Institute of Actuaries of India

Transcription

1 Institute f Actuaries f India Subject ST4 Pensins & Other Emplyee Benefits May 2012 EXAMINATION INDICATIVE SOLUTIONS

2 Slutin 1 : The plitical, ecnmic and fiscal viewpints f the State will determine the precise rles that it will play. Hwever, the rles are likely t fall within the fllwing categries : prvide benefits t sme r all f the ppulatin educate r require educatin abut the imprtance f prviding fr the future regulate t encurage r cmpel benefit prvisin by r n behalf f sme f the ppulatin regulate bdies prviding benefits, and thse bdies with custdy f funds, in an attempt t ensure security fr prmises made r expectatins created. prvide benefits t sme r all f the ppulatin Civil servant pensin system r Natinal ld age pensin scheme educate r require educatin abut the imprtance f prviding fr the future Natinal pensin scheme (NPS) regulate t encurage r cmpel benefit prvisin by r n behalf f sme f the ppulatin Prvident fund, Gratuity, Superannuatin, Emplyee depsit linked insurance, Emplyee state insurance regulate bdies prviding benefits, and thse bdies with custdy f funds, in an attempt t ensure security fr prmises made r expectatins created Insurance, mutual funds, banking prducts, pst ffice fferings The cmmercial bjectives f emplyers in prviding benefits are as belw: cntrlling csts prviding benefits that emplyees perceive t be attractive prviding benefits that are at least in line with thse ffered by cmpeting emplyers taking advantage f any financial incentives frm the State, e.g. tax incentives rewarding certain classes f emplyees, e.g. lyal staff. [5] Slutin 2 : Risks facing the spnsr f a Defined Benefit pensin scheme are as fllws: Investment risk Return n existing investments may turn ut t be lwer than expected leading t additinal cntributins t be made by the spnsr Reinvestment risk Risk that future cntributins and investment prceeds after will need t be invested under unfavurable investment cnditins leading t a lwer yield n amunts invested in future Default risk Risk that the issuer f investment instrument will default r becme inslvent leading t a capital lss Asset liability mismatch risk Risk that value f liabilities will increase mre than the value f assets under certain macr ecnmic scenaris Opprtunity cst There is a risk that the return n scheme assets turn ut t be lwer than the returns that culd have been achieved had thse funds been invested internally within the cmpany Lngevity Pst retirement mrtality experience may turn ut t be lighter than expected, leading t verall increase in scheme csts Page 2 f 11

3 In service mrtality culd be different frm expected Salary increments may turn ut t be higher than expected Scheme withdrawal experience culd be different frm expected Higher than expected benefit imprvements There is a risk f mis estimating the amunt and incidence f cntributins due t: The use f an unsuitable mdel The use f unsuitable parameters Errrs in membership data r data used t derive parameters Cntributins may be required at inpprtune times at amunts higher than expected, depending n the verall scheme experience Risk f inadequate funds r under funding t pay the benefits as they fall due, leading t higher than expected cntributins being paid t the fund, at a time when the spnsr has insufficient liquid assets t pay these additinal cntributins Risk f excess funds leading t: A risk that spnsr may nt be able t use these excess funds fr ther purpses A risk f financial penalty being impsed by tax authrities wh may view this as taxevasin Illiquidity risk Even if the scheme is adequately funded, there is a risk that the spnsr may nt be able t liquidate the assets t pay ut the benefits as they fall due. Risks related t benefits Benefit changes There may be a change in regulatin leading t a higher benefits being paid t scheme members, leading t verall increase in cst Risk f unappreciated benefits If scheme benefits are nt appreciated by members/beneficiaries, it can be thught that the capital used t prvide these benefits has nt been put t the best use Risks related t general peratin f the scheme Fraud r misapprpriatin by an emplyee r a third party Inapprpriate advice Incrrect benefit payments Higher than expected administrative csts Penalty r fines by regulatry authrities Risks related t regulatin and taxatin Change in regulatry envirnment leading t increased cntributins Changes in taxatin rules [5] Slutin 3 : Spnsr s perspective: Bk reserving prvides greater flexibility fr the spnsr cmpared t financing methds where explicit funds are set aside, since the risk f making cntributins at inpprtune times is substantially reduced N specific assets are earmarked fr pensin scheme liabilities, therefre cntributins remain ttally self invested and are available fr nrmal business activities f the scheme spnsr Member s perspective: The main prblem with bk reserving is the lack f security cmpared t ther financing methds In the event f inslvency f the spnsr, the members may nt receive full benefits The benefits received by the member will depend n: Whether the spnsr had taken any inslvency insurance Winding up pririty f bk reserves Page 3 f 11

4 Whether any third party guarantee is available Hwever, bk reserving wuld imply mre capital wuld be available fr nrmal business activities, which might results int greater benefits fr the members in the lng run The factrs that the spnsr wuld need t cnsider are as fllws: 1. Opprtunity cst Since the cmpany is rapidly grwing, it is likely that it wuld require capital t supprt nrmal business activities. Frm a financial perspective, the cmpany shuld set aside funds nly if it wuld get a higher effective investment return cmpared t what it wuld get by investing the funds within the business Setting aside funds will substantially increase the security f prmised benefits in eyes f the scheme members 2. Flexibility Financing the benefits wuld require that regular cntributins be made at regular intervals. Call fr such cntributins may be made at inpprtune time. Cmpany wuld ideally want t have flexibility with regard t payment f cntributins Any deficit within the fund needs t be made up by the cmpany while a surplus may nt be reclaimed by the emplyer 3. Regulatin Cmpany wuld need t cnsider any regulatry issues with regard t financing f benefits 4. Taxatin Cmpany wuld need t cnsider any tax issues invlved. Tax benefits might be available fr the cmpany depending n legislatin which culd enhance the effective net f tax return n scheme assets (iii) The cmpany culd g fr any f the fllwing methds f funding the benefits: 1. Lump sum in advance Under this methd, a lump sum cntributin is made when a member jins the scheme Entire funding is dne even befre the first benefit payment is made The methd wuld tie up excessive capital within the scheme which culd have been put t a better use within the business Excessive fund build up within the scheme might be viewed unfavrably by tax authrities, wh might impse a penalty fr ver funding The methd wuld prvide the maximum security fr the prmised benefits as the cntributin is expected t cver all scheme benefits 2. Terminal funding Under this methd, a cntributin is paid whenever a benefit starts t be paid The cntributin is designed t cver all future benefit payments The methd des nt prvide any security f past service (r accrued) benefits Terminal funding wuld require payment f huge sums f mney within the scheme t secure future benefits. This might result int liquidity prblems Regular cntributins Under this methd, cntributins are made at regular intervals t meet prmised scheme benefits Greater flexibility than ther tw advance funding methds with regard t timing and stability f cntributins Greater security than terminal funding as a fund gradually builds up ver the service perid f the member, rather than at the end f service perid Page 4 f 11

5 A hst f funding methds available t meet cmpany s desired funding criteria e.g. security, stability, durability, realism etc. Slutin 4 : The pssible surces f lss wuld fall in three areas Assumptins gain/ lss Experience lss [13] Enhancement in plan benefits The assumptins gain/ lss wuld arise due t change in assumptins during the year frm 31 March 2011 t 31 March 2012 Fr example a decrease in discunt rate r increase in medical inflatin basis will give rise t an assumptin lss The experience lss culd be due t the fllwing reasns The prbability f prviding the benefit lwer attritin than assumed leading t higher number f members becming eligible fr the benefit lwer deaths (better lngevity) than assumed The expected cst f the benefit Higher increase in average hspitalisatin cst than assumed Higher benefit payments than expected during the year Slutin 5 : The fllwing factrs need t be cnsidered while setting up a DB scheme What level f benefit shuld be prvided? Shuld the benefits be defined in mnetary r real terms? If in real terms shuld they be related t the purchasing pwer r earnings? On what events shuld benefits be prvided, e.g. n death, n retirement, n leaving emplyment, whilst unable t wrk, during emplyment, n divrce? In what frm shuld the benefits be prvided, e.g. an annuity, a cash lump sum, gds, services? Shuld the apprach differ between individuals in the grup? If they shuld differ, in what way, e.g. frm, level, real nature, events? Shuld the individuals be given any ptins abut the events, frms r levels f benefits? Backgrund: We understand that the Cmpany currently prvides the Gratuity benefit that is better than the Act. The cmpany wuld like t explre ptins t understand ptins fr redesign f the benefit s that the csts fr prviding the benefits are ptimised. Objective: The Cmpany wuld like t ptimise the spend by redesigning the benefit. Optins fr redesign: The ptins fr redesign wuld depend n the inputs prvided by the Cmpany n the aspects t be cnsidered fr redesign Sme f the pssible ptins culd be [5] Page 5 f 11

6 Grandfather the benefit and prvide benefit as per Act t new entrants Prvide ptin t the existing emplyees t cash ut the additinal future accrual and prvide benefit as per Act t thse wh pted t cash ut and the New entrants Aspects t be cnsidered fr redesign: What level f benefit shuld be prvided? While the benefit cannt be less than the mandatry benefit, the cmpany culd chse t prvide a higher level f benefit than the mandatry minimum Shuld the benefits be defined in mnetary r real terms? Wuld the cmpany want t limit the benefit at 10 lakhs as per act r a multiple f salary r any ther limit Des the Cmpany want t prvide a death in service insurance benefit if nt being prvided nw Shuld the apprach differ between individuals/ grades/ age grups/ service grups in the Cmpany If they shuld differ, in what way, e.g. level (accrual rate), real nature (multiple f salary), events (vesting criteria)? Shuld the individuals/ grades/ age grups/ service grups be given any ptins abut the levels f benefits? The cmpany can prvide flexibility t emplyees t cash ut the future additinal benefit fr instance. [10] Slutin 6 : Spnsr may be unwilling t finance future benefits under the scheme, because: Existing members are being transferred int a new scheme fr future benefit accrual The spnsr may be experiencing financial difficulties because f which it is unable t cntinue financing the scheme benefits The trustees may have decided t discntinue the scheme if they think this wuld be the best way t secure accrued benefits because f a weak spnsr s cvenant The discntinuance benefits wuld depend n the fllwing factrs: 1. Rights f beneficiaries Rights may be viewed as what the individual wuld receive if they: left the scheme vluntarily at the mment f the discntinuance remained in the scheme until retirement (but withut any further accrual) remained in the scheme until retirement and cntinued t accrue benefits Trustees wuld need t cnsider the terms f the scheme t understand the discntinuance benefits explicitly mentined in case f scheme discntinuance Trustees wuld als need t ensure that they cmply with any verriding legislatin 2. Expectatins f beneficiaries Members wuld expect their past service benefits t increase in line with salary grwth If there had been any practice within the scheme f awarding discretinary benefits, such as pensin increases r enhanced early retirement terms, there may be an expectatin that these will cntinue Cntributins paid by r n behalf f the beneficiaries may als create an expectatin that the benefits will be at least as valuable as these cntributins The existence f any minimum funding target, whether by statute r vluntary practice f the scheme, may als give the beneficiaries the expectatin that the funding target will be achieved and that they will receive the benefits t which the target relates Page 6 f 11

7 3. The level f assets (maximum 3 marks) Rights and expectatins f members are nly relevant if sufficient assets are available If the assets are insufficient t meet the rights f the beneficiaries then a lwer benefit will be paid Where the benefits have t be reduced, legislatin r scheme rules may indicate which types f benefits are t be reduced r which types f beneficiaries are t have their benefits reduced Expenses related t discntinuance prcess may need t be paid in full befre any benefits culd be paid ut frm the fund Cnsideratin needs t be given t any additinal funds that might becme available frm the spnsr n accunt f legislatin r inslvency insurance If the assets are mre than the liabilities, cnsideratin must be given t legislatin, scheme rules, surces f surplus and rights and expectatins f members befre deciding the amunt f surplus that culd be refunded t the spnsr 4. Methd f prvisining Methd f prvisining fr discntinuance benefits will als have an impact n level f benefits made available t the members If liabilities are liquidated r transferred t a third party, there wuld be a cst invlved in disinvesting and transferring assets. These csts have t be brne ut by the scheme in full befre discntinuance benefits culd be decided The amunt f benefits culd further depend n the benefit ptins available with the third party and these may be different frm scheme (iii) The fllwing methds are available fr the trustees t prvisin fr the utstanding benefit payments: 1. Gradual remval f liabilities by the cntinuatin f the scheme withut any further accrual f benefits. 2. Transfer f the liabilities t anther pensin scheme with the same spnsr 3. Transfer f the funds t the beneficiary t extinguish the liability 4. Transfer f the funds t an insurance cmpany t invest and prvide a benefit 5. Transfer f the liabilities t an insurance cmpany t guarantee the benefits 6. Transfer f the liabilities t a central discntinuance fund, perated n a natinal r perhaps industry wide basis [13] Slutin 7 : The design features t be cnsidered in setting up a defined cntributin scheme are The level f benefits The affrdability f cntributins Market practice and alignment t market Segmented apprach based n age/ past service Any legislative requirement Fixed r variable cntributins Page 7 f 11

8 Optinal r Mandatry Cntributry r nn cntributry Tax benefits Death in service insurance r underpin In a DC scheme the benefit which will be prvided t the emplyee [ED (finance)] is nt knwn in advance; it will depend n: The cntributins that are paid, which is defined as 12% f Basic salary. The actual increases in salary in the future wuld determine the actual cntributins that wuld be paid The investment returns n the funds in the perid befre retirement. This wuld in turn depend n the timing f cntributins, the chice f the pensin fund manager, the type f fund, the earnings declared and the macr ecnmic factrs impacting the return & The cst f buying a pensin at retirement frm the annuity service prviders. This wuld in turn depend n the ecnmic scenari prevalent at the time f purchase, the number f players, the level f cmpetitiveness in the market etc. We culd hwever demnstrate the pensin benefit (grss) payable assuming sme scenaris n the salary escalatin rate, investment return in the future and the cst f buying pensin assuming n decrements up t retirement. The scenaris chsen shuld clearly articulate the key dependencies fr the pensin benefit and caveat the risks invlved. Slutin 8 : [10] Risk Bnds (issued by gvernments and large crprates) have generally stable market prices than equities In the event f default, bnd hlders generally rank higher than equity hlders and have a better chance f recvering their investment amunts Bnds are a gd match fr fixed nminal liabilities, whereas equities are a gd match fr real liabilities Return Equities are likely t give mre verall return than bnds in medium t lng term Equities are likely t prduce real returns (i.e. higher returns when inflatin is high), whereas fixed interest bnds prduce nminal returns Trustees Trustees will be cncerned with security f prmised benefits and nging slvency f the spnsr and the scheme Since the scheme is new, disinvestment f funds is unlikely therefre bnds can be held t maturity. In such a situatin, returns frm the investments are practically fixed with very little uncertainty Hwever, since the liabilities f a DB pensin scheme are real, while returns frm the bnds wuld be fixed, it is likely that in future that liabilities may grw at a faster pace than the assets, especially in a high inflatin scenari, increasing the chances f inslvency in future Members Members wuld be cncerned with security f prmised benefits and maximizatin f their wn discretinary benefits Page 8 f 11

9 Frm the viewpint f members, the current investment strategy can be cnsidered safe, given the specific circumstances f the scheme Hwever, the current strategy is unlikely t prduce much surplus s members culd nt hpe fr much discretinary increases if this strategy cntinues Spnsr Spnsr wuld be cncerned with reducing the verall cst f the scheme and reducing uncertainty f cntributins Bnds are likely t prduce fixed interests, which might be lwer than alternative investments Since the liabilities f the scheme are real, bnds (which prvide fixed returns) are nt a gd match. This implies that the spnsr may have t bring in mre funds t make up any deficit arising ut f this mismatch (iii) Since the liabilities f the scheme are lng term and real, sme expsure int real assets wuld greatly reduce the mismatch risk and increase returns. Intrductin f equities and index linked bnds wuld be beneficial (iv) The fllwing steps need t be fllwed: Mdel Develpment Time hrizn: Decide n time hrizn t prject assets and liabilities. In the given case, since funding rati is t be calculated fr next 10 years, the time hrizn needs t be at least 10 years 1. Liability cash flw mdel: Regular funding mdel may need t be mdified include the fllwing additinal functinalities: 1. Prjecting cash flws rather than just present values 2. Prjecting liability at each future valuatin date ver the chsen time hrizn using the chsen funding methd 3. Prjecting cash flws pertaining t all ptins and embedded guarantees 4. Including future new entrants 2. Number f simulatins: Decide n the number f scenaris. In this case, since prjected metrics need t be calculated fr each f the next 10 valuatin dates, number f simulatins needed wuld be large, e.g. 10, Investment mdel: 1. A stchastic investment mdel wuld need t be develped/selected; e.g. Wilkie mdel 2. The mdel will require a number f parameters t be specified (e.g. mean, variance and prbability distributins f varius investment returns), links and crrelatins between varius parameters (e.g. crrelatin between bnd and equity returns) 4. Valuatin data: 1. All f data needed fr regular funding valuatins will be required 2. Infrmatin regarding future new entrants t the scheme need t be included Perfrming simulatins 5. Decide n an initial asset mix, say 50% bnds and 50% equities 6. Run the investment and liability cash flw mdels tgether fr the chsen number f simulatins 7. Fr each f the 10,000 simulatins, calculate the value f assets and liabilities ver each f the next 10 valuatin dates and calculate the funding rati 8. Once all simulatins are ver, assess whether the chsen asset mix has met the primary bjective; i.e. whether the scheme has remained slvent ver next 10 years in 9,500 simulatins Page 9 f 11

10 9. If the primary bjective has been met, the investment strategy is shrt listed t be cnsidered while assessing secndary bjective, else the investment strategy is rejected. 10. Repeat steps 6 thrugh 10 by varying initial asset mix in each case. 11. List dwn asset allcatins that have been shrtlisted and rank them in rder f maximum funding rati at the end f chsen time hrizn; i.e. 10 th year in this case. Select the strategy that has resulted in the highest verall funding rati at the end f 10 th year. Slutin 9 : The assumptins relevant fr cnsideratin under the different funding methds are as belw: the discunt rate ; the rate at which earnings grw (e); the rate at which pensins increase in payment (p); the rate at which leaving service benefits are revalued (r); the age at which members retire frm the scheme (R); the age at which members enter the scheme (entry age); and the rate at which new members enter the scheme (new entrant rate). [16] Standard Cntributin Rate The cntributin rate (emplyer and emplyee) apprpriate t a particular funding methd befre taking accunt any Actuarial Surplus. It is nrmally expressed as a percentage f pensinable pay. Mdified Cntributin Rate The cntributin rate (emplyer and emplyee) btained by adjusting the Standard Cntributin Rate t allw fr any Actuarial Surplus. It is nrmally expressed as a percentage f pensinable pay. There are varius ways f amrtizing the Actuarial Surplus and hence f adjusting the Standard Cntributin Rate. The methd used shuld be apprpriate fr the purpse. (iii) Attained Age methd Standard cntributin rate (%) = 117,000,000/ 9,000,000 = 13 Actuarial liability (INR) = 300,000, ,000, ,000,000 = 500,000,000 Entry Age methd Standard cntributin rate (%) = 18,920 / = 11 Actuarial liability (INR) = 300,000, ,000, ,000, ,000,000 9,000, = 518,000,000 Prjected Unit methd Actuarial liability (INR) = 300,000, ,000, ,000,000 = 500,000,000 Standard cntributin rate (%) = 12,000,000 / 1,000,000 = 12 Current Unit methd Actuarial liability (INR) = 240,000, ,000, ,000,000 = 440,000,000 Standard cntributin rate accrual bit (%) = 8,000,000 / 1,000,000 = 8 Page 10 f 11

11 Standard cntributin rate revaluatin bit (%) = (256,000, ,000,000) / 1,000,000 = 16 Ttal standard cntributin rate (%) = 24 [15] Slutin 10 : The actual experience f a scheme shuld be mnitred: T check whether the methd and assumptins adpted fr financing the benefits cntinue t be apprpriate. Fr example, t check whether an initially assumed pst retirement mrtality assumptin f 100% f a certain mrtality table, cntinues t be valid If nt, what changes shuld be made in rder t achieve the desired level f prudence. Fr example, if pst retirement mrtality experience is turning ut t be 90% f a certain mrtality table, what revisin shuld be made t that assumptin fr the purpse f triennial actuarial valuatins T check if the scheme benefits, rules and plicies are financially viable r can be sustained in future. Fr example if discretinary pensin increases are turning ut t be t expensive, due t a cmbined effect f increasing lngevity, the practice f awarding discretinary increases may be stpped altgether Cmmn cnsideratins Cnsideratin shuld be given t whether the perid under investigatin was typical and whether the experience is likely t be representative f future experience Cnsideratin wuld als need t be given that the perid f investigatin des nt cntain any significant abnrmal events r randm fluctuatins that culd have resulted in biased estimates f mrtality Cnsideratin shuld be given t whether analysis has been perfrmed n sufficiently hmgeneus grups that are expected t exhibit similar levels f mrtality. If analysis has nt been dne n hmgeneus grups, it wuld be imprtant t ensure that the individuals t whm the investigatin related are still relatively hmgeneus with the individuals whse benefits will be affected by future experience Pst retirement mrtality It wuld be essential t cnsider and identify any trend during the analysis, e.g. mrtality imprvements. Cnsideratin shuld be given t whether there is any reasn why these trends may cntinue int future and assumptins abut future experience shuld be mdified accrdingly Cnsideratin shuld be given t the verall vlume and credibility f data frm which the results have been derived Salary escalatin It wuld be essential t cnsider whether the implied salary escalatin rates are biased because f the impact f ecnmic cycles. It wuld be essential t identify and remve the impact f such cycles befre incrprating results f the analysis Cnsideratin shuld be given t ther crrelated macr ecnmic factrs ver the investigatin perid and expected t prevail ver future perids. [8] [Ttal Marks 100] ****************************** Page 11 f 11