Relationship Confidence Level & Funding Ratio

Dutch Pension funds constantly keep their members informed about the development of the funding ratio. But actually..., what is the confidence level that belongs to a certain funding ratio?

The answer to this question varies greatly by pension fund. To create some sort of insight in the relationship between the Funding Ratio (FR) and confidence level, we will discuss a highly simplified, but certainly realistic example.

Confidence and Equity
The required confidence level for Dutch pension funds is anchored in the Dutch Pension Act (Pensioenwet), at a 97.5 %  level.

Article 132 , paragraph 2 of the Pension Act  states:
A pension fund will set the regulatory own funds so that the probability of the pension fund having 
less assets at its disposal than the amount of the Technical Facilities (TF) within a year is reduced to 97 1/2 %

Funding ratio
Under the Dutch Pension Act, the required one-year confidence level of 97.5 % is directly related to the Regulatory Own Funds (ROF) and thus to the Required Funding Ratio (RFR). In a simplified formula stated: RFR = (ROF + TF) / TF.

At higher funding ratios than the RFR, the actual confidence level will be more than 97.5 % and vice versa: if the actual funding ratio is lower than the RFR, the corresponding confidence level will be less than 97.5%.

In practice, calculations show that the required funding ratio of most Dutch pension funds has an outcome somewhere between 120% and 130% .

Funding Ratio and Investment Risk
The fluctuation of the funding ratio depends largely on the investment risk that a pension fund is willing to take. Netherland's largest pension fund, ABP, adopted an investment policy that aims at roughly 40% fixed income and 60% equities. This policy resulted in the next yield and 5-year backward moving annual volatility (risk) :

The average ABP annual return over the past 5 years was about 5 % with a volatility of 15.9%.

Volatility Funding Ratio

The volatility of the funding ratio depends not only on the volatility of investments, but also on the volatility of the discounted liabilities. In the Netherlands, liabilities are discounted at a risk-free rate, with help of the so-called 'ultimate forward rate' (UFR).

On balance, the ABP's annual funding level volatility over the past 10 years turns out to be approximately 17 % .

This percentage has the same order of magnitude as the annual funding level volatility of an average pension fund in the Netherlands .

As the funding volatility has the same order of magnitude as the investment volatility, we may conclude that the confidence level that corresponds to a certain funding ratio is mainly determined by the investment risk .

To get sight at the 'one year confidence level' for various funding levels, please take a look at the the next chart that's based on a highly simplified approach. We do not seek exactness, but want to get an impression of the confidence sensitivity. Therefore, we abstract from the additional volatility effects that may arise from other risks (like liabilities and expenses ). The calculation is performed for two different risk strategies of a pension fund :

1. The 'current risky' investment strategy with an expected investment volatility of 15 %
2. A 'risk-averse' investment strategy with an expected investment volatility of 4%

Here are the results :

On the basis of graph above a first serie of important conclusions can be drawn:

• A 100% funding ratio corresponds with a 50% confidence level
• If the funding ratio exceeds 100%, the 'current risky' investment strategy results - as expected - in a lower confidence level than a risk-averse strategy.
• Although perhaps at first sight surprising, the reverse is also true:
  If the funding ratio falls to a level less than 100% , a risky investment strategy results in a higher confidence level than the 'risk-averse' investment strategy. And this is exactly the situation in which a number of Dutch pension funds, but also many foreign pension funds, are in.

To draw some more specific conclusions, we zoom in on the graph:

Now, a second set of interesting conclusions becomes visible:

• Required Funding Ratio
  The 'current risky' investment strategy of Dutch pension funds in combination with the legally required confidence level of 97.5 %, urges a funding ratio of about 130 %.  In a risk-averse strategy the required funding ratio would be somewhere around 110 % .
   
• Actual Confidence Level
  A legally required confidence level of 97.5% with a funding ratio of 110% for a risk-averse fund would result in an actual confidence level of about 75% in case of a risky investment strategy .
  As most Dutch pension funds have adopted a risky investment strategy, the actual average confidence level is about 75% in case of a 110% funding ratio and about 50% in the case of a 100% funding ratio.
   
• Maximum Confidence Level Decline?
  There's a maximum decline of 24% in confidence level in case of a transition from a risk-averse to a risky investment. The maximum decline corresponds with a funding ratio of approximately 108%.
   
• Indexation Potential?
  The current average funding ratio of Dutch pension funds fluctuates around 100%. This implies that as far as future actual annual returns result in an excess return above the required return on liabilities, this so-called 'excess-return' should first be used to achieve the required funding ratio of about 130%.  In most cases this leaves no room for indexation in the coming 10 years.
   
• Partial Indexation?
  It's quite common to apply 'partial indexation', above a 105% funding ratio. However, if the actual funding ratio is still below the minimum required confidence level (of 130%), "partial indexation" lowers the funding ratio and diminishes the recovery-rate. In this case, the (partial) indexation policy should be tested for feasibility. The expected return minus the (future expected) indexation and minus the required return on liabilities, should be sufficient to grow to the required funding ratio of 130% within the statutory recovery period of 10 years .

Solvency II to pension funds ?
Finally, we zoom in on the possible introduction (IORP legislation) of a required 99.5% confidence level, as is valid for insurers under Solvency-II:

A final set of key conclusions now becomes visible :

• Solvency II
  Increasing the current confidence level of 97.5 % (Pensions) to 99.5% (Solvency II ) implies an increase of the required funding ratio from 110% to about 113% for risk-averse pension funds and an increase from 129% to 139%  for pension funds with a (current) risky investment policy.
   
• Unrealistic Solvency-II Growth Path
  Based on the current average funding ratio of around 100%, pension funds should be able to climb to a funding ratio of around 139% within a (statutory limited) 10 years period to reach a Solvency-II confidence level of 99,5%. I think most of us will agree that this is a complete unrealistic scenario. In this case pension funds will ultimately be forced (by the regulator) to de-risk their investment portfolio. De-risking will result in lower (expected) returns and further loss of indexation potential.  Implementing Solvency-II requirements will turn pension funds into 'nominal pension insurers'.
   
• Basel
  Confidence levels in the financial markets seem to know no end. If, in the long term, the confidence level requirement of 99.9 % ( Basel banking regulations requirement) should become obligatory for pension funds, things would really get out of hand. In this case, the funding ratio requirement would increase further to 116 % ( risk-averse strategy ) or even 147 % ( risky strategy).
   

Reflection
The question is whether it's wise to judge pension funds with long term liability structures and corresponding investment policies, on basis of a one-year 97,5% confidence level. It would probably be more realistic and practical to scale up to a 99.5 % confidence level on basis of a 5 or 10-years period:

Illustration: In case of a portfolio with a 15% risky investment strategy, the 5-year average 99.5 % confidence level would lead to a required funding ratio of 118 % .

Conclusions
Based on the global approach above, the following conclusions can be drawn:

• The actual confidence level of Dutch pension funds is far below the (statutory) required confidence level of 97.5 %. For pension funds with a risky (= 15% volatility) investment strategy and a funding ratio between 100% and 110%, the actual confidence level varies from 50% (at a 100 % funding ratio) to 75%  (at a 110 % funding ratio).
   
• There's only very limited indexation potential for pension funds with a funding ratio between 100% and 130 %, due to the obligation to grow the actual funding ratio (with priority) to the statutory required level (130%).
   
• Introduction of an IORP risk framework based on a Solvency-II confidence level of 99.5% would imply that pension funds are forced to de-risk their portfolio. De-risking will result in lower (expected) returns and further loss of indexation potential. Implementing Solvency-II requirements will turn pension funds into 'nominal pension insurers'.
    
• Due to their long-term obligations and corresponding investment strategies, pension funds can be more adequately controlled and steered on basis of a five-year average 99.5 % confidence level, instead of the actual one-year 97.5% confidence level.

Blog-Disclaimer
The calculations and conclusions in this blog are very rough approximations which by definition do not apply to an individual pension fund and are only intended for discussion purposes. Please consult your own pension fund if you are interested in the confidence level results regarding your own pension fund. In this case don't forget to ask your pension fund to report according the template style of this blog!

Aftermath: International Funding Ratios Comparison
The funding ratio's and mentioned statutory requirements in this blog are based on the actual situation in the Netherlands. Funding ratio's in other countries vary considerably!

In an excellent rare Netspar thesis  (2010) the diverse funding ratios of public sector pension funds are compared regarding three kinds of Methods:

1. Reported Ratio: Funding ratios officially reported by each scheme.
2. Fair Value: This method, inspired by Dutch plans, uses a market discount rate to account for pension liabilities. Dutch pension industry refers discount rates to nominal swap rates since the market of government bonds is not deep enough for the industry. 30-year nominal swap rate, which roughly has the same duration of 15 years as a typical pension fund, is used as the market discount rate for nominal liabilities
3. Expected Return: This (actuarial) method, following the U.S. practice, is based on an assumed discount rate of 8% which reflects the American’s expectation of annualized long term pension asset return.

Here are the results:

For example: if you would like to compare the Netherlands with the US on basis of Fair Value (the Dutch mandatory method), the funding ratio of the US would be 31% compared to around 90% in the Netherlands. Please keep this in mind if you examine the above charts in this blog!

But let's stay optimistic about US pension funds, the funding ratio ofl US corporate plan's is already rising!

US Pension Fund Fitness Tracker

Find out what your actual pension confidence level is!!!


Used Links & Sources
- Dutch Pension Act (in English)
- Advisory Report of the UFR Committee
- A fixed UFR, a costly mistake?
- Long duration bond benchmarks for U.S. corporate pension plans
 - Netspar Thesis (2010): What Explains the Diverse Funding Ratios..
- US Pension Fund Fitness Tracker

Why Life Cycle Funds are Second Best

Life Cycle Funds (LCFs) are seen as the ideal solution for pension planning. Unfortunately they aren't..... They're Second Best....

Pension Funds solutions (PFs), are far more superior to LCFs, as will be shown in this blog with regard to the performance of a pension plan.

Life Cycle

A Life Cycle approach presumes that, while your young and still have a long time before retirement, you can risk to invest more than an average pension fund in risky assets like stocks, with an assumed higher long term return than bonds,

As you come closer to the retirement age, you'll have to be more careful and decrease your stock portfolio incrementally to zero in favor of (assumed) more solid fixed income asset classes like government bonds.

A well known classic life cycle investment scheme is "100-Age", where the investment in stocks depends on your age. Percentage stocks = 100 -  actual age.
E.g.: If you're 30 years old, your portfolio consists of 70% stocks and 30% bonds.

Here's what the average return of a life cycle '100-Age' investment looks like when you start your pension plan at the age of 30 and assume a long term 7% average yearly return on stocks and 4% on bonds.
The return of this life cycle fund is compared to a pension fund with continuously 50% in stocks.

Key question is however, is the younger generation also risk minded and the older generation risk averse?

As often in life and also in this case, what would be logical to expect, turns out just to be a little bit more complicated in practice....

Misunderstanding:Younger people have a high risk attitude
Research by Bonsang (et al.; 2011) of the University of Maastricht and Netspar shows that on average 25% of the 50+ generation is willing to take risk.

 The research report shows evidence  that  the  change  in  risk  attitude  at  older age  is driven by 'cognitive decline'.  About 40 to 50% of the change in risk attitude can be attributed to cognitive aging.

Unfortunately other recent research also shows that only 30% of people under age 35 say they're willing to take substantial or above-average risks in their portfolios (source:Investment Company Institute).

This implies that -  although they would theoretically be better of on the long run - younger people will certainly not put all their eggs in one basket, by investing all or most of their money in stocks.

Pension Fund Investment Horizon
In contrast to individual pension member investors, a pension fund has a long term perspective of more than 20-50 years as new members (employees) keep joining the pension fund in the future. Therefore a pension fund can keep its strategic allocation in stocks relatively constant over time instead of decreasing it.

This implies that a pension fund on the long term has an advantage (longer horizon) above a life cycle fund. Let's try to find the order of magnitude of this difference.


Comparing a Life Cycle fund with a Pension Fund
First of all, we have to take into account that younger people will not over invest in stocks.

Let's assume:

• A 30 year old 'pension plan starter', retiring at age 65
• Contribution level   (€, $, £, ¥,): 1000 a year
• A long term 7% average yearly return on stocks and 4% on bonds
• Life Cycle Investment scheme
  A modest 50% stocks, with a yearly 2% decrease as  from age 50
• Pension Fund Investment Scheme
  A constant 50% investment in stocks (and 50% in bonds)
• Inflation 3%, Pension and Contribution indexation: 3%

 This leads to the next yearly return of these portfolios, as follows:

To find out the overall difference in return between LCF en PFS, we calculate the Return on Investments (ROI) of both investment schemes with help of the:

Pension Calculator

The outcome looks like this:

As you can see the ROI outcomes (left axis) on the investments (yearly contribution) from 'dying age' 65 to age 69 are negative as the cumulative payed pensions (compared to your contribution) didn't (yet) result in a positive balance. Or to put it in another way, if you die between age 65 and 69, you died too early to have a positive return on your paid contribution.

Overperformance
The right axis shows the difference between the LC ROIs and the PF ROIs.
As you may notice,  the pension fund has a structural yearly overperformance of more than 0.3%  and an average overperformance between 0.4% and 0.5% per year.

Overperformance expressed in pension benefits
Expressed in terms of yearly pensions the differences are as follows:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	11673	83%
LC '100-Age'	12304	93%
PF 50% stocks	13172	100%

For a 40 year old pension plan starter, the differences are:

Investment Scheme	Pension at 65	Relative
LC 55year -2% p/y	5359	82%
LC '100-Age'	5578	92%
PF 50% stocks	6040	100%

Conclusion

Investing in life cycle funds ends up in a 7% to 18% lower pension than investing in a pension fund with 50% investment in stocks.


So..., Be wise and choose a pension fund for your investment if you can!


Aftermath
Of course, every pension vehicle has its pros and cons ... So do Life Cycle AND Pension Funds.....

Related Links/Sources
- CNNMoney:The young and the riskless shun the market (2011)
- Cognitive Aging and Risk Attitude (2011)
- America’s Comm. to Ret.Security: Investor Attitudes and Action (2012) 
-  “Saving/investing over the life cycle and the role of pension funds” (2007)
- Excel Pension Calculator Blog
- Benny AND Boone Comic Strips
- Study: Public employee pensions a bargain (2011)

Excel Pension Calculator

Why isn't there just a simple pension Excel calculator on the internet, so I can do my own pension planning?

Well..., from now on there is!

Simply download the Excel Pension Calculator (allow macro's !!) and get an idea of how much you'll have to invest to end up with the pension benefit level of your dreams.... or less... ;-)

Or..., just fill in how much you can afford to invest monthly and see for yourself what pension benefit level is within reach, based on expected return rates, investment methods and inflation.

Just to give a small visual impression of the calculator...

Press on 'Calc' buttons to calculate the variable to the left, while leaving all other variables constant.

Graphics

Also some modest graphics are available. A small example....

Take a look at the next graph that shows how your yearly pension is yearly  funded by:

1. the yearly desavings (= dissavings) from your saving account
2. the yearly addition from the pension fund (= estimated savings of pension fund members that will die in this year)
3. the yearly return on your saving account

Notice the immense impact of the (yearly increasing) addition of your pension fund (= savings of the active members who are expected to die in a particular year and contribute to the savings of your account) compared to the other components (desavings and returns).

Options

The calculator offers several interesting options:

• Set the calculator to 'Saving Account' instead of 'Pension Fund' to notice the difference in outcomes between these two systems.
• Switch to the life table of your choice (p.e.  the country where you live)
• Set and name your own personal Life Table or Investment Scheme
• Simulate longevity effects by manipulating the Life Table Age Correction field

The Excel Pension Calculator has much more features. More than I can handle in this blog. Just download the calculator and play with it to really touch base and to learn what pension is all about....

- Download the Excel Pension Calculator

Enjoy!

Disclaimer: This pension Calculator is just for demonstration purposes. The accuracy of the calculations of this calculator is not guaranteed nor is its applicability to your individual circumstances. You should always obtain personal advice from qualified professionals. Also take notice of the disclaimer in the Excel Pension Calculator.

P.S. I : On request a Quick Start tip

1. Download Calculator and open Excel Spreadsheet

2. Don't forget to"Enable Macros" !! 
3. Enable iterative calculation; Set Max. Iterations=1000, Max. Change=0.4

3. Change 'Start Age  Contribution' to your actual age

4. Notice that the amount 'Saving Surplus at age 120:' changes

5. Press the 'Calc' button next to 'Contribution' to calculate your Contribution

6. Or, Press the 'Calc' button next to 'Pension'  to calculate your yearly pension

7. Set any other Field as you like and press any of the 'Calc' Buttons   

P.S. II : New update, version 2012.2 on April 4,  including a single premium option.
P.S. III: New update, version 2012.3 on April 20, drop down menus (under Excel-2010) now also operate under Excel-2007 versions...

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

Humor: Actuary Scrooge

Today's Brainer:What's the difference between a pension fund and an investment fund?

Actuary $crooge shows...

source

Gold: Risk or Rescue?

For those of you who are still doubting...we live in a crazy world....

The Dutch Central Bank (DNB) has ordered (by court !) the glass-workers pension fund (SPVG) to decrease its 13% Gold allocation to less than 3% within two months.

DNB and Court arguments in short:

1. An investment of 13% is not in line with the Prudent Person Rule, which includes the principle that: assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
   
   
2. Gold is a commodity and holding 13%  is classified as 'overweight' in comparison to the 2.7% average that Dutch pension funds have invested in commodities.
   
   
3. 15% allocation in Gold is a 'concentration risk' that could lead to a coverage shortage if the gold price imploded (volatility of Gold is relatively large).

At first, it seems unbelievable that important decisions, with substantial financial impact  - even in Court - are not based on financial facts, but on 'general principles' and the way the market 'used to do it'.

A decision based on an argument that refers to 'the average pension fund,' would more or less imply that pension funds would not be allowed to base their investment strategy on their own specific situation or a changing market outlook. Pension Fund Boards appear to be  'captured' by the market and a Supervisor who obviously has a hard time to develop 'own standards'....

Secondly, DNB actually takes over the investment responsibility of the pension Board. One could wander if DNB is (sufficiently) aware of the possibility that it can be hold financially responsible for the effect of a negative outcome if it turns out in the near future that SPVG has suffered a substantial financial loss, caused by this DNB-designation.

Is Gold really a risk?....  or a rescue?

Checking the facts.... 
Let's just check if DNB's and Court's arguments are valid.....

Yearly Return
We start by comparing the yearly returns of Gold, the S&P-500 Index and '10-Y Treasury Bonds' over the period 1971-2010.

To make Bonds risk-comparable with Gold and the S&P-500 Index, the yearly average Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in a specific year are valued, and sold at the average interest rate one year later (approximation).


Here is the result:

To bring some sense and order into this chart, we calculate the 'Moving Compound Annual Growth Rate' (MCAGR).
We start in 2010 and calculate the  compound average yearly return backwards moving up (year by year) to 1971. This is the result:

Now, this looks better... and a bit surprising as well!!! On the long term Gold (μ=9.2%) and the S&P-500 (μ=10.2%) are tending to a rough 9-10% yearly return......  A little bit Surprising is that Bonds (μ=7.6%) get along very well with their big risky brothers...
Take your time to 'absorb' the impact of this chart.....

Risk
Next, we take a look at Risk. We define Risk at first as the Standard Deviation (SD). We directly cut trough to the 'Moving Risk' (Moving SD).

We might conclude here that during recent years there was an increase of risk with regard to the S&P-500 (the 'red' crisis 'Mount K2' is clearly visible). Note that also for a longer period, i.c. the last 30 years, the S&P-500 Risk is substantial higher than the Risk of Gold and much higher than the Risk of Bonds. Only looking at a period of 40 years, Gold shows 'optical' up as more risky (SD=σ=25.8%) than the two other asset categories, Bonds (SD=σ=6.9%) and S&P-500 (SD=σ=18.1%).

However this way of presenting Risk is strongly discussable. Another view of Risk that comes closer to what we naturally 'perceive' as Risk, is to define Risk as only as the Downside Standard Deviation (look up : Sortino ratio ), where all positive yearly returns are eliminated (DSD) or set to zero (DSDZ).....
Let's have a look:

Now, these charts give us a quite a different sight on Risk-reality....
It shows that -on the long term -  not Gold (DSD=Dσ=7.5%) is the riskiest asset, but the S&P-500 (DSD=Dσ=10.6%). Bonds (DSD=Dσ=0.5%), as aspected, have the least volatility and are therefore less risky.

Perhaps the Risk of Bonds is a bit underestimated (very few observations) by the DSD-method (excluding positive yearly returns). In this case the downside deviation of yearly Bond-returns, replacing positive returns by zero, which generates a standard deviation of 3.2%, gives a better indication of a more likely standard deviation on the long run.


Why Gold? 
Although these simple calculations already put the DNB conclusions in a different light, let's get to the main point that should be addressed in defending why Gold should be a substantial part of any Pension Fund portfolio:
 

 Gold Reduces VaR

In a 2010 (october) publication the World Gold Council published a document called Gold: Hedging Against Tail Risk. This interesting report concludes:

1. Gold is first and foremost a consistent portfolio diversifier
2. Gold effectively helps to manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances such tail-risk events (VaR).

Following this excellent WGC report, let's test the balancing and risk-reducing  power of Gold by analyzing (classical) Risk (SD) in combining Gold with different allocations (0% up to 100%)  in an asset mix with Bonds, respectively investments in S&P-500 stocks.

This chart clearly shows that Gold has the power to reduce the S&P-500 Risk (SD) from18.1% to 13,3% with an optimal asset location mix of  approximately 60% S&P-500 and 40% Gold. 

In case of Bonds the Risk (SD) is reduced from 6.9%  to 4.8% with an optimal mix of 80% Bonds and 20% Gold.

Asset Liability Model (ALM)
In practice it is necessary to optimize, by means of an adequate ALM study, the  allocation mix of stocks, Bonds and Gold. Just as a 'quick & dirty' excercise, let's take a look at the next asset-combination scenarios, based on data over the period 1971-2010:

Just some head line observations:

• From scenario M1 it becomes clear that even a 100% Bond scenario is't free from Risk. So diversification with other assets is a must.
  
• Looking at M2-M5 we find that the optimal mix, defined as the mix that best maximizes Return (Compound Annual Growth Rate)  and Sharpe Ratio (at a Risk free rate of 3% or 4%) and minimizes Risk (Standard deviation), is something something in the order of: 70% Bonds, 15% stock and 15% Gold.
  
• Scenarios M6-M8 and M9-M11 take todays most common (but strongly discussable!) practice as a starting point. Most pension funds have allocated around 50% or 40% to Bonds and 50% or 60% in more risky asset categories (stocks, etc.). It's clear that even in this situation Risk can be reduced and Return can be optimized, if Stocks are exchanged to Gold with a maximum allocation of 20% or 30%.

Notifier

Although this 'rule of thumb exercise' on this website provides some basic insights, please keep in mind that finding the optimal mix is work for professionals (actuaries).

A serious ALM Study is always necessary and should not only take into account a broad range of diversified asset categories, but should also focus and optimize on:

• The impact of the liabilities (duration) and coverage ratio volatility
• The Timing: Mean values and Standard Deviations are great, but the expected return highly depends on the actual moment of  investment or divestment in the market.
• Future expectations. In the current market situation (2011) the risk of interest rates going up and therefore Bond market value going strongly down, isn't hypothetical. Secondly, the stock market has been pumped up by trillions of 'investments' (?) in the US economy. Once this crisis-aid definitely stops, the question is if these 'cement investments' will be strong enough to keep stocks up. Personally I fear the worst...
  Not to mention a scenario with declining stock rates in combination with increasing interest rates and inflation......
  Who said the life of an actuary was easy???

Conclusion
We may conclude that:

• Investing in Gold up to a 10% to 15% allocation, reduces the Risk of a portfolio consisting of Bonds and S&P-500 Stocks substantially. 
• Gold is less Risky than investing in S&P-500 Stocks

Therefore the 'not with facts' underpinned intervention of DNB looks - to put it euphemistically -  at least strongly discussable....

A wise and modest underpinned allocation of Gold is no Risk, it's a Rescue!

Related Links:
- Spreadsheet with Data used in this Blog
- Prudent person Rule
- IPE: Dutch regulator orders pension scheme to dump gold
- GOLD: HEDGING AGAINST TAIL RISK
- Downside Risk:Sortino ratio
- Dutch Central Bank Orders Pension Fund To Sell Its Gold
- Pension Fund Benchmarking 
- Strategic Risk Managment and Risk Monitoring for Pension Funds

Bonus: Gold, Hedging against Tail Risk Video

Pension Fund Weigh House

Investment Benchmarking of Pension Funds has been made extremely difficult.

Just ask your Pension Fund's actuary whether your Pension Fund has achieved a 'market conform investment performance'... For sure you'll get a dazzling multiform and relative answer. It's all about 'market indexes' (stock and bond indexes), risk appetites, asset mixes, derivatives, uncertainty and lots of other interesting complex stuff that underpins the fact that the final answer to this simple question is nuanced, complex and relative.

A simple question
Ahead of all this growing complexity and 'levels of detail', a first key question has to be answered by every Pension Fund:

Was it worth setting up a complex multi fund investment plan instead of simply investing in 10-Years Government (Treasury) Bonds over an arbitrary period of (at least) the last 10 years?


Even this simple question, will probably not lead to a simply answer from your fund's investment manager or actuary.

Pension Fund Weigh House Help
This is where the help of the 'Pension Fund Weigh House' comes in...

Just look up the yearly return over the last ten years in your Pension Fund's annual report. Next, do the test at 'Pension Fund Weigh House'  (PFWH) and see for yourself whether your Pension Fund has  performed better than the simple benchmark: 10-Y Bonds.

 

Did your Pension Fund perform better than Bonds? (the compound mean over the last 10 years) Congratulations!
Was it worth the risk? Well..., just look at the Risk (Standard Deviation) or - even better - the Sharpe Ratio at different levels of possible 'Risk Free Rates' to find out. The Higher the Sharpe Ratio, the more it was worth to take the risk.

Market Value

To compare Bonds 'fair' with Market Value based Pension Fund performance, the yearly Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in January of a specific year are valued, and sold at the interest rate one year later.

Do it yourself

The standard example as presented on PFWH concerns the performance of the Dutch pension fund ABP, the third largest pension fund of the world. Answer the key question 'Was it worth?' for ABP for yourself.

ABP (Pfd-R) Performance 2001-2010

 

Go to PFWH and change the numbers and 'heads' in the application to fit the numbers of your own (pension) fund or change both columns (Bonds & PFD-R) to compare two pension funds .
Compare your pension fund to either  '10-Y Euro Government Bonds', '10-Y US Treasury Bonds' or the 'S&P 500 Index'.

From now on you may answer this extremely difficult question "How did my pension fund perform?" yourself in a  5 minute weigh house test.

Have (professional) fun!

Dutch Pension Muppet Show

There's a lot of fuzz about the performance of the largest (€ 246 billion assets) Dutch Pension Funds ABP and the somewhat smaller (€ 91 billion) PFZW (former PGGM). According the Dutch television program Zembla and Bureau Bosch Asset Consultants, Dutch pension funds would have consistently underperformed.

ABP commented: "The yearly return of 7.1% on average since 1993 is much higher than returns on government bonds would have been and is in part thanks to our equity investments."

PFZW overshoots ABP wit the comment: "PFZW's calculations show a return of 8.4% on average during the past 20 years which is much higher than the 10-year Dutch government bonds of 5.3% on average during the same period."

Great statements, but who's right?

Performance Test
Let's quickly "do the proof" by comparing (benchmarking) the 'modest' yearly performance of ABP with the yearly performance of 10 year Government Euro Bond Yield Benchmark as provided by the ECB.

Both pension funds are not limited to  the Dutch market, therefore  performance is not related to Dutch Government Bonds, but to 10-Y Euro Government Bonds.

As the yearly performance of ABP in a particular year is in fact a kind of 'compound performance' of the years before, it's more realistic to relate ABP's (yearly) performance to the 10-years moving average of 10-Y Euro Bonds.  

What becomes clear from is that ABP's volatility overshadows the 10-year Bond's volatility by far. As a consequence ABP's out-performance should be significant.

Let's test this by looking at the YTD (Year To Date) performance of ABP on the long run:

The average performance of ABP 1993-2010 indeed turns out exactly 7.1% as published, but hardly outperforms the 10-year Euro Bonds Moving average of 6.8%.

0.3% '18-years out-performance' (OP-18) for such a high volatility is strongly discussable. The long term out-performance 1994-2010 (OP-17) was 0.0%. The out-performances of shorter periods (OP-[18-x]) are not stable and strongly swap from positive to negative.

Benchmarking Pension funds performance with Euro Bonds 0f 20 years or longer would be even more adequate and in line with the duration of pension fund's liabilities. Taken into account that 20 year Bonds on average score a 0.25% à 1.00% higher return than 10 year Bonds, it can be concluded that Dutch pension funds on average do not out-perform Government Bonds. Not to mention the influence of the yearly investment-costs of at least 0.2% on the returns.....

Pension Fund PFZW

Pension Fund PFZW is completely lost on their non-transparent and backwards changing performance of 8.4% over the last 20 years.

From their annual (inconsistent) accounts it can be concluded that their 2001-2010 performance came down to 4,8%. This performance is exactly the same as the performance op ABP in that period and underperforms the moving average 10-years Euro Bonds with 0.7% !!!

Conclusion

It's clear that pension funds don't convince in the outperformance of Government Bonds and that the pension industry is in desperate need for an impartial benchmark with regard to out or underperformance of Bonds.

The comments from ABP and PFZW, Boenders and Cocken are like 'shooting from the hip' and must be qualified as highly unprofessional.

Dutch pension fund members are watching an extra edition of the Muppet show. Who's gonna stop this pension media madness and bring some order in the pension room?


Related Links and Sources:

- Source: 10 year Government Euro Bond Yield Benchmark
- 'grave miscalculations' in Zembla (Boender aand Kocken
- Watch: Zembla 
- Download: Spreadsheet with calculations as presented
- IPE: Heavyweights ABP, PFZW come out swinging against Zembla
- Bloomberg: 10-year, - -  30-year performance Gv. Bonds

In control through better communication!

End of November 2010 the Dutch Regulator (DNB) met with certifying actuaries as well as external auditors. Both meetings were dominated by the theme of "accuracy of reporting" for pension funds, an important DNB monitoring theme.

DNB stressed that all pension fund reports are a key source of surveillance information. With confidence, every Pension Fund stakeholder should be able to rely on the accuracy and completeness of the information in pension fund reports. In practice, this is not always the case. DNB will increasingly hold pension fund boards, certifying actuaries and accountants responsible for taking appropriate actions and - if  necessary - DNB will enforce action.

Topics
Main topics on the accountant-Actuary table are:
- the valuation of technical provisions
- the valuation of the required equity and
- compliance with the prudent person rule.

In control through better communication

The introduction in 2011 of so called 'multi-party meetings' (ie consultation between pension fund management, actuary, accountant (auditor) and regulator DNB) with some larger pension funds will certainly help to improve communication between all concerned parties.

This excellent initiative will also certainly help pension funds to increase control.
Key issue is that the pension Board has (to keep) final responsibility and DNB has to take care that they do not implicitly take over part of this responsibility. Secondly DNB is responsible for an efficient and clear regulation/governance structure. Too many informal consultation meetings might not be efficient and bear the risk of unclear responsibilities. 


Sources:
- Newsletter Pensions DNB (Dutch, 2011)
- Source: Four leaved clover Coin

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....