The Future of Occupational Pensions is Unfunded, Insured DB

Transcription

1 The Future of Occupational Pensions is Unfunded, Insured DB Stockholm 2011 Con Keating BrightonRock Assurance 1 Summary Occupational pensions are affordable at the level of the state and the private sector Much misguided regulation and practice has been introduced This has proved overly costly and has resulted in most sponsors withdrawing provision DB is massively more efficient than DC, which is merely a tax-advantaged savings scheme. The emphasis upon funding in DB is wrong Pension Indemnity Assurance can surplant this at significant cost savings This extends even to unfunded book-reserve arrangements Which reinstate sponsor incentives And should even lower the sole pension risk faced by members sponsor insolvency. And it was invented in Sweden! 2 1

2 DB vs DC GDP per capita Savings are sufficient Collective solutions are highly efficient Convexity may lower collective cost Historic View of GDP Year share 3 Changing consumption patterns As we get richer and more productive, we can be expected to spend more on health, education and retirement. Both absolutely and proportionally The fifty year projections of GDP show this increasing almost fourfold 4 2

3 Further Risk-Sharing Benefits Inter-temporal effects Young and old actives Member Employer Total Open Closed Open Closed Open Closed A function of returns achieved Savings pot at retirement Considerable disparity in individual outcomes under DC Annuitisation at retirement Group is 25% or so superior Savings incentives are not the same for different income and tax regimes And really quite small. 5 DB the problem A pension is a claim on future production Producers can contract on their future production Without the intervention of financial markets In fact financial market claims are just such contracts Though subject to the animal spirits of those markets The efficient contract is the direct promise of the sponsor producer Funding introduces a time inconsistency It is inconsistent to demand contributions today to fund a promise of pensions payable in the far future These remove the incentive for the sponsor to offer pensions at all Funding can be seen as security for the pension promise It is inefficient for the sponsor and the pensioner The problem that it attempts to solve is sponsor insolvency 6 3

4 Earnings Economic growth is greater than the increase in life expectancy and pensions payable PNFC earnings have averaged 12.5% p.a. It is evident that the public and private sectors can collectively afford pensions. But there may be a problem in distribution 7 Markets and Earnings Financial market returns are unrelated to corporate earnings And an order of magnitude more volatile This holds internationally This suggests that funding may be misconceived and that it will induce dependencies in the real economy from these activities 8 4

5 Funding and Regulation Occupational Pension Schemes Risk is the product of the likelihood of sponsor insolvency and the consequence of the level of funding at insolvency. The order is important unless the sponsor is insolvent the level of funding is immaterial, though fund investment income may be an issue. But regulators properly have no role intervening in corporate insolvency This leaves them only scheme funding (assets) as a control variable Even if a scheme is 100% funded at sponsor insolvency this is insufficient for the scheme to buy-out liabilities or run them off standing alone. This leads to asset based solvency regulation much favoured in Europe But funding regulations are themselves very costly Sponsor insolvency really is the sole risk faced by scheme members 9 Solvency 2 Solvency 2 treats an occupational pension scheme as if it is an insurance company this is a mistake. They are economically very different. It will require all pension schemes to be funded at 130% - 150% of the technical best estimate of liabilities. The Dutch FTK system is very similar and its difficulties are now well-known In the context of UK corporate schemes ( 1.1 trillion liabilities) this will require an additional billion of investment. Total UK pension contributions (of all types 2010) were 82 billion Total UK business investment was 122 billion (pre-crash high: 144 billion) UK budget funding deficit was billion The current annual PPF insolvency estimate is 0.4% of schemes and average funding is 82%. This means that the pensioner risk is actually less than 1 Billion before insolvency expenses 10 5

6 Pension Indemnity Assurance The average UK annual insolvency rate is 0.6% of active companies Let us suppose that schemes are only 50% funded Let us suppose that this insolvency rate applies in steady state Then the annual total insured loss, if all are covered, is 3.3 billion and the total steady state exposure if schemes run off at 5% p.a. is just 34.5 billion Even is schemes are entirely unfunded this figure merely doubles to 69 billion. The Solvency 2 funding approach is hopelessly inefficient. It removes any incentive for the sponsor to offer DB pensions It makes the provision of DB actuarial unfair and excessively costly. A PIA policy is an asset of the scheme it reduces sponsor pension provision costs significantly. PIA will come to be seen as the correct solution internationally 11 Pension Schemes have changed Derivatives now account for 7% of scheme assets We have LDI, Fiduciary Management, ETVs and a host of actions But costs continue rising 12 6

7 De-Risking Really hasn t worked 13 Complexity Why? Large number of control variables The concept of prudence has run riot Apparent costs have escalated beyond control One current illustration: BBC BBC m Surplus Interest on Surplus 52 Lower than assumed investment returns Effect on liabiliges of changes in market condigons ContribuGons lower than required - 5 Salary growth higher than assumed - 17 Membership profile different from assumed mortality to MC with 1% pa floor to 2010 post regrement discount rate Change early regrement terms 271 Mortality Changes base table 128 allowance for future improvements Effect assumpgon salary increases RPI to Change in discount rate to allow for weaker covenant Salford reserve - 12 Shor8all pre change Changes benefit structure 474 Shor8all post change

8 An Illustration Prudence The BBC trustees had a covenant review conducted This found that the covenant deteriorated from strong to tending to strong This is equivalent to about a 10 basis point increase in the insolvency likelihood of the BBC The Trustees therefore lowered the discount rate used to evaluate liabilities by 18 basis points On a stand alone basis this amounts to an increase in liabilities of 296 million note: this is not the 216 million of their attribution analysis Let us suppose the deficit is actually 1 billion, then the true increase in risk is 1 million Prudence is not biased, reckless conservatism but rational and well-informed behaviour. But this is not the sole source of the problems There are also basis risks in the hedges taken on 15 Basis Risks Longevity The basis in index-hedges can be enormous The swap spread is highly volatile relative to gilts Derivatives collateral support agreements can result in forced sales of assets Assumptions on asset returns seem to be inverse to the market And

9 Basis Many have resisted Hedging is speculation Scheme income yields are problematic 17 Why does this matter? 18 9

10 Incentives The problem with funding is that it removes any incentive for the sponsor to offer occupational DB. Unfunded book reserve reinstates these. The problem of sponsor insolvency can be resolved by pension indemnity assurance This is not a compensation fund arrangement such as the PPF or PSV ag It is provision by the sponsor for the possibility of its own failure As such it is an asset of the scheme With countercyclical properties It is inexpensive in terms of premiums And the asset value behaviour more than offsets this 19 Summary Occupational pensions are affordable at the level of the state and the private sector Much misguided regulation and practice has been introduced This has proved overly costly and has resulted in most sponsors withdrawing provision DB is massively more efficient than DC, which is merely a tax-advantaged savings scheme. The emphasis upon funding in DB is wrong Pension Indemnity Assurance can surplant this at significant cost savings This extends even to unfunded book-reserve arrangements Which reinstate sponsor incentives And should even lower the sole pension risk faced by members sponsor insolvency

11 The changing world Investment assumptions: The developed world is losing importance With that comes increased world trade Perhaps as much as 34% of Global GDP Increases investment demand % GDP With constrained saving - 24%? The result is the re-emergence of a risk premium 2%? Certainly such radical change will induce financial market volatility, as these adjust Before ending a couple of questions China India Asia Ex Sub-Sahara MENA Latin America CIS US EU - 27 Japan ROW 21 Papers and Two papers on pensions Don t stop thinking about tomorrow Available from: Don t stop believing Available from: And the future should be unfunded, insured DB 22 11