Sylvester: ABP, Cut Pensions?

At the end of 2011, let's take a short view on the madness around cutting pensions.

As a leading example, I'll discuss ABP, a Dutch 240 billion pension fund and one of the largest pension funds in the world.

Being fanatic blog readers and actuaries, you're probably 'in' for a teasing joke on Sylvester or 'New Years Eve'.

As you all know communication is key in the pension business. However, as pension investment results get more volatile and complex (in  time) to explain, communication about pension issues becomes more and more Chinese for ordinary pension members.

The latest threat, cutting pension benefits, urges board members to develop themselves to a kind of  'five-legged sheep' ....  The new 'normal' pension board member is undoubtedly the ideal combination of an actuary, accountant, investment specialist, communication expert, ICT specialist and - on top of - a keen psychologist.

Communication is a Profession
I'll give a short slightly exaggerated demonstration to all pension board members and actuaries of how difficult reading and understanding a well meant pension board message is, to an average pension member.

In order to 'save what can be saved' ABP's Vice-Chair Joop van Lunteren pleads for political help in ABP's 2011 Q3 Press Release.
Besides the question if a press release is indeed the right place for such a call, most pension members will have a hard time to understand what Mr. Van Lunteren wants so rightfully to express. For these pension members Mr. van Lunteren's message is more like Chinese...

ABP's Q3 Results: Cutting Pensions?
Now to more serious business...  Altough ABP's Q3 results are indeed not splendid,

the call for a more long term sustainable valuation system that makes pension funds less dependent upon volatile interest rates makes sense!

Also, there no need for panic (direct cutting measures), as from the 2010 annual report we can find that the annual benefits payments summed up to around € 7.5 billion on a total of assets of around € 240 Billion. If ABP would be allowed to wait for the effects of taken measures en developing markets for another five years, a 10% cutting of benefits would only have an impact of around € 4 to 6 billion on the total assets of around € 240 mln.
More info about Cutting Pension rights on Actuary Info....

Happy Silvester and good luck ABP!


Sources/Links:
- ABP Q3 Press Release
- ABP Annual Report 2010 
- Ming Imperial Fonts

How to prevent cutting pension benefits?

Continuing increase of lifespan, low interest rates and stock market under-performance are the cause of pension fund's funding ratios (FR) falling to a level of underfunding (< 100%).

Sure..., it's questionable whether valuing assets an liabilities at market value is the best way to value a pension fund (after all, a 'run on the pension fund' is not possible!). However, changing a pension fund's 'valuing method' to a more artificial method (e.g. 5 years average risk free discount rate) seems no realistic option to prevent underfunding. It would be perceived as a cosmetic brew and no solution at all for sponsors that have to consolidate pension obligations in their balance sheet.

Left without alternatives, pension funds are forced by law (and the regulator) to take action. There seems to be no other choice, than to 'cut pension rights'....  Or is there?

Conditional Benefits
A quite simple and effective solution is to split up current an future Pension Benefits (PB) in a guaranteed (certain) part PB_certain (99,9% confidence level) and a conditional part PB_conditional .

The Liabilities of the the conditional part L_cond, can be used to act as a Reserve to guarantee the liabilities of the guaranteed pension benefits  L_certain. In this approach all inflation, longevity and investment results are absorbed by the conditional part L_cond.
As a consequence, the funding ratio (FR) of the pension fund gets 'cured'....

Let's see how this turns out for a healthy pension fund without a shortage:

What in fact is happening here, is that we use the cooperational characteristics of a pension fund to finance its own equity (Reserve + L_cond). As no shareholders are involved, all equity is owned by the members of the pension fund, who profit not by means of dividend, but in the form of conditional pension benefits.

Now have a look at that same pension fund with a shortage on basis of conditional pension benefits:

Undoubtedly this 'new pension model' situation looks much better than the old model and certainly better than the pension balance sheet after cutting pension benefits:

Just imagine what 'reforming a pension fund on basis of conditional pension rights' could mean for your pension fund.

When life gets difficult, we have to turn to simple actuarial solutions....

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