Pension Cuts, Why?

So here we are in the 21st century of 'Pension cuts'. How could this happen and can we do something about it?

No flood of words in this blog, more staccato text and illustrations.

Let the images do their work......

Risk Management
is all about

'getting the picture'

instead of endless calculation and deliberation.

Cappuccino

Let's start with comparing your pension with a cup of coffee......

- Most Pension agreements started in the fifties and sixties of the 20th century
- Employees were promised a nominal pension (plain coffee, so to speak)
- Any additional returns meant indexation (steamed-milk in your coffee)
- Fabulous returns in the seventies and eighties made (full) indexation possible
- The idea of 'free indexation' caught fire
- Cappuccino = Coffee + steamed-milk = Nom. Pension + Indexation, was born
- Common opinion, Science up front, started to redefine our pension concept...
- Credo: 'Pension is only pension if it's "Real Pension" (indexed)  
- The 21th century's first decade returns made it clear: no room for Indexation!
- Things (returns!) got worse; Stock markets underperformed, Low Bond rates
- Nominal Pension under pressure: Pension cuts seem inevitable

Key question: How to cut pension rights?

1. Cut Nominal Pension and keep room for Indexation?
2. Cut on Indexation as much as possible, before cutting Nominal Pension?

Return wrap up

Looking backwards at 10Y T. Bonds and Stocks (S&P 500) as an example, this is - in short - our 'back-up' challenge for the future :

Table 1

Period	Average Arith. Returns		Risk (Standard Deviation)
	Bonds	Stocks	Bonds	Stocks
1960-1980	4.04%	8.06%	5.39%	15.95%
1980-2000	10.21%	18.38%	11.14%	12.51%
2000-2011	7.56%	2.37%	8.39%	18.45%
Period	Average Compound Returns
	Bonds	Stocks
1960-1980	3.91%	6.82%
1980-2000	9.64%	17.69%
2000-2011	7.22%	0.53%

In addition, due to implementing Market Value Principles in the nineties and later, Bonds have become more risky on the balance sheet.

To paint the dilemma of pension funds even more,
- actual artificial low interest rates (how long?)
- extremely overvalued stock market (Total Market Cap/GDP=95%)
- increasing covariance of asset classes in times of crisis
- systemic risks everywhere
- worldwide unsure economic outlook
- unregulated and non transparent hedge and debt markets
- unidentified risk in derivatives; central clearing on its way
- upcoming unsure supervisory legislation (e.g. Solvency)

make it very hard , if not impossible, to take sustainable underpinned decisions.

To illustrate the investment part of this dilemma, take a look at the next chart:

Confidence Level

As a consequence of the above development (and longevity effects) our pensions got screwed up.

In short the next chart illustrates what happened to the (1 year) confidence level of our pensions on basis of the historical returns and risks as defined in
Table 1 on basis of a 'Return Portfolio'  approach:

The above chart clearly shows that our initial cautious (Nominal⁺ Pension) approach in the sixties, was replaced by an (retrospective) much too optimistic (Real Pension) belief in the eighties and nineties. 

A real pension objective puts the nominal pension at risk
Even more important is to realize that - as the approach 2000-2011 shows - it's only (questionable) possible to achieve a kind of Real Pension (with a corresponding substantial (needed) return of 5% or more) by putting the Nominal Pension (extra) at risk!!!!

More in detail:

Long term view

Looking not just at '1 year return risks', but also at 3 and 10 year return risks, we may conclude the risk of underperformance is still substantial.

Therefore, the challenging question  that still remains, is:

Is it wise to put our 'nominal pension' at substantial risk to achieve a highly unsure real pension?

Outlook
Mean Variance analysis in historical perspective, gives food for thought....
The 2012-2020 outlook seems tricky and is not directly showing a 'shiny future'...

Some remarks...

• Last decade⁺ (2000-2011) with higher Bond than stock returns (see Table 1), shows a  major optimizing problem
  
• Future approach (2012-2020) is based on the current low 10Y Bond rate of about 2% (SD=8%), which will keep low as a result of the FED's low rate strategy,  and low expected stock returns of about 4% (SD=16%). 
• Even if the outlook returns would be slightly higher, this wouldn't change the picture..... 

Investment Management: What a fool believes
As  risk or investment manager these are challenging times. Perhaps the only truth in investment land is:  What a fool believes




But what a fool believes ... he sees
No wise man has the power to reason away
What seems ... to be
Is always better than nothing
And nothing at all keeps sending him

NB All (above) calculations, tables and charts are indicative and strongly simplified to make it possible to 'get the picture' and 'get feeling for the direction', in order to support complex decision making  without straying too far from reality..... 

Related Links:
- Gold-plated pensions lose shine (2012)
- Where Are We with Market Valuations? (2012)
- Value-at-Risk: An Overview of Analytical VaR (JPM)
- Solvency II nightmare still looms but worst-case scenario averted


Spreadsheets (Raw, download):
- Real ambition
- Risk Return

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

New Actuarial Ethics

As actuaries we have to act in a complex world. This is no easy task. If we're honest, we have to admit that in this last decade we got ourselves dragged along the road of unrealistic and too optimistic ROI outlooks.

'Good' and mathematically sound advices turned out 'Bad'. Pension Plans are in trouble. New ROI-hope seems to be on our doorstep. With a look of weariness and despair, board members and clients seek our advice.

It's our duty to advice them in this financial jungle. Unfortunately we can not look into our Cristal Ball and predict the future. Moreover, topics like the ROI and longevity outlook become more and more an ethical issue instead of a mathematical exercise in uncertainty.

Yes, it's our responsibility to guide insurance companies, pension funds and other financial institutions through an unsure future. As new age risk managers, we have an enormous responsibility on our shoulders to winnow the Bad from the Good advices. One thing is sure, we have to do better than we did in the past, but how?

E=A-L ?
It's not enough to judge whether a 'one point Equity estimate' keeps the Assets and Liabilities in balance. What's even more clear, there is no one point E, A or L. There are only probabilities and to judge those, our personal ethical principles become even more important than our essential technical skills and experiences.

Our main puzzle is that this decade has shown that observations of the past are no convincing guarantee anymore for predictions of the future. This implies that we have to fall back on other, more ethical, principles in our advice. The good old ethical principles and methods to deal with actuarial dilemmas, need a fresh up.

Genuine Moral Intelligence (GMI)

Main issue is, that the more 'objective' and significant our data get and the more sophisticated our models may become, the more our advice becomes susceptible to unpredictable developments.

On top of all this, more control, increasing data or more advanced models, will only create a false sense of certainty. These old instruments won't  help us anymore en will only reduce the long term returns and aggravate the ultimate volatility. The only way out is to throttle back on our 'risk attitude' on basis of some new ethical principles.

These new ethical principles are not just about 'minimal legal compliance'. Modern actuary ethics goes further than that. In fact ethics is reincarnated as 'Genuine Moral Intelligence' (GMI).


GMI, as defined by Richard E. Thompson, is: Aristotelean decency, vision, purpose, and uncommon sense.

The applicable GMI equation is given by:  

GMI = ER + UPVs + RSI

ER = Ethical Reasoning
Rather than "pick an ethical theory and stay the course," one may ask and answer a series of questions.
Some examples: Who are the stakeholders? What ethical principles apply? How do they apply?

UPVs = Underlying Personal Values.
UPVs are used to answer the above questions.
Some examples:

• As a board member, do you vote for continuing a needed community medical service that is losing money, or for cutting the service to avoid financial problems?
• As a pension board member, to what kind of probability are you willing to increase the pension of the pensioners at the risk of having to raise the contribution of future pension fund members?

Underlying personal values also determine whether we act according to our morally intelligent conclusion, or choose to ignore it.

RSI = Reasonable Self Interest
Ethics only makes sense if we can come up with a sound answer to the question "Why act ethically?"

Here, Aristotle comes in with a helping answer: "To serve one's own self-interest".
Keep in mind there's a difference between self-interest and greed. The wise Aristotle explains: "Love of self is a feeling implanted by nature, but selfishness is rightly censured, because selfishness is not mere love of self but the love of self in excess, like the miser's need for money."

So self-interest is nothing unethical in itself. An example from the famous Adam Smith stresses this:

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." (reasonable self-interest)

From now on actuarial advice is different!

GMI could be the new key to economic recovery. We have to get back into realistic pension plans. We need to establish the necessary changes (due to aging) in our social security systems. It's our task as actuaries to share and discuss the above principles with our clients and the boards we advice, in order to force the crucial (economic) change that's needed. This is no easy task, as board members are often not used to such transparent en open discussions involving their own underlying personal values, preferences and (reasonable) self-interest.

So from now on, when you discuss an actuarial report or advice on board level, it's different! From now on, we've got New Actuarial Ethics, where GMI is inclusive. 

This new ethical theme, including the communication and discussing techniques, should be incorporated in our actuarial education program....


Used Sources/ Related Links:
- Thompson: Ethics is dead, what do we do next?
- The crystal ball 
- When Bad Things Happen to Good Plans
- Actuarial Ethical Dilemmas(2010,ppt)
- Actuary Duty (Vrystaat)
- Clay Bennett Cartoons

Isle of Risk

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.
No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.
Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......
Let's start with behavioral finance

Behavioral Finance
One of the world’s best experts in the field of behavioral finance is James Montier.
His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:

• You know less than you think you do
• Be less certain in your views, aim for timid forecasts and bold choices
• Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day
• Listen to those who don't agree with you
• You didn't know it all along, you just think you did
• Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)
• Don't take information at face value, think carefully about how it was presented to you
  

Trinity of Risk
According to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':

• Business Risk (risk of business going broke)
  
• Financial Risk (risk of using leverage)
  
• Valuation risk (the margin of safety)
  

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"

1. The Fake Rolex Watch Mistake
   Ask the investment bank which sold you a fake Rolex what the Watch is worth
2. The Poker Game Mistake
   Ask someone else playing in the same game how you should bet
3. The War of the Worlds Mistake
   Believe in a valuation technique Because everyone else thinks it's true
4. The Cash Card Mistake
   Tell an investment banker exactly how your firm evaluates complex securities
5. The Carton of Eggs Mistake
   Don't check to see if the eggs are broken, just look at the egg carton before buying
6. The "My Brother-In-Law Told Me It Was a Good Investment" Mistake
   Bernie Madoff and the rating agencies
7. The 2+2=5 Mistake
   Technical errors in valuation

Financial Crisis 2008-201x
Back to Montier, who's very clear about the role of Bernanke with regard to the role of the FD in the current

• Ben Bernanke, Washington Post, October 27, 2005
  “There is no housing bubble to go bust.”
• Speech Bernanke FED May 17, 2007
  “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy Investor
For those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:

• Don’t equate happiness with money.
• Exercise regularly.
• Devote time and effort to close relationships.
• Pause for reflection, meditate on the good things in life.
• Seek work that engages your skills, look to enjoy your job.
• Give your body the sleep it needs.
• Don’t pursue happiness for its own sake, enjoy the moment.
• Take control of your life, set yourself achievable goals.

Map of Risk
Risk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

To help you get on the way, take a look at my Isle of Risk

(click the image for a larger image)

James Montier's Links
- Google Book Behavioural investing
- Was It All Just A Bad Dream? (febr. 2010)
- The Little Book of Behavioral Investing
- Applied behavioural Finance (pdf presentation)

Other links:
- High Frequency Trading Is A Scam
- High Frequency Trading Youtube
- FT: Markets: Ghosts in the machine
- High Frequency Trading -- Results from Simulation