding ratio. But actually..., what is the confidence level that belongs to a certain funding ratio?

The answer to this question varies greatly by pension fund. To create some sort of insight in the relationship between the Funding Ratio (FR) and confidence level, we will discuss a highly simplified, but certainly realistic example.

Confidence and Equity
The required confidence level for Dutch pension funds is anchored in the Dutch Pension Act (Pensioenwet), at a 97.5 %  level.

Article 132 , paragraph 2 of the Pension Act  states:
A pension fund will set the regulatory own funds so that the probability of the pension fund having 
less assets at its disposal than the amount of the Technical Facilities (TF) within a year is reduced to 97 1/2 %

Funding ratio
Under the Dutch Pension Act, the required one-year confidence level of 97.5 % is directly related to the Regulatory Own Funds (ROF) and thus to the Required Funding Ratio (RFR). In a simplified formula stated: RFR = (ROF + TF) / TF.

At higher funding ratios than the RFR, the actual confidence level will be more than 97.5 % and vice versa: if the actual funding ratio is lower than the RFR, the corresponding confidence level will be less than 97.5%.

In practice, calculations show that the required funding ratio of most Dutch pension funds has an outcome somewhere between 120% and 130% .

Funding Ratio and Investment Risk
The fluctuation of the funding ratio depends largely on the investment risk that a pension fund is willing to take. Netherland's largest pension fund, ABP, adopted an investment policy that aims at roughly 40% fixed income and 60% equities. This policy resulted in the next yield and 5-year backward moving annual volatility (risk) :

The average ABP annual return over the past 5 years was about 5 % with a volatility of 15.9%.

Volatility Funding Ratio

The volatility of the funding ratio depends not only on the volatility of investments, but also on the volatility of the discounted liabilities. In the Netherlands, liabilities are discounted at a risk-free rate, with help of the so-called 'ultimate forward rate' (UFR).

On balance, the ABP's annual funding level volatility over the past 10 years turns out to be approximately 17 % .

This percentage has the same order of magnitude as the annual funding level volatility of an average pension fund in the Netherlands .

As the funding volatility has the same order of magnitude as the investment volatility, we may conclude that the confidence level that corresponds to a certain funding ratio is mainly determined by the investment risk .

To get sight at the 'one year confidence level' for various funding levels, please take a look at the the next chart that's based on a highly simplified approach. We do not seek exactness, but want to get an impression of the confidence sensitivity. Therefore, we abstract from the additional volatility effects that may arise from other risks (like liabilities and expenses ). The calculation is performed for two different risk strategies of a pension fund :

1. The 'current risky' investment strategy with an expected investment volatility of 15 %
2. A 'risk-averse' investment strategy with an expected investment volatility of 4%

Here are the results :

On the basis of graph above a first serie of important conclusions can be drawn:

• A 100% funding ratio corresponds with a 50% confidence level
• If the funding ratio exceeds 100%, the 'current risky' investment strategy results - as expected - in a lower confidence level than a risk-averse strategy.
• Although perhaps at first sight surprising, the reverse is also true:
  If the funding ratio falls to a level less than 100% , a risky investment strategy results in a higher confidence level than the 'risk-averse' investment strategy. And this is exactly the situation in which a number of Dutch pension funds, but also many foreign pension funds, are in.

To draw some more specific conclusions, we zoom in on the graph:

Now, a second set of interesting conclusions becomes visible:

• Required Funding Ratio
  The 'current risky' investment strategy of Dutch pension funds in combination with the legally required confidence level of 97.5 %, urges a funding ratio of about 130 %.  In a risk-averse strategy the required funding ratio would be somewhere around 110 % .
   
• Actual Confidence Level
  A legally required confidence level of 97.5% with a funding ratio of 110% for a risk-averse fund would result in an actual confidence level of about 75% in case of a risky investment strategy .
  As most Dutch pension funds have adopted a risky investment strategy, the actual average confidence level is about 75% in case of a 110% funding ratio and about 50% in the case of a 100% funding ratio.
   
• Maximum Confidence Level Decline?
  There's a maximum decline of 24% in confidence level in case of a transition from a risk-averse to a risky investment. The maximum decline corresponds with a funding ratio of approximately 108%.
   
• Indexation Potential?
  The current average funding ratio of Dutch pension funds fluctuates around 100%. This implies that as far as future actual annual returns result in an excess return above the required return on liabilities, this so-called 'excess-return' should first be used to achieve the required funding ratio of about 130%.  In most cases this leaves no room for indexation in the coming 10 years.
   
• Partial Indexation?
  It's quite common to apply 'partial indexation', above a 105% funding ratio. However, if the actual funding ratio is still below the minimum required confidence level (of 130%), "partial indexation" lowers the funding ratio and diminishes the recovery-rate. In this case, the (partial) indexation policy should be tested for feasibility. The expected return minus the (future expected) indexation and minus the required return on liabilities, should be sufficient to grow to the required funding ratio of 130% within the statutory recovery period of 10 years .

Solvency II to pension funds ?
Finally, we zoom in on the possible introduction (IORP legislation) of a required 99.5% confidence level, as is valid for insurers under Solvency-II:

A final set of key conclusions now becomes visible :

• Solvency II
  Increasing the current confidence level of 97.5 % (Pensions) to 99.5% (Solvency II ) implies an increase of the required funding ratio from 110% to about 113% for risk-averse pension funds and an increase from 129% to 139%  for pension funds with a (current) risky investment policy.
   
• Unrealistic Solvency-II Growth Path
  Based on the current average funding ratio of around 100%, pension funds should be able to climb to a funding ratio of around 139% within a (statutory limited) 10 years period to reach a Solvency-II confidence level of 99,5%. I think most of us will agree that this is a complete unrealistic scenario. In this case pension funds will ultimately be forced (by the regulator) to de-risk their investment portfolio. De-risking will result in lower (expected) returns and further loss of indexation potential.  Implementing Solvency-II requirements will turn pension funds into 'nominal pension insurers'.
   
• Basel
  Confidence levels in the financial markets seem to know no end. If, in the long term, the confidence level requirement of 99.9 % ( Basel banking regulations requirement) should become obligatory for pension funds, things would really get out of hand. In this case, the funding ratio requirement would increase further to 116 % ( risk-averse strategy ) or even 147 % ( risky strategy).
   

Reflection
The question is whether it's wise to judge pension funds with long term liability structures and corresponding investment policies, on basis of a one-year 97,5% confidence level. It would probably be more realistic and practical to scale up to a 99.5 % confidence level on basis of a 5 or 10-years period:

Illustration: In case of a portfolio with a 15% risky investment strategy, the 5-year average 99.5 % confidence level would lead to a required funding ratio of 118 % .

Conclusions
Based on the global approach above, the following conclusions can be drawn:

• The actual confidence level of Dutch pension funds is far below the (statutory) required confidence level of 97.5 %. For pension funds with a risky (= 15% volatility) investment strategy and a funding ratio between 100% and 110%, the actual confidence level varies from 50% (at a 100 % funding ratio) to 75%  (at a 110 % funding ratio).
   
• There's only very limited indexation potential for pension funds with a funding ratio between 100% and 130 %, due to the obligation to grow the actual funding ratio (with priority) to the statutory required level (130%).
   
• Introduction of an IORP risk framework based on a Solvency-II confidence level of 99.5% would imply that pension funds are forced to de-risk their portfolio. De-risking will result in lower (expected) returns and further loss of indexation potential. Implementing Solvency-II requirements will turn pension funds into 'nominal pension insurers'.
    
• Due to their long-term obligations and corresponding investment strategies, pension funds can be more adequately controlled and steered on basis of a five-year average 99.5 % confidence level, instead of the actual one-year 97.5% confidence level.

Blog-Disclaimer
The calculations and conclusions in this blog are very rough approximations which by definition do not apply to an individual pension fund and are only intended for discussion purposes. Please consult your own pension fund if you are interested in the confidence level results regarding your own pension fund. In this case don't forget to ask your pension fund to report according the template style of this blog!

Aftermath: International Funding Ratios Comparison
The funding ratio's and mentioned statutory requirements in this blog are based on the actual situation in the Netherlands. Funding ratio's in other countries vary considerably!

In an excellent rare Netspar thesis  (2010) the diverse funding ratios of public sector pension funds are compared regarding three kinds of Methods:

1. Reported Ratio: Funding ratios officially reported by each scheme.
2. Fair Value: This method, inspired by Dutch plans, uses a market discount rate to account for pension liabilities. Dutch pension industry refers discount rates to nominal swap rates since the market of government bonds is not deep enough for the industry. 30-year nominal swap rate, which roughly has the same duration of 15 years as a typical pension fund, is used as the market discount rate for nominal liabilities
3. Expected Return: This (actuarial) method, following the U.S. practice, is based on an assumed discount rate of 8% which reflects the American’s expectation of annualized long term pension asset return.

Here are the results:

For example: if you would like to compare the Netherlands with the US on basis of Fair Value (the Dutch mandatory method), the funding ratio of the US would be 31% compared to around 90% in the Netherlands. Please keep this in mind if you examine the above charts in this blog!

But let's stay optimistic about US pension funds, the funding ratio ofl US corporate plan's is already rising!

US Pension Fund Fitness Tracker

Find out what your actual pension confidence level is!!!


Used Links & Sources
- Dutch Pension Act (in English)
- Advisory Report of the UFR Committee
- A fixed UFR, a costly mistake?
- Long duration bond benchmarks for U.S. corporate pension plans
 - Netspar Thesis (2010): What Explains the Diverse Funding Ratios..
- US Pension Fund Fitness Tracker

Country Corporate Tax Competition Market

The global competition on corporate tax rates is 'on'.

More and more countries use corparate tax as an instrument to attract international companies to stimulate economic growth in their country.

Let's suffice with a sectional view of some remarkable corporate tax outcomes and developments on basis of KPMG's excellent Corporate Tax Oversight.

I'll leave the interpretion up to you.

	Corporate Tax Rates in Year
Location	2006	2007	2008	2009	2010	2011	2012	2013
Top-3 Max. Corp. Tax
United Arab Emirates	55,0%	55,0%	55,0%	55,0%	55,0%	55,0%	55,0%	55,0%
United States	40,0%	40,0%	40,0%	40,0%	40,0%	40,0%	40,0%	40,0%
Japan	40,7%	40,7%	40,7%	40,7%	40,7%	40,7%	38,0%	38,0%
Region Average Corp. Tax
Global average	27,5%	27,0%	26,1%	25,4%	24,7%	24,5%	24,4%	24,1%
OECD average	27,7%	27,0%	26,0%	25,6%	25,7%	25,4%	25,2%	25,3%
Europe average	23,7%	23,0%	22,0%	21,6%	21,5%	20,8%	20,4%	20,6%
North America average	38,1%	38,1%	36,8%	36,5%	35,5%	34,0%	33,0%	33,0%
Asia average	29,0%	28,5%	28,0%	25,7%	24,0%	23,1%	22,9%	22,5%
Europe: Competition
Switzerland	21,2%	20,6%	19,2%	19,0%	18,8%	18,3%	18,1%	18,0%
Netherlands	29,6%	25,5%	25,5%	25,5%	25,5%	25,0%	25,0%	25,0%
Italy	37,3%	37,3%	31,4%	31,4%	31,4%	31,4%	31,4%	31,4%
Sweden	28,0%	28,0%	28,0%	26,3%	26,3%	26,3%	26,3%	22,0%
Ireland	12,5%	12,5%	12,5%	12,5%	12,5%	12,5%	12,5%	12,5%
United Kingdom	30,0%	30,0%	30,0%	28,0%	28,0%	26,0%	24,0%	23,0%
Germany	38,3%	38,4%	29,5%	29,4%	29,4%	29,4%	29,5%	29,6%
Non-Europe: Competition
China	33,0%	33,0%	25,0%	25,0%	25,0%	25,0%	25,0%	25,0%
Kuwait	55,0%	55,0%	55,0%	15,0%	15,0%	15,0%	15,0%	15,0%
Greece	29,0%	25,0%	25,0%	25,0%	24,0%	20,0%	20,0%	26,0%
Indonesia	30,0%	30,0%	30,0%	28,0%	25,0%	25,0%	25,0%	25,0%
Israel	31,0%	29,0%	27,0%	26,0%	25,0%	24,0%	25,0%	25,0%

Global Oversight
Here's the complete global oversight of Corporate Tax Rates in 2013.

Learn About Tableau

More information about 'individual income tax rates' is also available at KPMG.

History

The corporate tax rates competition is not just a last decade issue.

Ever since the eighties of the last century, corporate average OECD tax rates declined.

Only the US, as the world's strongest economy (but for how long?), could affort it to stay at a traditional more or less constant 40% tax level from 1987 to 2013.

Finally

Of course, as we all know, big 'smart' companies like Goole hardly pay any tax...
Famous is the so called "Double Irish Dutch Sandwich"

Source KPMG Tax

Links:

- Monitoring the OECD’s Campaign Against Tax Competition

- US senator deems Ireland the ‘Holy Grail of tax avoidance’ 

- iTax Avoidance 

- OECD Tax Reforms in time

- US Officially Has Highest Corporate Tax Rate In The World

QIS: Longevity Risk Sharing

In a recent discussion about the future and fundamentals of the Dutch pension system I discussed the importance of solidarity.

As expected, the participants quickly came up with the various forms of solidarity, including solidarity between:

– higher and less educated people

– women and men

– old versus young people

Longevity Risk Sharing

Remarkably non of the participants had any idea about the financial impact of one of the most fundamental forms of risk sharing in case of a life annuity: Longevity Risk Sharing. Let's call it in general 'mortality solidarity'.

When asked, most participants strongly underestimated the impact of mortality (mortality share) as part of the yearly payment in the form of a life annuity. On the other hand, they overestimated the impact of 'return'.

Some of the participants had the idea that they would be 'better of' with a traditional individual investment plan in combination with a little more investment risk (and return) ...

Life Annuity Composition
So let's do a mini QIS (Quantitative Impact Study) of 'mortality solidarity' by examining the development of the composition of an annual lifetime annuity, regarding three basic elements: Mortality, Return and Desaving.

Here is the result for a Dutch man, age 65, with a lifetime annuity based on an average 5% yearly return:

Translated in table form:

	Yearly Payment Composition				Cumulative Composition
Age	Mortality	Return	Desaving		Mortality	Return	Desaving
65	16%	51%	33%		16%	51%	33%
66	17%	50%	34%		16%	50%	34%
67	18%	48%	34%		17%	50%	34%
68	19%	46%	34%		17%	49%	34%
69	21%	45%	35%		18%	48%	34%
70	22%	43%	35%		19%	47%	34%
71	24%	41%	35%		20%	46%	34%
72	26%	39%	35%		20%	45%	34%
73	28%	38%	35%		21%	45%	34%
74	30%	36%	34%		22%	44%	34%
75	32%	34%	34%		23%	43%	34%
76	34%	33%	33%		24%	42%	34%
77	36%	31%	33%		25%	41%	34%
78	38%	30%	32%		26%	40%	34%
79	41%	28%	31%		27%	40%	34%
80	43%	27%	30%		28%	39%	34%
81	45%	25%	29%		29%	38%	33%
82	48%	24%	29%		30%	37%	33%
83	50%	22%	28%		31%	36%	33%
84	52%	21%	27%		32%	36%	32%
85	55%	20%	26%		33%	35%	32%
86	57%	18%	25%		34%	34%	32%
87	60%	17%	23%		35%	33%	31%
88	62%	16%	22%		36%	33%	31%
89	65%	15%	20%		37%	32%	31%
90	67%	14%	19%		39%	31%	30%
91	69%	13%	17%		40%	31%	30%
92	72%	13%	16%		41%	30%	29%
93	73%	12%	15%		42%	29%	29%
94	75%	11%	14%		43%	29%	28%
95	77%	11%	12%		44%	28%	28%
96	78%	10%	12%		45%	28%	27%
97	79%	9%	11%		46%	27%	27%
98	80%	9%	11%		47%	26%	26%
99	82%	8%	10%		48%	26%	26%
100	83%	8%	10%		49%	25%	25%
101	84%	7%	9%		50%	25%	25%
102	85%	7%	9%		51%	25%	24%
103	85%	7%	8%		52%	24%	24%
104	86%	6%	8%		53%	24%	24%
105	87%	6%	7%		54%	23%	23%

Observations

As is clear from the table above :

• Already at the start the start of the annuity, at age 65, 16% of the yearly payment is due to mortality risk sharing and 'only'  51% is related to the 'return'.
• As a pension member continues to live, the  'mortality share' of the annual payment increases. At the age of 83 already 50% of his annuity is due to mortality effects and the 'return share'  is already down to 22%.
• As from age 77 of, the 'mortality effect' on the annual payment exceeds the 'return effect'.
  
  

Conclusion

From some simple calculations, we can conclude that longevity (mortality) solidarity is a fundamental part of a life annuity.
 

AfterMath

Make your calculations with other interest rates, ages or life tables with the Pension Calculator (Excel).

You may download the pension calculator HERE

Links/Sources

- Solidarity: Sticking together or ..(Google Books, P. de Beer)

- Benefit of collective schemes (IPE)

- HFC: Pension Challenge

- Download the Excel Pension Calculator

Global Country Perspective

Do you find it - just like me - hard to get a clear picture of a country's impact and contribution from global perspective? Here's some help...

GCI
The Global Competitiveness Index (GCI) is a comprehensive tool that measures the microeconomic and macroeconomic foundations of national competitiveness. It is composed of 12 "pillars", or categories.

Competitiveness is the set of institutions, factors and policies that determine the level of productivity of a country taking into account its level of development.

Charts

With the help of the free Tableau (visual) software I've created several charts that give an rough idea of a country's competitiveness an productivity in relation with it's relative global size (% of total world GDP).

The last rectangle chart 'Country GDP world Share' shows in a scaled way the GDP proportions of all 148 measured countries in the world. The color of each rectangle represents the GCI-level of each country (dark red=poor, dark green = splendid).

Remarks

If you look specifically for the Netherlands in the first chart.... Click (or double click) on the word 'Netherlands'. In general, move you mouse across the different circles and rectangles to view more detailed information.

Enjoy!

Source World Economic Forum,

The Global Competitiveness Report 2013-2014

Base period 2013-2014

Learn About Tableau

Test: Rational Thinking in a Crisis

End October 2007 my wife and I were flying from New York to San Diego. Due to an overheated engine our Captain took the one and only right decision: an emergency landing (at Chicago). Thankfully, a successful emergency landing.

Although - for a split second - we were disappointed that we would not arrive at San Diego that night, we immediately realized that our goal was no longer arriving at time, but surviving!

 How do we respond in crises situations? Take the next simple test to find out.

Original Source: Risk & Return

Estimating Bubbles

In a presentation for more than 200 actuaries at 'Actuarieel Podium" (actuarial Platform) on October 2 (2013) (Actuary Day) in the Netherlands, I tested the ability of Dutch actuaries to estimate the number of bubbles in a bottle of champagne.


Take the Test
Test your own bubble estimation ability. Think for a while:

How many bubbles are in a bottle of Champagne?

If you think you've got the right answer, check it by clicking on the picture below...

Conclusion 
If the order of magnitude of your answer was right: Congratulations!
If not, like most actuaries at my presentation, one thing is clear:

As actuaries we fall short in estimating bubbles!!!! (crises)

Key question is: why can't we estimate bubbles?

Short answer: because we have been only professionally trained in estimating relatively small numbers and small risks, not (systemic) crises.

One thing is sure: we need to fix this educational bubble-lack in our professional actuarial training.

Links
- Beekman Wines: Champagne - How Many Bubbles?
- Application of Actuarial Science to Systemic Risk Report (2013)
- Actuarial Viewpoints on and Roles in Systemic Risk Regulation
- Actuarieel Podium (Dutch)

Aftermath
49 Million Bubbles in a bottle of champagne may seem much, it's nothing compared to the U.S. Debt:



Learn more (in Dutch) on how we can do better as actuaries in the next presentation: 'From Backroom to Boardroom' (in Dutch) by Jos Berkemeijer

From Backroom to Boardroom (Dutch) from Jos Berkemeijer

7 Principles of an Effective Capital Adequacy Process

The Federal Reserve Bank not only fights inflation, but also unmanaged risk and  systemic risk.

Recently the FED  announced seven new Capital Adequacy Process (CAP) Principles for complex bank holding companies (BHCs).

Although these principles only intend to effect BHC's with a consolidated assets of $50 billion or more, they are in fact a simple and adequate guideline for any Financial Institution (FI) that takes risk management and its stakeholders seriously.

The new principles emphasize that managers, risk managers and actuaries not only have to focus on technical risk, but also on the implementation of a sound risk framework, including an effective risk control and a transparent risk governance.

Here are the Seven Principles of an Effective Capital Adequacy Process:

1. Sound foundational risk management
   The FI has a sound risk-measurement and risk-management infrastructure that supports the identification, measurement, assessment, and control of all material risks arising from its exposures and business activities.
    
2. Effective loss-estimation methodologies
   The FI has effective processes for translating risk measures into estimates of potential losses over a range of stressful scenarios and environments and for aggregating those estimated losses across the FI.
    
3. Solid resource-estimation methodologies
   The FI has a clear definition of available capital resources and an effective process for estimating available capital resources (including any projected revenues) over the same range of stressful scenarios and environments used for estimating losses.
    
4. Sufficient capital adequacy impact assessment
   The FI has processes for bringing together estimates of losses and capital resources to assess the combined impact on capital adequacy in relation to the FI's stated goals for the level and composition of capital.
    
5. Comprehensive capital policy and capital planning
   The FI has a comprehensive capital policy and robust capital planning practices for establishing capital goals, determining appropriate capital levels and composition of capital, making decisions about capital actions, and maintaining capital contingency plans.
    
6. Robust internal controls
   The FI has robust internal controls governing capital adequacy process components, including policies and procedures; change control; model validation and independent review; comprehensive documentation; and review by internal audit.
    
7. Effective governance
   The FI has effective board and senior management oversight of the CAP, including periodic review of the FI's risk infrastructure and loss- and resource-estimation methodologies; evaluation of capital goals; assessment of the appropriateness of stressful scenarios considered; regular review of any limitations and uncertainties in all aspects of the CAP; and approval of capital decisions.

ORSA for European Insurers
A lot of the above mentioned principles are embedded in the 'Own Risk and Solvency Assessment' (ORSA) for European Insurers  as part of Solvency II regulation:

Implementing ORSA
It's our dedicated mission as actuaries to guide management on the implementation of ORSA or any other risk implementation program. And yes... it won't be easy.....

Links & Sources

- FED's 7 Principles Publication

- Solvency II & ORSA

- Dilbert & Risk

Actuarial Cookery in the Boardroom

Suppose your friend gave you the recipe for a delicious 'Paleo Tomato Soup'.

Does that recipe also guarantees you a delicious meal ?

Undoubtedly you answered this question with a clear "no".

Why?

As we all know, it is the 'touch of the chef' that determines the quality and final taste of the meal. The recipe is the score and the chef the performer of the culinary piece of music, that will end up on your plate.

Although the above example probably sounds logical to us, the actuarial cooking practice appears different. Let's take a look at the next example.

An Excellent ALM Advice

What about a 'plate of five' asset mix advice that's on the board's breakfast table, as the ultimate outcome of your excellent ALM analysis...

Illustration: Colin Daniel

Does this ' computer recipe' actually guarantees a sound decision about an adequate investment policy?

Actually, the answer to this question can hardly be other than 'NO'.

Your advice is a static advice in a dynamic world and - on top of - the final question remains whether the asset manager is able to 'spice up' your recipe.

The actuary as Risk-Director

Key question is whether we as a profession - keeping ourselves inadvertent in the role of  'technical experts' - merely feel responsible for delivering the recipe for a cold asset mix salad on basis of 'expected values' ​​and variances.

Or ... that we actuaries are willing to act as 'risk-director' in the interactive process of creating a dynamic investment policy that's based on a nonlinear constructed healthy and varied based asset mix over time. Albeit..., without taking the driver's seat in the advice process, but with the obligation to report the eventual existence of any GMCs ('Genetically-Modified Cickens') in the asset-mix.

Economic Risk Management or ALM?

In the thorough process of adopting a dynamic investment policy, financial boards more and more take decisions based on the study of different future economic scenarios.

This development challenges actuaries to invest more in the development of "Economic Risk Management" (ECRM) models instead of traditional ALM modeling. In ECRM 'asset class data' (as in ALM) and economic data (GDP, inflation, consumer confidence, etc) are mixed in an integral set of data, that's analysed and - with future expectations, 'stress-test conditions' or of 'believes' -  (nonlinear) translated and optimized in a dynamic asset mix.

This economic risk approach requires new nonlinear economic-asset models that urge for a close cooperation between economists and actuaries, resulting in an serious interactive board discussion (board members and economical & actuarial experts) of the ECRM models.

This approach is not limited to the well-known three or four so-called 'muddle through scenarios', but covers the outcome and impact of a large number of more precise formulated possible economic scenarios on the asset mix and the investment strategy.

Scenarios that help determine the overall risk appetite and result in a major impact on the composition of the strategic asset mix.

New Q&A's

In other words, new scenarios that give answers to questions like:

• What happens if China suddenly withdraws from U.S. bonds?
• What happens when the U.S. Fed stops its QE program?

As with the current ALM approach, the focus should not be only on the quantitative outcome of the ECRM model, but more on the discussion and wider perception of how economic risk affects the optimal asset mix and the dynamic asset policy, allowing boards to take more informed and underpinned investment policy decisions.

In this approach, ALM and ECRM are helpful but not dominating decision support tools in the creation of the final investment policy and not an unintended consultant's dictate that's implicitly adopted ("take note") by the board and then subsequently implemented.

How to Check the Quality of your ALM or ECRM Advice?

Fortunately, it is easy to check whether your ECRM or ALM advice is actually a good quality decision document or just a bite-sized chunk.

If your advice offered only 'one option' or was adopted without a serious debate or any amendments, then -  to put it euphemistically - your advice is 'ready for improvement'.

Actuaries: Backroom to the Boardroom

Finally, it all comes down together whether we as actuaries want to profile ourselves as 'recipe writers' or pick up the 'risk-director role' as an 'actuarial chef'. If you choose the latter, please stand up and help to bring out actuaries from the Backroom to the Boardroom. Success!

Pension Egg Choice

Imagine you're a new pension fund member and your pension fund offers you the next simple proposal regarding your future pension income.

With closed eyes you are allowed to take out two 'pension eggs', either from nest I or nest II. Which nest do you choose?

Think about this proposal and remember: your complete financial old age depends solely on the nest of your choice.

I discussed the above dilemma  last week (august 2013) in a presentation with an across-section of Dutch pension representatives. This dilemma illustrates in a simple way the precarious choice Dutch pension funds and their members have to make in deciding between a traditional Nominal Pension with conditional CPI-indexation (nest I) and a fully CPI-indexed 'Real' Pension (nest II).

Key point is that to achieve a higher Real Pension, you have to put your Nominal Pension 'at risk'.

And who is consciously willing to put 'future income' substantial  at risk?

As 'pension income' is in fact 'deferred income', there's also a kind of implicit understanding that your future retirement income security should be 'in line' with your actual income security and not substantial lower.

Retirement Income Security  ≈ Actual Income Security ?

No wonder that all of the 23 attendees at my presentation chose Nest I (Nominal + Indexation) as favorite.

Remark

After the meeting one of the attendees stated that the '10'-valued egg in Nest II should have been valued at at least a value of 20 or higher to create an equal or higher average expectation, as higher risk would implicate also higher return.

I positively smiled for a moment... told him that his remark (and many others that followed) was formally right and suggested that he would test the 'Pension Egg Choice' in his pension board, including an extra voting with an 20-valued egg instead of a 10-valued egg. A day later he called me back and told me the extra voting didn't substantial change the voting outcome.......

Remember that more risk doesn't automatically imply more return. If volatility (risk) increases without a well-argued expected increase in 'average return', the 'compound average return' will (even) decrease with half of its variance.

Worldwide Pension Funds Alert

Not only Dutch pension funds face the Pension Egg Dilemma, but in fact all pension funds worldwide do. To fund their pension liabilities they have to make average returns of more than 5%, 6% or even 7% for more than 50 years on a row or more. And to achieve those kind of return levels with a (nominal) risk free rate and a treasury bill outlook, both varying between 2 to 3.5 percent, implies that they'll have to invest in risky asset classes.

As a consequence the ultimate pension outcome could be lower than on basis of a risk free approach that guarantees a nominal pension. In other words: your Nominal pension is at risk.

Example

To illustrate what is happening, let's look at a 30 year old Dutch pension fund member (Tom) with an retirement age of 65.

The pension fund (theoretically) offers Tom the next options. Tom values these options on basis of a 20 year period:

1. Option 1
   Tom's contribution is invested in totally risk free assets at 3% (orange line), resulting in a sure (€,$,£,¥)  10000 yearly pension
    
2. Option 2
   Tom's contribution is invested in 30% risk free and 70% risky assets (purple line), resulting in a 25.9% (100%-74.1%) change of an outcome below his yearly 10000 (nominal) pension, but also an almost 50% probability of a pension of around 23904 or more.
   
   Looking closer at the downside, there's also a 10% probability of ending up with a negative return, corresponding with a yearly pension of 4255 a year or less.

However, Tom suddenly realizes the limitations of a linear model approach. If the 'risk free asset part' of his investment  is really completely independent (can't be dragged down) from the risky part and also insensitive to market conditions, there's a downside risk limitation.  A 30% really 'completely market valued risk free' would in Tom's case  imply a total minimal guaranteed portfolio return of nearly 1% (30% of 3% = 0.9% ≈ 1%) , corresponding with a minimal yearly pension benefit level of around 5645.

In case of 70% risk free investment approach (green line), the downside return risk would be limited to a minimal 2.1% return corresponding with a minimal pension of around 7506, approximately 75% of Tom's nominal pension target.

This 70% risk free approach could be quite acceptable for Tom, as he realizes there'll be no extra return without taking extra risk...

Nevertheless..., pension fund life and its member's choices ain't easy. So Tom asks the pension fund's actuary what his pension outcome would be on a 50 year evaluation basis.... here it is

Now Tom's risk of ending up with a yearly pension outcome of 10000 or less has decreased to a 15.3% (100-84.7). Tom could decrease this downside risk further to 8.6% by choosing a less risky asset mix of 70% risk free and 30% risky assets. However, this drops his upside potential. On average (50%) his pension outlook of around 23904 will drop to a little less than 17850.

Now Tom fully starts to grasp the impact of long term return assumptions...  After all, is assuming a 6% or 7% 50-year return not way to optimistic?

Your own Pension Confidence Level Calculator

As shown in the examples above the key questions are i.a. :

1. How much of your guaranteed* nominal pension P are you willing to risk to end up with a higher pension P+U
2. How much uncertainty (100% - confidence) are you willing to accept that your pension is lower than a certain amount?
3. What's the real (nonlinear) downside risk of my pension?

To find the answers to these kind of questions and to calculate your own pension perspective, you may download the

Pension Confidence Level Calculator

in Excel.

With the Pension Confidence Level Calculator you may calculate your pension confidence with all kind of asset mixes, co-variances, (pension) ages and several user definable life tables.

Remember the calculations are only illustrative and indicative approximations, to be used for instructional purposes. Ask your pension fund to make a more detailed and personal calculation.

Next

Now that you've experienced that most pension funds need an ambitious return that may put your nominal pension at risk, the question is what to do?

Main problem is that pension funds do not act in this alarming situation. As a kind of sitting duck they play a kind of 'waiting game' in the hope that bond yields and other markets recover.

Meanwhile you could at least do something to get the fuzzy pension picture clear. Simply follow this Cookbook :

Pension Fund Restructure Cookbook

1. Your Retirement Income is not a one point estimate, so ask your pension fund's actuary:
• to calculate what future average return rate is needed to (100%) fund the liabilities, given the actual market value of the assets of the pension fund
• to calculate (estimate) your future pension at different constant future return rates
• to estimate the probability level of achieving each future return rate or more (confidence level) for the rest of your life, in accordance with the applied actuarial models
2. Next, ask your actuary to formulate his advised investment risk approach in line with the Pension Eggs presentation as presented in this blog, but now with more nests.
3. Now let your board and pension members determine their risk appetite by voting which nest they choose
4. Finally, let the actuary in cooperation with the investment advisory committee, propose an 'investment strategy' that is completely in line with the new defined risk appetite 
5. Take a decision to (phase-wise) implement this new investment strategy.

Result

Perhaps the outcome of the above exercise will be a lower pension than you expected, but:

• probably not as low as you would have got if you kept on gambling on uncertain high returns 
• and certainly not lower than what you need and define as a decent minimum pension income 

Anyhow, enjoy the Pension Confidence Level Calculator....

Links/Downloads

- Download the Pension Confidence Level Calculator

- Long-range confidence interval projections and probability estimates

- Portfolio-optimization by the mean-variance-approach

- 'Employee Retirement Income Security Act - ERISA'