Pension Fund Market Valuation ParaDox

Is Market Valuation (MV) the right tool for pension funds?

Mid 2009, the new appointed ABP chairman Nijpels and - previously - the ABP CFO ten Damme (picture on the right), stated that the relatively new method of MV is inadequate for pension funds.

Both think that valuation of pension funds could be better based on a (seven year) moving average interest rate.
Nijpels en Ten Damme are supported in their view by Albert Röell, Chairman of KAS BANK, who advises the Dutch regulator DNB to reassess its policy.

Nevertheless DNB doesn't seem to respond.
Neither Roëll nor the world's third-biggest pension fund gets an answer. Is ABP crying over spilt milk?

Why MV?
At first sight, there seems nothing wrong in calculating the value of a pension fund, on MV basis. Market (consistent) valuation implies that the value of an asset or liability is defined by it's market price. If the market is too thin, a mark-to-model approach can be used....

Clearly MV increased the transparency and accountability of pension funds. However, 2008/2009 show that MV, based on the actual term structure of interest rates, leads to excessive volatility in funding ratios.

Is MV the best method?
Of course MV can be a best practice method in helping to define the pension fund value in case of a merger, a takeover or with regard to managing assets. But is MV also the best method for managing the pension fund as a whole, from a board, regulator or 'pension fund member' perspective?

• Future certainty
  The first fundamental question is :
  
  
  can we define the value of long-term
  ( 60 years or more) cash flows at all?
  
  
  The answer is: No, we can't!. Just take a look at an average CFO, who's proud to present his next quarterly company result with 60% certainty. What would be the certainty of the long-term company result of - let's say - 20 years ahead. Exactly: Almost zero.
  
  It's impossible for anyone, no Nostradamus Actuary included, to predict the compound and correlated long term effects of interest rate, stock market, derivates, inflation, salary increases, mortality, disability, longevity and costs. Therefore, if it's not possible....., don't pretent you can.
  
  
• Pension fund: Not for Sale
  Second important subject for consideration is that a pension fund (in general) is not listed on the stock market. Also, in general, it is not for sale on the market. Therefore, the hourly, daily or monthly calculated MV is only of limited interest with regard to the pension fund's strategy, policy or control.
  
  Neither is MV the right base for monthly adjusting of the contribution rates, funding rates or indexation capacity.

Principles
Simply stated, it's important that a pension fund:

1. can meet its obligations "on the long-term"
2. is sufficiently liquid to pay his annuities "on the short-term"

Moving average
The first statement implies that if you take the funding ratio as steering/testing parameter (there are more!), there is - given the mentioned long term uncertainty - no other option than to base the valuation on a more (term dependent) 'moving average' of interest rates in combination with the moving average value development of other asset classes. The choice of the moving average period is critical.

Dead Money
Even more, if the pension fund is forced to act on basis of MV, it has to keep extra (non-volatile) buffers to withstand the possible effects of non-relevant short-term market fluctuations. On top of this many pension funds tried to downplay their indexation ambition.

The consequence of all this is that MV generates a substantial amount of structural "dead" capital into the balance sheet. "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.

Paradoxical measures
In case - due to market developments - the MV goes down , short-term prudential constraints (as enforced or stimulated by the regulator) will moreover endanger the long-term objectives of pension funds. Consequently leading pension funds from the frying-pan into the fire.

There's another interesting aspect that pleads against MV. In general (Dutch) pension funds cannot go bankrupt, as they are allowed to cut back on the participants’ entitlements in extreme (emergency) situations. So the key question is what kind of minimum security level we enforce upon ourselves. Just an example to illustrate this:

Example
What would you prefer:

1. 100% of the yearly pension that you have been promised, on basis of a 125% funding ratio
2. 125% of the yearly pension that you have been originally promised, at a 100% funding ratio target

Remember there is no ultimate warranty whatsoever in either situation.

The only difference is that in scenario A the chance that your entitlements will be cut down is slightly smaller than in scenario B. But this last situation is as hypothetic as it can be, as contributions will be raised first, before any cut down scenarios will be considered.

So its better to use the funding ratio surplus for legalized controlled indexation and pension benefits improvement than as 'dead' money.

A final argument in the war against MV for pension funds is the next illustration .....

ParaDox
Let's take a look at a company called ParaDox.... ParaDox produces parasols (sunshades) for the high season.

In winter, ParaDox produces at full speed in order to achieve a top level inventory at the start of the summer.

In winter, however, hardly any parasols are sold. During this cold season the price of the parasols on the market (in the shops) drops to about 50% of the summer price. Even more, parasols sales go 80% down in winter (cf. long-term investment market).

If ParaDox would apply MV based techniques, it would have to depreciate their current stock to 50% of the (summer)value. Surely ParaDox would go bankrupt. No, every sensible human being, including actuaries, would decide that in this situation it's best to value the stock of ParaDox on basis of the 'moving average' (realized) sales price over one or more recent years.
N.B. Even if ParaDox would have one or two 'bad summers', deprecation would not be considered.

If in this ParaDox case it's clear that market valuation (i.c. deprecation) is unwise, the more it must be clear that in a company with long-term obligations and high uncertainties , like a pension fund is, it's naive to operate and steer on basis of MV.

Moving Average Period
Now that's illustrated that the Moving Average Method (MAM) is preferable above the MV method (MVM) for pension funds, there's still one thing to decide: the 'MAM period'.

If the MAM period is chosen too short, it will suffer the same disadvantages as the MVM.

If it's chosen too long, there's the risk of not being able to adapt fast enough to realistic contribution levels, if needed. In this situation there's also the risk of unintentional intergenerational financial effects. However, these effects can be yearly calculated and translated into a sound policy.

From this perspective it seems reasonable to fix the MAM periode to the average duration of nominal pension liabilities, which is (in The Netherlands) about fifteen years (in real terms, it is even longer).

Hope
Let's trust that DNB listens to ABP and KAS BANK, so that 'pension funds' and 'pension fun' become one again!

Related links:
- P&I/Watson Wyatt World 300 Largest Pension Funds
- Market-consistent valuation of pension liabilities (must read!)

Paradox of Cautiousness

Actuary, Accountant, Supervisor or Consultant, life is full of paradoxes....

Let's examine a very interesting statement made by the respected President of the Dutch Supervisor DNB, Dr. A.H.E.M. Wellink, in a recent interview on Dutch television (2009;Pauw & Witteman, in Dutch):

"If the (economic) growth fall is between minus 1 and minus 2, and I think it is minus 2, I would express myself in a very subtle and nuanced way, by saying:
"I think it's closer to minus 2 than minus 1". And then, if you listen well, you would know it's actually minus 2.
To be sure, we - me and my (supervisory) colleagues - say it in a more cautious way ..."

What can we conclude from this short prodigious statement?

Communication fuzz
What first becomes clear in this statement is that responsible board members of (local) supervisors, due to media attention and unrealistic expectations, are forced to communicate in euphemisms or coded idiom.

As a consequence, professionals as well as the public, can only have a best guess at what the real message could be, with communication fuzz as a result.

President Wellink should be allowed to simply state that what he actually means, in this case:
"I think the economic growth will be around minus 2 percent".

Diferent meaning
Second problem with trying to communicate in a 'cautious' way, is that the word 'cautious' has a different meaning for different stakeholders.

For example: an investment will have a different risk profile for the investor, the asset management company, the company's shareholder or the supervisor. Each of these stakeholders will therefore have their own definition of the word 'cautious'.

As a consequence, last but not least, it is the question whether it's 'cautious' if you state the negative growth higher (less negative) than what you really think it is. Most people in the public domain will probably qualify this statement as incautious.

Paradox
Life of supervisory board members is not easy. They are confronted with a persistent paradox, the Paradox of Cautiousness.

If board members report 'early warnings' they are treated as 'messengers of bad news', accused of market interference or irresponsible actions and launching self fulfilling prophecies. On top of this they may get fired or even be held responsible for the negative financial impact of their statements.

On the other hand, if they don't report their findings public and try to solve the problems in a diplomatic way behind close doors, they may get accused afterwards for not having warned in an earlier phase.

Life is full of risks, not only financial risks, but also the risk of the consequences of (non) communication.

Actuaries
As actuaries, we're often in the same difficult situation as President Wellink. We also have to act cautious, realize our 'cautious' advise regarding the Pension Fund, could implicate an 'incautious' advice for the sponsor or the participants of the pension fund.

Not only actuaries, but also accountants, investors or - in short - everyone who has an advisory or controlling function, have to deal with this 'Paradox of Cautiousness'.


Risk Escalation Management & POP
In most cases the Paradox of Cautiousness can be avoided by proactive Risk management.

If (recalculation of) your Risk Management Models or Scenario's indicate a significant change of risk in the (near) future, immediately take action, propose measures and demand adequate decisions. Don't postpone your actions in order to be sure of the observed changes nor on the advice of friendly 'experienced' stakeholders that tell you with a smile there'll be no problem at all and you're overreacting.

Once you're in the phase where incidentally ad-hoc repair management by the board has failed and serious structural repair management scenario's have to be put on the table, you're too late!

You'll have past the so called point of no return - in this case - the Point of Paradox (POP), you're caught in

The Paradox of Cautiousness

If you put your warnings and proposals in this phase on the table, stakeholders will tell you they felt caught by your actions. Soon board members and other stakeholders will blame you for not having warned them earlier and will question your accountability. Before you realize what's going on, you're in phase three: Crisis management, your head is on the block.

Rules of Thumb
From Wellink's simple example, we may conclude several rules of thumb about being cautious:

• Dimension cautioness
  Never state that you are cautious in general, always dimension cautiousness with regard to the different stakeholders and the type and size of risks.
  
  
• Early stage warning
  In line with "good governance" always try to warn in an early stage, before the Point of Paradox (POP) when things are (about) to move in the wrong direction, but are still manageable. Warn in a transparent way, open and visible to all stakeholders. Arrange a board level discussion and make sure you've got a completely free hand in what and how you put your findings and vision on the table.
  
  
• External Advice
  Make sure that you're allowed (and have budget) to hire external consult whenever you think this is necessary. In case of discussions or decisions that may have substantial financial impact, don't doubt, but hire external legal or financial consult to assist you and to validate your findings.
  
  
• Contract & Access
  Make sure your contract includes conditions that prevent your employer from firing you during your report findings period and make sure you have (formal) access to any (supervisory) board member when you think this is opportune.

After this heavy stuff, let's conclude with a nice parable...

Parable of the Cautious Actuary
There was a very cautious actuary,
who never laughed or cried.
He never risked, he never lost,
he never won nor tried.
And when he one day passed away,
his insurance was denied,
For since he never really lived,
they claimed he never died.
- Unknown -