Pension Fund Gambling

The essence of a DB pension fund's risk strategy can be captured in a single graph:

Key issue is that the portfolio duration of a DB-plan's Liabilities varies between 12 and 14 years, whereas the duration of the DB plan’s Assets is generally much shorter, 4.5 to 5 years (Moore 2007).

Secondly, 2008, 2009 and 2010 have proven that investment statistics and models have failed. Sustainable models are nearby dead.

All this implies that, despite all (developed) models, risk strategies, derivatives and experts, ultimately, a Pension Board has to take a decision without a reasonable amount of certainty. In other words they have to gamble.... And to brighten up your day, it's your responsibility as an actuary to advice this pension board!

Read more about this fundamental pension challenge in:

The Prudent Man Standard

Legal and Investing Implications of LDI Safeguards for Pension Risk

Links:
-Public Pension Funds Gamble With Risky Investments
-The Prudent Man Standard

How Defined Benefit Plans work(ed)

Pension plans suffer, from a rare disease....

UK
According to IPE more than 90% of UK Defined Benefit (DB) schemes are underfunded. The aggregate funding position of almost 7,800 schemes reported a deficit of £218.7bn at the end of February 2009.

NL
The situation in the Netherlands is hardly better.Figures from the Dutch regulator,DNB, show around half of the country’s 650+ pension schemes are under-funded. The Dutch government has extended the recovery period for pension funds from three to five years. The main question is: "Is that long enough?"

How Defined Benefit Plans work(ed)


Pension funds, especially DB schemes, have to face that their worst dreams, a complete doom scenario, is becoming true :

• First the subprime market collapsed
• Then, as trust broke down, the stock market went down as well
  
• On top of that Interest rates dropped dramatically

Titanic lessons
Just like the 'unsinkable' Titanic was protected by compartments, we had protected our pension schemes with diversification. And just like the Titanic, we actuaries, asset managers, and quants made a fundamental mistake. We underestimated the correlation between the different compartments (bonds, subprimes, stocks). One hit in the vital front compartment was enough to draw our pension dreams to the bottom of the ocean.

Optimistic view
But let's not stay pessimistic.

Do you know how long it took the market to recover after 1929? .....

ONLY 25 YEARS!

Global Investment Returns Yearbook 2009
And there are more reasons to stay positive about the equity results on the long term, as is shown in the very interesting downloadable Credit Suisse Global Investment Returns Yearbook 2009, that analysis returns from 1900 until the end of 2008.


As this yearbook shows us in more detail, it is only a matter of statistical faith, that equity performance on the long term will recover.

So the only thing we can do is, just like a sick patient: stay cool, rest (don't move), don't panic and wait until trust and the markets recover.

God bless you....

DB plans outperforme DC plans by 1%

Watson Wyatt has been comparing rates of return between defined benefit
(DB) and defined contribution (DC) plans for more than 10 years.¹
This most recent comparison finds that between 1995 and 2006, DB plans
outperformed DC plans by an average of 1 percent per year.



Asset-Weighted Median Rates of Returns
DB and 401(k) Plans — 1995-2006

Year	Number of sponsors	DB plan	401(k) plan	Difference
2006	914	12.90%	11.34%	1.56%
2005	2, 584	7.74%	6.69%	1.05%
2004	2,583	11.81%	9.80%	2.01%
2003	2,514	21.35%	19.68%	1.67%
2002	2,085	-8.56%	-10.93%	2.37%
2001	2,239	-3.78%	-6.07%	2.29%
2000	2,058	-0.01%	-2.76%	2.75%
1999	1,472	13.46%	14.41%	-0.95%
1998	2,958	14.25%	15.29%	-1.04%
1997	2,931	18.82%	19.73%	-0.91%
1996	3,034	14.53%	14.10%	0.43%
1995	3,063	21.10%	19.20%	1.90%
Average		10.30%	9.21%	1.09%

Source