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?
PrinciplesSimply stated, it's important that a pension fund:
- can meet its obligations "on the long-term"
- is sufficiently liquid to pay his annuities "on the short-term"
Moving averageThe 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 MoneyEven 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 "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.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 measuresIn 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:
- 100% of the yearly pension that you have been promised, on basis of a 125% funding ratio
- 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 PeriodNow 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).
HopeLet'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!)
As the story goes, insurance began around 1688 at a coffeehouse in London called Lloyds, where shipman discussed and divided their risks.
The answer to this question depends on who you ask...
The first actuary....
However, already in the 3rd century the Roman jurist Ulpian devised a table for the legal conversion of a life annuity to an annuity certain.
It was pointed out by Greenwood that the valuation (duration) of the annuities was deliberately chosen to high, in order to protect the interests of the legal heir.
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