THE SELECTION OF ACTUARIAL ASSUMPTIONS IN AN UNSTABLE ECONOMY, MEXICO A CASE HISTORY MARCELA FLORES QU IROZ BUFETE DE CONSULTORIA ACTUARIAL, MEXICO

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1 THE SELECTION OF ACTUARIAL ASSUMPTIONS IN AN UNSTABLE ECONOMY, MEXICO A CASE HISTORY I MARCELA FLORES QU IROZ BUFETE DE CONSULTORIA ACTUARIAL, MEXICO When an economy unergoes rastic variations of the macroeconomic variables from one year to another an from one political perio to another, the setting of economic-financial assumptions to calculate long term efine benefit plans liabilities becomes extremely complex. In this article we are going to concentrate on Plans that are not fune but that recognize the liabilities base on accounting principles (Mexico, Bulletin D-3, equivalent to FASB87 in the USA). The objective of these accounting principles is that the companies recognize the liabilities in the financial statements as they are accrue an also that the calculation methoology reflects more accurately this accrual basis. We know that each hypothesis shoul reflect the best estimate of the future performance of the Plan with regar to each hypothesis. Also, an as mentione in paragraph 202 of FASB87, Basis for Conclusions: "The Boar also aresse assume compensation levels an conclue that they.shoul (a) reflect the best estimate of actual future compensation levels for the iniviuals involve an (b) be consistent with assume iscount rates to the extent that both incorporate expectations of the same future economic conitions."

2 On the other han, in non inflationary economies the accounting principles recommen the use of nominal rates in the calculation. However, the ifferences between the nominal rates in unstable economies from one year to another are highly significant an therefore o not reflect the best assumption estimates. In an unstable economy, with hyperinflationary an recession perios, it is not so easy to ientify the correlation between variables or to make forecasts in nominal terms for more than three years starting on the current year, an to make inferences base on experience oes not reflect the future experience of assumptions. As an example, in the following charts we show the figures of the Mexican economy for the last I I years ( ), in nominal an real terms on:. Inflation Yiel of Government Bons Minimum Wage Average salary increases reporte in companies engage in ifferent activities. (Sample of 150 companies) /'- NOMINAL RATES Y % % % -GOMRNMWT BONDS % -MINIMUM WAGE % 80.00% 60.00% 40.00% 20.00% 0.00% " a -, - Q a - h - m % - m O a - N % m - z. " ~ ~

3 REAL RATES (INFLATION FREE) As can be seen in the charts of the high inflation years, the relationship between the economic variables is not clear. This relationship was present in the years in which inflation was uner control ( ), but since there was instability before 1991 an after 1995, that relationship between. variables cannot be inferre. In the unstable economic scenario in Mexico: Long term efine benefit plans liabilities lose purchasing power with time, because actual salary increase rates are negative, for several years. If the liabilities are fune, since the yiel rate is much higher than the salary increase rate (more than 30 points in a single year), the Plans are excessively fune, because it is not possible to estimate that the ifferential can be so high.

4 The various hypothesis selection criteria use to calculate the liabilities an etermine the Net Perioic Cost are: Flat nominal rates Real rates (inflation free) 0 Not restate for inflation ' 0 Restating of real inflation known at year en Select rates In orer to show the variations uner the various hypothesis selection methoologies, below we show four charts with the Actuarial Valuation figures in a case history from January 1, 1993 through December 31, 1995 of a 560 employee company with the following features: Jan. 1, Dec. 31, % 8.01 % Dec. 31, % 7.05% Dec. 3 1, % 51.97% I Proi. Dec. 31, % % In these examples a typical Retirement Plan in Mexico is being contemplate, which grants at the normal 65 years ol retirement age with at least 15 years of service, a lump sum payment equivalent to three months of salary plus 20 ays of salary per each year of service.

5 EFFECTS OF ASSUMPTIONS USING FLAT LONG TERM NOMINAL RA JES ACTUARIAL FIGURESAND EFFECT ON FINANCIAL SJA JEMENJS TYPICAL RETIREMENT PLAN IN MEXICO ASSUMPTIONS SALARYINCREASE EXPECTED WORK UFE OBLIGA~ONS DISCOUNT RATE MINIMUM SALARYINCREASE RA TE RENRN ON ASSETS PROJECTED BENEFIT OBUGATION FUNDED STATUS TRANSITION (ASSETS) LlABNJTIES NET (GAINS) OR LOSSES (10% CORRIDOR) UNRECOGNIZED NETIGAINSJ OR LOSSES SURIECT TO AMORTI~~TION (ACCRUED) /PREPAID ACTUAL PROJECTED ACTUAL PROJECTED ACTUAL PROJECTED ACTUAL PROJECTED 10 ENE DlCl DIC DIC DIC DIC DIC DIC ,754,396) 63,552,523) ($3,816,373) (f ) (f ) (S ) (17,766,999) ($9,531,859) 10 SO s 0 so so so 10 so ( ) ($3,552,523) (13,816,373) ($ ) ($5,125,963) ($ ) ( ) (19,531,859) 12,754,396 12,524,863 $2,524,863 $ $2,065,797 S S INTEREST COST. SERVICE COST RETURN ON AMORTIZATION OF TRANSITION LlABlUTIES (ASSETS) AMORTIZATION OF UNRECOGNIZED NETIGAINJ.. OR LOSS ACCUMULATED BENEHTOBUGATION UNFUNDED ACCUMULATED BENEFITS ADDITIONAL WBlUrY INTANGIBLE ASSETS MAXIMUM INTANGIBLE ASSETS CHARGE TO EQUITY

6 EFFECTS OF ASSUMPTIONS USING REAL RATES (INFLATION FREE) WITHOUT RESTATING FOR INFLATION ACTUARIAL FIGURES AND EFFECT ON FINANCIAL STATEMENTS TYPICAL RETIREMENT PLAN IN MEXICO ASSUMPTIONS SALARY INCREASE EXPECTED WORK LIFE OBLIGATIONS DISCOUNT RA TE MINIMUM SALARY INCREASE RATE RETURN ON ASSETS PROJECTED BENEFIT OBLIGATION FUNDED STATUS TRANSITION IASSETSJ LIABILITIES NET (GAINS) OR LOSSES HO% CORRIDORJ linrfcogn17fo NET..-. * fgainsi -..., OR -..- LOSSES..-. SUBJECT TO AMORTIZATION (ACCRUED) I PREPAID ACTUAL PROJECTED ACTUAL PROJECTED ACTUAL PRWECTED ACTUAL PRWECTED lo ENE DIC DIC DIC DIC DIC DIC DIC 1998 INTEREST COST SERVICE COST RETURN ON AMORTIZATION OF TRANSITION LIABILITIES (ASSETS) AMORTIZATION OF UNRECOGNIZED NET (GAIN) OR LOSS PAYMENTS SO SO SO $0 SO SO SO ACCUMULATED BENEFIT OBLIGATION UNFUNDED ACCUMULATED BENEFITS ADDITIONAL LIABILITY INTANGIBLE ASSETS MAXIMUM INTANGIBLE ASSETS CHARGE TO EQUITY

7 EFFECTS OF ASSUMPTIONS USING REAL R A M AND RESTATING THE PROIECTION FOR INFLATION AT EACH YEAR-END ACTUARIAL FIGURES AND EFFECT ON FINANCIAL STATEMENTS TYPICAL RETIREMENT PLAN IN MEXICO ASSUMPTIONS MINIMUM SALARY INCREASE RATE RETURN ON ASSETS INFLATION RATE PROJECTED BENEFIT OBLIGATION. FUNDED..--- STATUS. - - TRANSITION (ASSETS) LIABILITIES NET (GAINS) OR LOSSES ACNAL PROJECTED 10 ENE DIC 1993 ($ ) ($2,999,896) $0 SO (12,283,643) ( ) $2,283,643 $ ACNAL 31 DIC 1993 ($3,183,107) $0 ($3, ) $2, PROJECTED 31 DIC 1994 (s4.060,asg) so (S4.wO.859) S2.2W.380 ACNAL PROJECTED 31 DIC DIC 1995 ($ ) (17,582,819) so so ( ) (17,582,819) S2.2W.380 $3,009,525 1.WA WS( 0.W' 6.WA 51.9PA 25.9PA PROJECTED BEFORE PROJECTED AFlER ACNAL INFLATION EFFECT INFLATION EFFECT 31 DIC DIC DIC 1996 (16,594,664) ( ) (S ) SO $0 $0 ($6,594,684) (57,635,829) ($9,613,509) 13, $2,675,153 $ UNRECOGNIZED NET(GA1NS) OR LC SUBJECT TO AMORTIUITION (ACCRUED) /PREPAID INTEREST COST SERWCE COST RETURN ON AMORl7ZATION OF TRANSITION LIABILITIES (ASSETS) AMORTlZAnON OF UNRECOGNIZED NET (GAIN) OR LOSS PAYMENTS SO SO SO $0 SO SO $0 SO ACCUMULATED BENEFIT OBLIGATION (S ) ($1,586,966) ($1,680,037) ($ ) $0 $0 SO $0 UNFUNDED ACCUMULATED BENEFITS ($ ) ($1,586,956) ($1,680,037) ($ ). ADDITIONAL LlABklTY INTANGIBLE ASSETS MAXMUM INTANGIBLE ASSETS CHARGE TO EQUITY

8 EFFECTS OF ASSUMI'TIONS USING SELECTED RATES ACTUARIAL FIGURES AND EFFECT ON FINANCIAL STATEMENTS TYPICAL RETIREMENT PLANT IN MEXICO ASSUMPllONS SALARY INCREASE EYPECTED WORK LIFE OBLlGAllONS DISCOUNT RATE MINIMUM SALARY INCREASE RATE RENRN ON ASSETS PROJECTED BENEFIT OBLIGATION FUNDED STATUS TRANSITION (ASSETS) LlABlLlTJES NET (GAINS) OR LOSSES (10% CORRIDOR) UNRECOGNIZED NET (GAINS) OR LOSSES SUBJECT TO AMORTIZATION (ACCRUED) /PREPAID ACNAL PROJECTED ACNAL PROJECTED ACNAL PWECTED ACNAL PROJECTED ' 10 ENE DlC DIC DIC DIC DIC OlC DIC 19% (12,754396) (13,685,328) ($3,835,503) ($4,933,939) ($5,149,380) ($7,474,587) ($7,780,804) ($10,3M,912) so s 0 so so so SO so so (s2, ) (S ) ( ) (14,933,989) (S ) ($7,474,587) ($7,780,804) ($10,3~,912) 12,754,396 $2,524,863 12,524,863 $2,295,330 $2,295,330 12,065,797 $2,065,797 S INTEREST COST SERVICE COST RETURN ON AMORTIZATION OF TRANSITION LIABILITIES (ASSE)TS) AMORTIZATiON OF UNRECOGNIZED NET (GAIN) OR LOSS PAYMENTS ACCUMULATED BENEFIT OBLIGATION (11,422 UNFUNDED ACCUMULATED BENEFITS ADDITIONAL LIABILITY ($1,422 INTANGIBLE ASSETS S MAXIMUM INTANGIBLE ASSETS $1.422 CHARGE TO EQUITY

9 The following erives from the figures above: Recognition Level of PBO after 4 years 61.30% 50.55% 70.36% 75.77% Recognition Level of ABO after 4 years % 89.31% % % Corrior for losses or (gains) in PBO% 1 0% 1 0% (6.24%) 8.63% ILosses or (gains) to be amortize in PBO% 11.28% 20.88% 0% 0% The conclusions from the application of several hypothesis selection criteria are as follows: a) Flat Nominal Rate.- A selection of iscount rates an equal salary increases each year is mae in this methoology consiering the average rates for several years an assuming that the economy in the future is stabilize an follows international trens (in the case of Mexico this means coming close to what happens in the U.S.A.). This metho tries to reflect a long term nominal rate, which is not a real rate in an unstable economy.

10 Uner this metho, the assumptions are not close to reality until there is stability an therefore variations in assumptions in etermining the Projecte Benefits Obligations an also Accumulate Benefits Obligations are generate, an they accumulate with time. But, if the economy oes not stabilize there will always be a fixe 10% variation corrior, plus a transitory item which amount becomes highly significant in proportion to the Projecte Benefits Obligations will not be fune. This is the most wiely use metho because it eliminates significant percentage increases from one year to another ue to the effects of inflation on the perio net costs an efers the effect of high inflation rates in time. In our opinion this metho oes not reflect the best estimate of the actual status of the liabilities an oes not abie by the accrual metho. b) Real Rates not restate every year for the effects of inflation. This methoology is equivalent to a flat rate in real terms, iscounting inflation, but with the same problem, mentione above, more severe as it iffers more from reality, an therefore oes not reflect either the best estimate of the Projecte Benefits Obligations nor follows the accrual metho. Real Rates, restating at the en of each perio, the liabilities to recognize the effects of inflation.- The actual average salary increase an iscount rates are etermine with this methoology base on the experience of the rate average uring an "N" perio of prior years. These rates are use as flat real rates to calculate the actual obligations at year-en an they are use to project the estimate for the following year-en. However, at the en of each year or each month, all obligations, liabilities an assets are restate for real inflation of the perio in question, in orer to restate at present value the figures at their purchasing power.

11 When the estimate values of the Projecte Benefits Obligations restate for inflation are compare with the calculation of those actual obligations at year-en with salaries that were increase to recognize the effects of inflation, the variations in assumptions are realistic. With this metho the etermination of the obligations is ajuste to reality. The problem of this methoology is that the accounting principles etermine the Net Cost at the beginning of the year but o not contemplate restatement an the assumptions variations ajustments are amortize on the following year, as part of the Perioic Net Cost, so in orer to apply this selection criteria, it woul be necessary to inclue in the Accounting Principles this restatement for inflation consieration in an unstable economy. Although in the accounting principles of unstable an inflationary economies like Mexico's this moification may be feasible, multinational companies woul face the problem of conciliation with international principles (in Mexico, basically with FASB87). ) Select Rates.- Nominal rates are selecte in this methoology in accorance with the economic bugets of the country, for a perio of years which can supposely be realistic an it is eeme that they will be stable after a specific year. Normally macroeconomic projections are applie for the first years projecte (three years) an they are base on the assumption that the economy will subsequently stabilize (flat long term rate beginning on the 4th year projecte). This metho reflects the accrual metho, realistically recognizes the salary increases nominally forecaste for the following years, recognizes the liabilities by the status of the economic situation an oes not generate significant or increasing variations in the assumptions as the other methos o.

12 In general terms, the reason why this metho is not use is because the calculation process requires more variables an because in high inflationary perios the Perioic Net Cost for the companies (specially when there are no funs), has significant impacts since, all the inflation is recognize as it accrues an is not eferre. In our opinion an as a conclusion, we can say that in an unstable economy calculation hypothesis have to be etermine: a) Uner a criteria of select rates, since in this manner you can come closer to reality an reflect the liabilities as they are generate, ajusting to amounts accrue, specially when there are no Funs. When there are Funs, the effect is reuce since the real interest rates pai in unstable economies are very high an therefore, the yiels cover in excess the effects of inflation. However, the select rates metho is also the one that comes closer to reality. b) If the real or flat nominal rates metho is use, at each year-en the obligations, assets an liabilities estimate, mae at the beginning of the year, shoul be restate to recognize the effects of inflation before etermining the variations in the assumptions to avoi a eferral in time.