1. 1 Valuation Rates and Portfolio Choice for DB Schemes Presented by: Craig Ansley - Director of Consulting Practice, Australasia Frank Russell Company New Zealand Society of Actuaries Conference Rotorua 13-15 November 2002

2. 2 Current Practice Investment strategy based on DB scheme as separate entity Valuation rates of interest taken as expected return on portfolio Fund values adjusted (upwards) from market values Can’t be justified - Exley, Mehta & Smith (1997)

3. 3 Overview Funding using the expected return Whose interest? Theoretical results for idealised world Relaxing the assumptions Practice vs theory

4. 4 PVs with deterministic returns

5. 5 PVs with stochastic returns

6. 6

7. 7 What’s the difference?

8. 8 Does it matter? Even if risk doesn’t matter, valuing at the expected portfolio return leads to systematic underfunding over the long term.

9. 9 Whose interest? Net cost of benefits is a company liability Member and company interests aligned on valuation and investment Contrarian member position would require less investment risk, higher valuations

10. 10 Idealised world No taxes No transactions costs Completely accessible and liquid markets Unlimited lending and borrowing at risk free rate Rational investors

11. 11 Theoretical results for idealised world Asset allocation strategy irrelevant Benefits and contributions must be valued at risk free rate Assets must be valued at market Miller & Modigliani argument:

12. 12 Relaxing the assumptions Taxation Quarantining assets and liabilities in a separate entity No company access to surplus Different tax rates for pension fund and company

13. 13 Taxation Benefits and contributions valued at risk free rate after tax Assets valued at market Introducing taxation (same rate for fund and company) but leaving the other assumptions in place does not change the theoretical results.

14. 14 Quarantining the fund No company access to surplus Different tax rates for pension fund and company Quarantining the fund does not matter per se; but changing the transaction rules or tax regime does matter.

15. 15 No company access to surplus Value liabilities unchanged Value of assets reduced by value of option Risk should be reduced to minimise value of option If the company cannot recover surplus in the fund, it is granting an option to the employees.  Invest in risk free asset

16. 16 Differential Tax Rates (Unrestricted company access to surplus) Company Tax Ratet C Pension Fund Tax Ratet P Pre-tax Investment ReturnR Return on funds with company tax rate R C = (1 - t C ) R Return on funds with pension fund tax rate R P = (1 - t P ) R R C and R P perfectly correlated

17. 17 Differential Tax Rates (Unrestricted company access to surplus) After-tax return on marketR M After-tax return on risk-free assetR F Risk-free incremental return Systematic risk irrelevant

18. 18 Example Expected return on bonds6% Expected return on equities9% Company tax rate33% Pension fund tax rate on equities7% Pension fund tax rate on bonds33%

19. 19 Example

20. 20 Differential Tax Rates AND No Company Access to Surplus Investment in tax-exempt equities Increases risk-free incremental return Increases value of option against company Option value decreases with term to maturity

21. 21 Why Not Invest 100% in Equities? Convex tax schedule Cost of credit increases to cover option against creditors Agency risk Bankruptcy costs

22. 22 Summary Increase in valuation rates justified by differential tax rates Valuing at expected portfolio return not justified Restricted company access to surplus is option against company Portfolio risk limited by external costs of risk