Pension Fund Smoke and Mirrors

Pension Funds are in trouble... How come?

Pension Fund Smoke and Mirrors

Related Link
Funds Stick to 'Unrealistic' Return Assumptions, Threatening Bigger Shortfalls

Coverage Ratio Solution Space

Dutch pension funds are in deep trouble. The average coverage ratio of many pension funds has fallen to a level well below 100% (underfunded). Some major Dutch pension funds with coverage levels around 90%, called Government to dissuade the planned pension rights cuts.

A delay in pension rights cuts seems justifiable. Key question is the reason for this requested delay. For reasons of reformulating new pension policies and ambitions, delay seems reasonable. With the intention to just 'buy time' in order to continue 'desperate hope' that the markets and low returns will recover, further delay could prove catastrophic.

Facing Reality

Pension funds have to cope with several hurricanes at the same time:

1. Relatively low interest rates
2. Underperforming stock market
3. Underestimated longevity risks
4. Need for higher confidence levels

Although low interest rates and underperforming stock markets could continue for several years, on the long term interest rates and stock markets will most likely recover, simply because economic growth imply higher returns on the long term.

Underestimating The Longevity Monster
One of the 'big' (?) surprises seems the recent development in longevity. For decades now, actuaries and researchers are structurally underestimating the effect of longevity.

Maggid's Longevity Forecast
Although longevity has been studied a lot, a decrease of the steady growth of the human lifespan in the coming decades will most likely turn out to be idle hope....

Lessons learned, we actuaries will seriously have to take into account that the linear increase of lifespan probably will continue until at least the age of 90 (Maggid forecast). This implies that we'll have to 'spice up' our mainly retrospective life expectancy models and corresponding forecasts with a healthy portion of common sense.

What about the 'risk free' discount rate?

More actu(ari)al trouble is caused by the fact of the low interest rates and sticky stock markets.
Pension funds face the substantial volatility and the low level of the so called "risk free discount rate" that drives the coverage ratio. Paradoxically we could state:

There's nothing more risky than a  'risk free' discount rate

The - artificial - low level risk free interest rate pulls down the coverage ratio of a pension fund.


At the same time it's necessary to level up the existing 97.5% confidence level of pension funds. A 97.5% confidence level implies that a pension fund will turn into default (underfunding) twice in an average person's lifespan.

Despite the fact that a 'twice in a life meltdown' is probably hard to explain to anyone, new upcoming Solvency demands for pension funds will be inevitable in order to create a level playing field on the financial market. Good governance, common sense and upcoming new regulatory initiatives will therefore certainly urge a higher pension fund confidence level like the 99,5% level in the insurance industry (Solvency II) or the 99,9% level in the banking industry (Basel II) .

Sitting Ducks
As is clear from the above image, successfully financing a pension-fund (portfolio) on the long term at the current ambition level, calls - in general - for high (unrealistic) interest rates. The 'solution space' for achieving the necessary  high coverage ratios that match the (new) capital requirements appears to be very narrow.

Therefore (there is no other way), most pension funds have to take time and redefine their (future) ambition instead of playing 'sitting ducks' and hoping for the best.

Used Sources, Links:

- Dutch life expectation 2010-2060
- Japanese life expectation: 86.5 years
- Dutch life expectation 2010-2060
- Japanese life expectation: 86.5 years
- Dutch - De risico's van het leven (risks of life) ...
- Will Life Expectancy Continue To Increase Or Level Off 

Pension Cut Delay Power

The coverage ratio (=  A / DFB = Assets / Discounted Future Benefits) is probably seen as the most important indicator of the health of a pension fund. Due to fair value accounting, low interest rates and the continuing credit crisis, the average coverage ratio dropped from 150% to  percent to 85-95% in the Netherlands. On basis of the Dutch pension law, Minister Donner and the Dutch Regulator (DNB) are now forcing some (major) pension funds to (unwillingly) cut  pension rights as from January 1, 2011.

Cutting pension rights now is premature

Although it looks certain that some major changes in the Dutch pension system will be necessary in the near future, pension cuts like proposed by DNB and the Dutch minister of Social Affairs seem inappropriate and unwise.

Board members like Dick Sluimers (APG/ABP Pension fund) argue that steering and judging a pension fund solely on basis of a 'day to day' (high volatility) coverage ratio is unprofessional. I would agree with Sluimers that a longer term average coverage ratio would be more appropriate to judge whether  a pension fund is on the right track...

Looking from a pension board captain's perspective: having just one  Coverage Ratio Indicator (CRI) on your pension dashboard is simply not enough to safely navigate your pension ship into the next harbor . Besides the day-to-day CRI and the Average long term CRI, a more dedicated indicator is needed....

Pension-Cut-Delay-Power 
Just like in case of a half full tank it's necessary to know the remaining distance and the the gas mileage of your car, in case of navigating your pension fund in heavy weather (i.c. relatively low coverage rates (70-100%)) it's important to know the the Pension-Cut-Delay-Power (PCDP ) of your pension fund.
The PCDP of a fund can be defined as the approximate maximal number of years that a fund is able to delay a required pension cut rate without ending up with a substantial (P%) higher required pension cut rate afterwards. In (an approximating*) formula:

PCDP = P * DFB / ABP

With:
P = Justifiable extra charge (in %) on top of required pension cut rate after PCDP years in case the coverage ratio is still insufficient at the same level as before.
DFB = Discounted Future Benefits (source : annual report)
ABP = Annual Benefit Payment (source : annual report)

Example: Pension Fund Dutch Metal scheme PME
Coverage Ratio ult. June 2010: CR=95%
From the annual report: DFB= €20bn, ABP= € 1bn
Set (choose) P=10%
Pension cut rate (without delay) as of 2011, suppose : PCR= 5% (=100%-95%)
*) approximating: Mature Pension Fund

Outcome:

Pension-Cut-Delay-Power = PCDP = P * DFB / ABP = 0.1*20/1 = 2 year
Pension cut rate (with 2 year delay) as of 2013: 5.5% (=5%*(1+10%))

Of course, the choice of P an PCR is up to the pension board within the limits set by the regulator.

Conclusion

As is clear from the above example, a two year delay relieves pension fund FME from the burden to put all energy, emotion and costs into an operation with minimal financial effects in the next two years, while at the same time it puts FME in the position to develop a new policy and new models to cope with the new market situation.

It's time for new pension dash board parameters like PCDC.

Actuaries are in the unique position to help pension fund members to regain control. Pick up your responsibility.


Related Links & Sources:
- PF APG (ABP) boss Dick Sluimers on the volatility of coverage ratios (2009)
- Dutch CPB: Who bears the pension loss?
- The great recession. CPB about the credit crisis
- Approximation PCDP Formula

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)