Pension Recovery: Yearly Negative Indexation

Hold your breath...

Since 2008, according to Milliman, the average funding ratio of the top 100 US (largest) Pension Funds has fallen from 99,6% to 71,7%.

Dutch pension funds developments are comparable.

One way of the other, pension funds have to plan their way out of this financial crisis.

On january 29, 2009, on a NETSPAR meeting, Theo Nijman, Professor Investment Theory of the Tilburg University, gave a presentation called Optimal design of recovery plans.

Nijman's recovery model
Summarized, Nijman shows several recovery options:

1. Do nothing:
   Hope that financial markets will recover and the interest rates will rise
   
   
2. Use control instruments:
• Indexation cuts, or no indexation of entitlements
• Recovery contributions (sponsor, employee)
• Return on mismatch (gamble)
• Reduction, if no recovery plan can satisfy the criteria:
  Reduction of guarantees
  

Recovery by Maggid
Although all kind of (IRS) regulations are in place, basically there's no reason for panic....
Everything in life is based on trust. So are our (ALM and VAR) models.

This implies that the only way out, is to stick to our models and their corresponding strategies as much as possible, which means in principle: Do nothing.

However, what we do need to do, is to (re)define and maintain our indexation strategy as follows:



Yearly negative indexation
This strategy implicates that for pension funds with funding ratio's of 80% or less, we'll have to apply "yearly negative indexation".

One off reduction of entitlements is not necessary in this situation and would be 'clumsy', unless the funding ratio would be less than 60% (you have to draw the line somewhere).

In fact this 'negative indexation' is not really new, it's just that we haven't been in this kind of situation before and because we didn't think we would end up in this scenario, we didn't develop any policy. Let's do it now!
Yearly negative indexation is in fact no more than the logical natural opposite of (positive) indexation.

In good times there's positive indexation en in bad times negative indexation, it's a simple as that. Books closed.


Redefine risk strategy?
Last but not least: if we never ever want to end up in a (crisis)situation like this again, we should redefine our risk strategy and select an asset mix that fits to a lower risk/return level.

The question is, when it's the the right time to reallocate, will you actually do it?

How Defined Benefit Plans work(ed)

Pension plans suffer, from a rare disease....

UK
According to IPE more than 90% of UK Defined Benefit (DB) schemes are underfunded. The aggregate funding position of almost 7,800 schemes reported a deficit of £218.7bn at the end of February 2009.

NL
The situation in the Netherlands is hardly better.Figures from the Dutch regulator,DNB, show around half of the country’s 650+ pension schemes are under-funded. The Dutch government has extended the recovery period for pension funds from three to five years. The main question is: "Is that long enough?"

How Defined Benefit Plans work(ed)


Pension funds, especially DB schemes, have to face that their worst dreams, a complete doom scenario, is becoming true :

• First the subprime market collapsed
• Then, as trust broke down, the stock market went down as well
  
• On top of that Interest rates dropped dramatically

Titanic lessons
Just like the 'unsinkable' Titanic was protected by compartments, we had protected our pension schemes with diversification. And just like the Titanic, we actuaries, asset managers, and quants made a fundamental mistake. We underestimated the correlation between the different compartments (bonds, subprimes, stocks). One hit in the vital front compartment was enough to draw our pension dreams to the bottom of the ocean.

Optimistic view
But let's not stay pessimistic.

Do you know how long it took the market to recover after 1929? .....

ONLY 25 YEARS!

Global Investment Returns Yearbook 2009
And there are more reasons to stay positive about the equity results on the long term, as is shown in the very interesting downloadable Credit Suisse Global Investment Returns Yearbook 2009, that analysis returns from 1900 until the end of 2008.


As this yearbook shows us in more detail, it is only a matter of statistical faith, that equity performance on the long term will recover.

So the only thing we can do is, just like a sick patient: stay cool, rest (don't move), don't panic and wait until trust and the markets recover.

God bless you....

Two reasons motivate less

In an earlier TED Show psychologist Barry Schwartz illustrated in a humorous and catching way the effects od "Too much choice".

Now, in another TED Show video called, "The real crisis? We stopped being wise", he shows us that the current financial crisis can't be solved by more rules or incentive policy.

Schwartz pleads for a new approach based on a Obama's approach to solve the current financial crisis. Already before his inauguration Obama said:

“We must ask, not just is it profitable, but is it right”

Schwartz: "In his inaugrual address, Barack Obama appealed to each of us to give our best, as we try to extragate ourselves form the current financial crisis. But what did he appeal to? He did not, happily, follow in the footsteps of his predecessor and tell us to just go shopping. Nor did he tell us , 'Trust us, trust your country. Invest. Invest. Invest.' Instead, what he told us, was, to put aside the childish things. And he appealed to virtue.



Two reasons motivate less?
Schwartz brilliantly illustrates the common wrong notion that if you have one reason for doing something and you are given a second reason for doing the same thing, it seems only logical that two reasons are better than one, and you are more likely to do it.

This is not always true. sometimes two reasons to do the same thing seem to compete with one another instead of complementing, and they make people less likely to do it.

Schwartz illustrates this in the next example:

In Switzerland, back about 15 years ago, they were trying to decide where to site nuclear waste dumps. There was a national referendum and some psychologists went around and polled citizens who were very well informed. And they said, “Would you be willing to have a nuclear waste dump in your community?” Astonishingly, 50% of the citizens said “Yes.” They knew, or thought, it was dangerous, they thought it would reduce their property values, but, it had to go somewhere, and they had responsibilities as citizens.

The psychologists asked other people a slightly different question. They said, “If we paid you six weeks salary, every year, would you have a nuclear waste dump in your community?” Two reasons: it is my responsibility and I am getting paid. Instead of 50% saying yes, 25% said yes.

What happens is that the introduction of the incentive gets us to a point that, instead of asking, “What is my responsibility?”, all we ask is “What serves my interest?”

When incentives don’t work, when CEOs ignore the long term health of their companies in pursuit of short term gains that will lead to massive bonuses, the (wrong) response is always the same: get smarter incentives.

So, in general, adding more or better incentives will not motivate us more or increase our responsibility!

Actuarial lesson
As actuaries we often try to find as many reasons as possible to convince a board of taking the right decision. Perhaps we should emphasize more on finding and communicating that one and only reason to take the right decision: a prudent, healthy and solid decision (investment) that benefits all stakeholders on the long and short term, in a balanced way.


text version of video