Sustainable Discount Rates

Steering pension funds on a 'one point' Coverage Ratio is like trying to proof global warming on a hot summer day...... It's useless.

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:

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:

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 + F_{Cash 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

Pension Fund Development

Pension Funds....What originally started with well-meant intentions, has developed to one of the most complex risk management topics and will end in a nightmare if we don't change our risk management approach drastically and fast.

Pension Fund times have changed
Back in the second half of the twentieth century, Pension Funds were an excellent (HR)-instrument to stabilize employer-employee relationship and keep retention high. Since then, a lot has changed:

• Employees became more flexible and international orientated
• Permanent or Lifetime employment is nowadays no longer key
• Increased social en technical complexity,  supervision, governance, etc., urge for an increasing professional approach.
• Original Pension Fund advantages (economies of scale:cost, funding, risk) are at stake, due to the enormous (rising) costs  (administration, supervision, management [risk, asset, hedging] , funding, etc).

But there's more...  Surreptitiously, like the famous 'boiling frog', the (member) composition of a pension fond has fundamentally changed during the last decades.

Some decades ago, at the start of a Pension Fund, almost all participants where existing employees of the corresponding company (sponsor).  Today, the number of 'current employees' is often overshadowed by the number of 'pensioners' and the - until now - quiet force of  'deferred pensioners' (former employees, that left the company before retirement).

Managing Pension Fund Powers
All Pension Fund concerned parties, the three member-groups as well as the employer (sponsor), have different and sometimes opposite interests with regard to the financial policy of the Pension Fund. The tension between these parties with regard to what's best for the employer, the employees, pensioners and deferred pensioners, will therefore increase as the Pension Fund becomes more mature.

The first step to manage this tension is to redefine Pension Fund Governance in line with the changed balance of power. Skipping this governance step seems not wise, as this will undoubtedly lead to future financial claims of the concerning power-discriminated parties.

The second step is just as important.

Even with the right balanced governance in place, it will be an almost impossible task to manage a Pension Fund if the often implicit 'embedded options' between the defined member groups (including the sponsor) are not proactively recognized, defined, explicated and - above all - financially and organizational managed (settled).

Regain Pension Fund Risk Control

To regain Pension Fund Risk Control, governance principles have be transparently defined and every possible - likely or unlikely - future situation (scenario), has to be identified, described, valued, controlled and managed.

In this approach, a strong segmented, segregated or 'split up' framework, helps to keep oversight at board level and urges to define all possible 'embedded options' as clear as possible and to clear out possible sticky, fuzzy or unspoken arrangements, deals or intentions.

Pension Fund's Objectives

Of course this comprehensive operation makes only sense if the Pension Fund's objectives are (upfront) well defined and if all members agree upon those objectives. Main objectives among others are:

General (financial) PF objectives

• Target Pension Benefit Level and volatility
• Target Contribution Level and volatility

• Target PF Growth Rate and volatility
• Target Risk level and volatility
• Target Coverage Ratio and volatility
• Target Indexation level and volatility
• Target Assets Returns and volatility
• Target Cost Rates and volatility
• Target AL-Mismatch and volatility
• Target Mortality Rates and volatility

FMCs

In so called Financial Member-Contracts (FMCs) has to be defined exactly what the explicit financial consequences are for every Pension Fund Member, each time the actual performance of one of the objectives scores (negative or positive) out of the defined expected 'volatility range' for a certain predefined period.

On top of, these FMCs have to give a clear upfront financial answer to other general or Pension Fund specific developments. Some examples:

• Consequences of a sponsor's default or down- or upgrade.
• Consequences of  possible exit of substantial employers, corporate split up, outsourcing, etc.  (upfront exit conditions, restructure consequences, etc.)
• New upfront entering conditions and principles in case of future take-overs or new employers joining the Pension Fund
• Defining upfront catch-up indexation rules in case the target indexation levels are not met.
• Consequences, principles, methods and guide lines that will be used in case of possible future changes in (pension) legislation, supervisory, governance or value) accounting.

Sponsor Default Risk
Last but not least, let's take a look at an interesting risk element.
One of the most risky and underestimated elements in the Pension Fund's Risk Management Framework is the 'default risk' and correspondent creditworthiness of the sponsor.

The sponsoring employer’s ability to support Pension Fund volatility by providing additional funding if required, is defined in the so called 'Employer Covenant' or 'Corporate Covenant'

Although, with regard to the obligations of the sponsor, legislation  from country to country differs strongly, the Corporate Covenant and more explicitly, the capacity of the sponsoring employer to cover (incidental) losses in the event of poor investment outcomes or the guarantee of incidental or temporary underfunding, is crucial and impacts the valuation of the Pension Fund strongly.


That this 'sponsor default risk' is not negligible, is well illustrated by the next table of Global Corporate Cumulative Average Default Rates by Standard & Poor.

Moreover the importance of the sponsor's default risk is in general essential if you take into account that the majority of companies is rated as BB an B, as is clear from the next 2003 and 2009 Corporate Ratings Distributions by S&P:

Valuing Corporate Covenant

If you're interested....In an excellent article called 'Corporate Covenant and Other Embedded Options in Pension Funds', Theo Kocken explains, how various contingent claims in a pension fund, such as the Corporate Covenant or Conditional Indexation, can be valued with the same techniques that are used to value options on stocks.

However, there's one slight problem.......

Vicious Value Circle
Future IASB proposals will  gradually move towards 'plain fair value' in case of Pension Funds. The new 2010 IASB draft versions make a first step by proposing - as AON calls it - a "third way" (between buffering and mark-to-market in combination with asset smoothing) .

As Pension Funds become more and more mature and the volatility of pension Funds is more and more reflected in the sponsoring employer's balance sheet and P&L, the question of valuing the Pension Fund becomes a kind of vicious circle.

On the one hand the value of the Pension Fund depends on the default risk and credibility of the sponsor. On the other hand the credibility and default risk of the sponsor depends strongly on the volatility of the Pension Fund.

This dependency implies that if either the sponsor or the Pension Fund gets into serious financial trouble, revaluing forces will pull the value of both institutions into a negative spiral towards a default situation, leaving the Corporate Covenant as a paper farce.


It's clear: Risk Management of Pension Funds is challenging and urges actuaries to keep eyes open.


Related links:
- Corporate Covenant and Other Embedded Options in Pension Funds
- Mercer: Assessing Employer Covenant (2009)
- S&P:Global Corporate Average Cumulative Default Rates (1981-2009)
- S&P:Global Short-Term Ratings and Default Analysis (1981-2009)
- AON: IASB Releases Exposure Draft on DB Accounting
- AAA:Pension Accounting and Financial Reporting by Employers