1 Pension Funds & Value-Based Generational Accounting Eduard Ponds 13th international AFIR Colloquium september 2003

2 Contents 1.Background 2.Method 3.Evaluation two pension deals 4.Conclusions paper

3 Background (1) Pension Deals in the Netherlands are implicit regarding: 1.What is the promised benefit? 2.Who is bearing the funding risks? Dominant stakeholders may have bias to favour themselves at the expense of others Implicit pension deals may lead to: –Unfairness –Transfers of value between stakeholders (hidden)

4 Background (2) Paper Chapman, Gordon & Speed (2001): –Principles financial economics to unravel transfers of value between stakeholders of a company pension fund –Primarily transfers between shareholders company and participants pension fund Paper Ponds (2003): –Industry pension funds dominant in the Netherlands –Intergenerational risk-sharing –Value of transfers between current and future cohorts

5 Aim paper Framework to evaluate a DB-plan with intergenerational risk- sharing on two criteria: 1.FAIRNESS Ex ante fair compensation for risk-taking for all cohorts Balance between excess return and mismatch risk 2.SUSTAINABILITY Expost acceptable outcomes for relevant variables (Contributions, Indexation, Funding Residu) Method = Value-based Generational Accounting

6 Mismatchrisk and Economic Value Pension fund taking more mismatch risk produces no Economic Value Taking more mismatchrisk Higher Expected Returnbut more volatile Hence : Lower Contributions: but more volatile Higher Indexation: but more volatile Lower Funding ratio: but more volatile No change in economic value when better results pension fund variables are adjusted for risk

7 Transfers of Value Pension Deal –What is the Pension promise? –How much mismatchrisk? –Who is bearing the risk? Rules pension deal: –Allocation of excess return and mismatch risk to stakeholders –Balance between return and risk-taking per cohort?? –If not, then value transfers

8 Value-based Generational Accounting Unraveling value transfers 1.  value per cohort = Value future benefits -/- value future contributions -/- value current benefits 2.  value intergenerational contract = Value future funding residu -/- value current residue 3.Zero-sum game:  value all cohorts +  value contract = 0

9 Actuarial Approach (traditional) –Stream future benefits has to be matched by contributions and investment returns –More equities: Higher return, so lower contribution rate Neglect of risk –Value transfers: Current workers: advantage of higher return Future workers: disadvantage of bearing the mismatch risk Economic approach –Costprice –Discount rate => riskfree rate of return Evaluation Pension Deals (1): Asset Mix and Contribution Rate

10 Settings Pension Deal 1.Asset Mix: moderate risky; 2.Contribution rate: - economic approach = 19.5% - actuarial approach = 13.4% 3.Indexation: always given 4.Risk allocation: The solvency risk is allocated to the future, i.e to subsequent generations

11 Results variants contribution rate

12 Evaluation Pension Deals (2): mimic Dutch case Settings pension deal 1.Mix: moderate risky asset mix; 2.Contribution rate: Base rate: actuarial approach Cuts: funding ratio > 100%: amortization period = 10 years Charges: funding ratio < 100%: amortization period = 35 years 3.Indexation policy: Full indexation if funding ratio > 100% No indexation if funding ratio < 100%

13 Results mimic Dutch case

14 Conclusions paper 1.DB plans: Standard-of-living insurance based on intergenerational sharing of mismatchrisk 2.Value-based generational accounting is proposed as a tool to test a Pension Deal for –Fairness –Sustainability 3. Taking more mismatch risk produces no economic value 4. Financial economics clarifies flaws traditional actuarial approach –Rules of thumb –No explicit balance between reward and risk-taking –Hidden and unintended value transfers

15 Sidenote Complete evaluation pension fund policy also needs welfare analysis. –Net gain measured in euro’s may be negative but in utility terms positive –Welfare analysis not explored in this paper, it is object of current research The aim of the paper is to demonstrate the relevance of value-based generational accounting.

16 Value-based (1) Capital market = arbitrage-free: –High expected return is market-compensation for risk-taking –Value Riskfree investment = Value Risky investment Economic value = Risk-adjusted discounted value of future outcomes Method: Deflators (UK actuaries) Risk-neutral valuation (financial economics)

17 Generational Accounting (1) Public Finance: –method of Generational Accounting in use to judge sustainability government finance in the long run Similarities Public Finance and Pension Funds: –Overlapping cohorts –Closing balance by adjusting tax rate resp. contribution and/or indexation –Zero-sum game