Understanding challenges around pension schemes discounting policies

Transcription

1 Understanding challenges around pension schemes discounting policies The lively debate around the use of the revised IORP Directive s Holistic Balance Sheet (HBS) gives us an occasion to provide a quick overview of pension schemes liabilities discounting policies and asset allocation practices in Europe and in the US. We conclude by explaining the threat posed to those pension funds that continue to use fixed discount rates and we stress the importance of managing assets in line with liabilities. What is the IORP Directive debate about? There are currently a great variety of occupational pensions systems in the EU Member States, with significantly different regulations and prudential regimes. This lack of a consistent framework makes it difficult to develop a harmonized Europe-wide supervisory regime for pension providers. In particular, there is currently no common framework to evaluate the liabilities of IORPs (Institutions for Occupational Retirement Provision) that operate defined benefits (DB) schemes and to compare their solvency capital requirements in a consistent way. This is why the European Insurance and Occupational Pensions Authority (EIOPA, a European authority which mission is to protect pension schemes members and beneficiaries) proposed the European Commission to revise the IORP Directive, seeking to develop a sound risk management framework, especially for the institutions providing DB schemes. The main stumbling block in EIOPA proposal is the concept of the holistic balance sheet (HBS): It is supposed to illustrate the overall funding requirements of IORPs by comparing the different components of liabilities (best estimate, risk margin and solvency capital requirements) with the different components of assets the IORP might have available (financial assets, sponsor support and pension protection schemes) 1. As the liabilities would have to be valued using a common discounting policy, many institutions may have to change their accounting methods. As a slight modification in discounting methods can dramatically change the value of an 1

2 institution s liabilities, schemes that currently use relatively high discounting rates may see their funding ratio deteriorated. Discounting pension liabilities, where are we now? Rules to discount pension liabilities differ from one country to another, and they vary with the type of institution that uses them. From the sponsor's side, firms using IFRS value their pension liabilities using AA corporate yield curves (for instance, using IBoxx Corporate AA10+ yields or 5-7 depending on the duration of their pension liabilities). In Germany, in line with the German GAAP, corporates usually discount their pension liabilities using the 15- years yields published by the Bundesbank. From the pension fund s stand point, an institution operating in a regulatory system with no specific rules apart from the prudent person principle must also value its liabilities under IFRS rules 2. Example of specific regulatory regimes in Europe: In the United Kingdom, in order "to allow schemes flexibility to match their investment strategy to the profile of their members" 3, the Pensions Regulator requires in the Pensions Act that trustees and the employer reach an agreement on the assumptions and method used to value the DB pension schemes' liabilities. Thus, in practice, some institutions discount liabilities using fixed rates based on gilts while others prefer using corporate bond yields 4. Reversely, no room is let to the Dutch pension funds. These later must follow the rules stipulated by the FTK (the Financial Assessment Framework): liabilities must be discounted depending on their maturity, using the Euro swap curve published by the DNB, the Dutch Central Bank. For long maturities, the swap curve is extrapolated beyond its last liquid point, from the last available rate to an Ultimate Forward Rate (UFR) determined by the Central Bank. In France, the pension liabilities discount rate is not a major source of debate. Indeed, relatively few pensions are privately funded, as most of the pensions are managed by government funds on a pay-as-you-go basis. Still, complementary retirement regimes must refer to different Codes, according to their nature. French IORPs such as institutions de prévoyance and mutuelles for instance cannot use a rate greater than the minimum between 3.5% and 60% of the "TME" (the average of French Government Bonds yields above 7 years 5 ). In practice however, some institutions have been using lower rates 6. 2

3 And what about the US? Two main sources of regulation influence the way US corporate pensions value their liabilities: for US GAAP balance sheet reporting, pension liabilities are valued using discount curves, such as the Citigroup Pension Discount Curve, calculated using AA zero-coupon current market rates. The US Pension Protection Act (modified in 2012 by the Pension Funding Stabilization provision) also provides a framework to value liabilities: three rates are used to discount cash flows, depending on their maturity. Each rate is determined by adding a cap and floor to the current year's corporate bond rates. For 2012, the cap is set at 110% and the floor at 90% of the 25-year average yield of each segment, computed by the U.S. Treasury. Each year, the cap and floor corridor will ramp up by 5% until In contrast to the US corporate pensions fund, US public pension funds are subject to the Government Accounting Standards Board (GASB) guidelines for discounting liabilities. These guidelines allow them to base their liability discount rates on the expected rate of returns of their assets, which gives boards very significant latitude to choose their rate. It results that on average, public funds like CalPers 8 are maintaining steady discount rates around 7.5%! 9 Going forward This overview gives an idea of how different every country s situation is when it comes to assessing pension funds liabilities and how difficult it will be for the European regulator to reach a common ground. However, we believe that the real challenge around pension schemes discounting policies is very straightforward. The regulator should make sure that the established framework enables pension schemes to manage their assets in line with their liabilities. That actually means providing a setting in which it is easy to manage the funding ratio. Using a mark-to-market yield curve instead of a fixed rate or an ultimate forward rate is already a big step toward managing assets in line with the liabilities. It allows pension funds to construct some form of liability hedging portfolio without necessarily using a heavy load of derivatives. Indeed, when liabilities are discounted using a fixed rate, their value does not depend on the yield-curve movements. But if the yields were to move upward, the pensions fixed income assets would depreciate, resulting overall in a decline of the scheme s solvency ratio. 3

4 To illustrate this, let s imagine a pension fund that uses a 2,5% discount rate, has a 100% funding ratio and is considered to be fully hedged by a bond portfolio of the same duration as the liabilities (16 years). A parallel upwards shift of 1% of the yield curve will have no impact on the value of the liabilities but will result in a mark-to-market depreciation of the assets of around 16%, thus a substantial move in the funding ratio (from 100% to 84%). Now if the pension fund were to use the yield curve to discount liabilities, the 1% yield curve movement would have impacted equally the assets and the liabilities, resulting in a stable 100% funding ratio after the yields move. This simplified example shows how a mark-to-market liabilities valuation increases the volatility of the liabilities, BUT helps monitor the funding ratio more consistently. Another significant improvement (already implemented, for instance, in the US or in the Netherlands) is making sure that the funding ratio becomes a risk measure that it is accounted for and managed. The benefit of using funding ratio to manage risk as opposed to volatility or VaR or any other standard measure has proved to provide greater security for future pensions at a minimum cost. But as simple as it seems, the management of the funding ratio is a challenge in itself. A study published in , surveying over 58 pension funds worldwide, shows that 88% of the institutions do monitor the risks associated to the management of assets, but that only 48% of them monitor the risk of having assets uncorrelated to the liabilities. Therefore, we see that more than the half of respondents invest without visibility and measure ex-post the resulting funding ratio, because required to do so. It also shows that two thirds of respondents only update their situation quarterly. Some pensions funds, such as ATP in Denmark, PP Pensions in Sweden or Healthcare of Ontario Pension Plan in Canada, didn t wait for regulation to push them towards a dynamic management of their funding ratio and un-surprisingly, they are among the few ones that are not worried at the moment. There are several ways of applying a dynamic process but the approach that we favor derives from the portfolio insurance theory. The process is rules-based and very straightforward. The portfolio is divided into two components: one designed to meet the scheme s liabilities, and the other, riskier, whose purpose is to boost performance. The allocation between the two parts varies periodically based on the margin between the pension fund s current funding ratio and the funding ratio that needs to be protected: the bigger the margin, the bigger the investment into the risky part. Thus risk taking is proportional to this margin for error. 4

5 By using a protection level that scales up each time a superior funding ratio is reached, the method contributes to a progressive improvement of the scheme s solvency, and helps to decrease significantly the contributions that are necessary in the context of funding recovery plans. Adina Grigoriu Actuary Co-founder & CEO Active Asset Allocation adina.grigoriu@aaaic.com Jacques-Yves Merelle Risk Management Active Asset Allocation jacques-yves.merelle@aaaic.com Vania Schleef Business Relationship Manager Active Asset Allocation vania.schleef@aaaic.com 5

6 1 Quantitative Impact Study (QIS) on Institutions for Occupational Retirement Provision (IORPs), Technical Specifications. October 8, Blome, S. et al. (2007), Pension Fund Regulation and Risk Management: Results from an ALM Optimisation Exercise, OECD Working Papers on Insurance and Private Pensions, No. 8, OECD Publishing. DOI: / P.13 3 Pension scheme funding requirements, Library House of Commons, 20 March We recommend the reading of the following article: John Ralfe. Smoothing won t solve our pension problems. Financial Times, December 9, Comment couvrir ses engagements face à la baisse de la rentabilité des actifs financiers et à la disparition de l actif sans risque? Aberdeen Asset Management, Image et Finance, (March 2012) p Bernstein, Martin (2012), Quantitative Pension Strategy: The Pension Funding Stabilization Provision, Citi Investment Research & Analysis, 22 June http: // 9 Andonov, Bauer, Cremers. Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans? (May 2012) P.8 10 Dupont, David, Halim, Sandy et Miller, Terrie. How Pension Funds Manage Investment Risks: A Global Survey, Rotman International Journal of Pension Management, vol. 3, no. 2 (Fall 2010), p Active Asset Allocation International Consulting (AAAiC) is a leading financial engineering company providing institutional investors and asset managers worldwide with state-of-the-art asset allocation techniques. We design customized asset allocation programs, taking into account investors particular risk or allocation constraints and financial regulation. Our models enable pension funds to improve their funding ratio with a substantial diminution of contributions. For more information, visit. AAAiC, Active Asset Allocation, DALM solution, taux d actualisation, outcome, asset allocation solution, Jaacques-Yves Merelle, EDHEC Risk-Institute Disclaimer 2013, AAAiC. All rights reserved. This document has been prepared by Active Asset Allocation International Consulting (AAAiC), as thoroughly as possible and with extreme caution. Information, descriptive analyses or statistics contained herein have been obtained from sources believed to be reliable, but not guaranteed and they do not engage the responsibility of AAAiC. This material has been distributed for informational purposes and for the recipients use only. It should not be considered as investment advice or a recommendation of any particular security, strategy or investment product and it does not release readers from the need to form their own judgment. AAAiC shall not be held responsible either for any direct or indirect damage incurred as a result of the use of information provided in this document. No part of this material may be reproduced in any form, without express written permission from AAAiC. Violation of this provision may lead to legal action. 6