Subject: Mercer Model for developing accounting discount rates in Canada

Transcription

1 Loyd Zadorozny Partner 161 Bay Street, P.O. Box 501 Toronto, Ontario M5J 2S Fax Filed: University Avenue Toronto, Ontario M5G 1X6 Subject: Mercer Model for developing accounting discount rates in Canada As requested, this letter provides an overview of the current Mercer Model (formerly referred to the Enhanced Mercer Model) for developing accounting discount rates in Canada. Mercer uses this model when assisting Canadian plan sponsors in establishing their best estimate assumption for accounting discount rates for their pension and non-pension post-retirement benefit plans. The letter also summarizes the accounting discount rates based on the CIA Model and the Mercer Model (both described in more detail below) at OPG s most recent fiscal year-end, December 31, Background Since the beginning of 2000, Mercer Canada has developed monthly accounting discount rates for Canadian pension and non-pension post-retirement benefit plans under Canadian, US and international accounting standards. These rates are used to assist Canadian plan sponsors in establishing their best estimate assumption for the accounting discount rate. Prior to 2012, Mercer s calculation of monthly accounting discount rates (as well as those of a number of other actuarial firms) was based on representative AA rated corporate bond yields provided by PC Bond Analytics at a number of maturities. Because of the limited number of AA rated corporate bonds in the Canadian market, especially at longer maturities, in September 2011 the Canadian Institute of Actuaries (the CIA ) published an educational note (the Educational Note ) proposing a methodology to derive a high quality corporate yield curve (the CIA Methodology ) which was generally believed to be an improvement to the use of representative yields provided by PC Bond Analytics. Mercer (Canada) Limited

2 Page 2 Under the CIA Methodology, AA rated corporate bond yields for maturities over 10 years are extrapolated based on AA rated provincial bond yields to which a spread is added to reflect the additional credit risk of AA rated corporate bonds. While recognizing that there are different ways to determine the spread used in extrapolating AA rated corporate bond yields, the Educational Note suggested an approach to determine the spread (the CIA Spread ). On a monthly basis, Fiera Capital (formerly Natcan) publishes a spot rate curve based on the CIA Methodology and the CIA Spread (the CIA Model or CIA Curve ). As a result of the Educational Note, Mercer updated its accounting discount rate model in The updated model (the Mercer Model ) is based on the framework proposed under the CIA Methodology but with a different spread approach, as described below. Mercer converted to the Mercer Model effective September 30, The Mercer Model is monitored periodically and may be adjusted in the future as needed to reflect changes in the market. Bond Data Used Under the Mercer Model, the data used is obtained from Bank of America Merrill Lynch, which is the same source of data used by Fiera Capital to develop the monthly CIA Curve. At December 31, 2012, one difference between the CIA Model and the Mercer Model was which bonds were included under each model: The CIA Model considered AA rated corporate bonds that were rated AA by at least two rating agencies. Considering the limited number of high quality corporate bond issues available in Canada for longer maturities, Mercer believes that as much relevant information as possible should be used in the development of the high quality yield curve. As such, the Mercer Model includes corporate bonds that are rated AA by at least one rating agency. We note that in March 2013, the CIA Model expanded its AA rated corporate bond universe to include bond issues that are rated at least AA by at least one rating agency. Following this modification to the CIA Model, both models now use the same data.

3 Page 3 As previously estimated by Mercer when the Mercer Model was developed, this modification in the bond universe used by the CIA Model increased the resulting CIA Model discount rates by approximately 20 basis points on average, bringing them closer to the level of the discount rates derived using the Mercer Model. Development of the Yield Curve Under the CIA Model, the short term yields to maturity (less than 10 years) are derived by fitting a curve through actual AA rated corporate bond yield data. For longer terms (over 10 years), a curve is fitted through extrapolated data created by adding the CIA Spread to long provincial bond yields at all maturities. The CIA Spread is set equal to 50% of the average AA corporate to provincials spread observed for mid-term maturities (5 to 10 years), plus 50% of the average spread observed for long maturities (above 10 years).mercer s concerns with the CIA Spread are that: The spread remains constant after 10 years whereas an increasing spread would be more consistent with market convention/theory; and The 50/50 approach to determine the CIA Spread is arbitrary. As a result, we believe that the CIA Model results in bond yields that will tend to underestimate the actual yields available on AA rated corporate bonds at the long end of the yield curve. In order to address the above concerns, under the Mercer Model, the Mercer Spreads are calculated differently than the CIA Spreads. To derive the Mercer Spreads, an average spread and average corresponding maturity are first calculated for three different maturity bands (6 to 10 years, 11 to 20 years, and 21 to 30 years). The results of these calculations at December 31, 2012 are summarized in the following table. Maturity range Number of bonds Average spread Average maturity 6 to 10 years 7 59 bps ( Base Spread ) 7 years 11 to 20 years 7 83 bps ( Mid Spread ) 15 years 21 to 30 years 2 96 bps ( Long Spread ) 26 years The spreads for all missing terms between the lowest and highest average maturities are then determined by linear interpolation between the Base Spread, Mid Spread and Long Spread. For

4 Page 4 maturities over the highest average maturity, the spread is assumed to remain constant at the level of the Long Spread. Once the Mercer Spreads are established, AA rated corporate bond yields are extrapolated by adding the Mercer Spreads to the AA rated provincial bond data for all maturities beginning with the average maturity in the 6 to 10 years maturity range (i.e., from maturity of 7 years as at December 31, 2012). This is slightly different than under the CIA Model where extrapolated data points are only created for maturities greater than 10 years. Under both the CIA Model and the Mercer Model, a yield to maturity curve is derived by fitting a curve through actual AA rated corporate bond yields at the short end and the longer-term hypothetical bond yields extrapolated using the methodology described above. Accounting Discount Rate Under both the CIA Model and the Mercer Model, the resulting yield-to-maturity curve must be converted to spot rates which can then be used to discount benefit payments (i.e., accounting discount rate). The following table summarizes the accounting discount rates based on the CIA Model and the Mercer Model as of December 31, % 3.29% +0.12% % 4.05% +0.32% % 4.36% +0.42% % 4.52% +0.46% The enclosed appendix summarizes the differences in the accounting discount rate for different plan durations under the two models at a number of dates between December 31, 2010 and December 31, Over this period, the discount rates based on the CIA Model were consistently lower than those based on the Mercer Model. As mentioned earlier, the gap between the two models narrowed in March 2013, when the CIA Model was modified to include bond issues that are rated AA by at least one rating agency (instead of two or more rating agencies).

5 Page 5 Summary The key features of the Mercer Model are that it: Follows the framework proposed in the Educational Note, but with a different spread approach. Meets discount rate criteria as set out in the various accounting standards. Is more transparent than the previous model that relied on PC Bond Analytics representative yields. Is consistent with market convention and theory (i.e., positive term structure of credit spreads). Uses a spread approach based on observed data (i.e., no arbitrary weighting of data). In Mercer s view, the Mercer Model is compliant with the recent Educational Note on accounting discount rates and with Canadian, US and international accounting standards. It is also our view that the Mercer Model addresses the concerns raised with respect to the CIA Model. We also believe that the yield to maturity curve obtained using the Mercer Model represents a valid extrapolation along the yield curve, producing accounting discount rates that typically will be higher than those under the CIA Model both prior to and subsequent to the alignment of bond data of the two models. Sincerely, Loyd Zadorozny Partner

6 Page 6 Appendix: Comparison of accounting discount rates produced by the CIA Model and the Mercer Model at various dates Discount rates as of December 31, 2010 Duration (years) CIA Model 1 Mercer Model Difference % 4.44% +0.08% % 5.23% +0.28% % 5.53% +0.34% % 5.70% +0.43% Discount rates as of March 31, % 4.57% +0.03% % 5.34% +0.26% % 5.63% +0.34% % 5.80% +0.44% Discount rates as of June 30, % 4.40% +0.11% % 5.25% +0.31% % 5.59% +0.40% % 5.78% +0.50% 1 Estimated by applying CIA Model to market data obtained at December 31, 2010.

7 Page 7 Discount rates as of September 30, % 3.92% +0.10% % 4.81% +0.30% % 5.24% +0.47% % 5.47% +0.56% Discount rates as of December 30, % 3.80% +0.13% % 4.76% +0.48% % 5.19% +0.67% % 5.42% +0.78% Discount rates as of March 30, % 3.70% +0.15% % 4.53% +0.41% % 4.93% +0.57% % 5.08% +0.61% Discount rates as of June 30, % 3.61% +0.17% % 4.47% +0.43% % 4.90% +0.62% % 5.07% +0.67% Discount rates as of September 28, 2012

8 Page % 3.31% +0.18% % 4.14% +0.45% % 4.47% +0.58% % 4.66% +0.65% Discount rates as of December 31, % 3.29% +0.12% % 4.05% +0.32% % 4.36% +0.42% % 4.52% +0.46%