Canadian
Institute
of
Actuaries
2006 General Meeting
Assemblée générale 2006
Chicago, Illinois
L’Institut
canadien
des
actuaires
2006 General Meeting
Assemblée générale 2006
PD-3 Assumption Setting For
Pension Plans
What is a Reasonable Going
Concern Discount Rate?
Bill Watson
Mercer Human Resource Consulting
Assumption Setting For Pension
Plans: What is Reasonable?
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2006 General Meeting
Assemblée générale 2006
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Current challenges
Mercer’s process for setting reasonable
assumptions
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Going-concern
Expected Return on Assets under CICA
Wrap-up
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Current Challenges
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Pension costs matter
2006 General Meeting
Assemblée générale 2006
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Plans have matured
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Now a significant part of a corporation’s
financial statements/cashflow requirements
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Aging workforce and an increase in retiree
liabilities
Relative to the size of the active operations
Sharp rise in costs in recent years due to
decreasing interest rates
Increased volatility
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Current Challenges
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Heightened Scrutiny
2006 General Meeting
Assemblée générale 2006
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Plan sponsor
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Pension and corporate governance
Finance area
Auditors
Regulators
Business community
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Current Challenges
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Increased litigation
2006 General Meeting
Assemblée générale 2006
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Class actions
Court decisions
Fiduciary concerns
What is the role of the actuary?
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Current Challenges
Lower Bond Yields
2006 General Meeting
Assemblée générale 2006
7%
6%
6.84%
6.78%
6.65%
6.51%
1.1%=
= 1.8%
5%
5.72%
5.45%
5.15%
4.69%
4%
Going Concern Discount Rate (FSCO Stats)
3%
4.22%
Long Canada Benchmark Bonds
2002
2003
2004
2005
2006
January 1st
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2006 General Meeting
Assemblée générale 2006
Current Challenges
Financial Pressure
+ Heightened Scrutiny
+ Increased Litigation
+ Lower bond yields
= Challenging Environment
for Pension Actuaries
Actuaries must be able to
justify their assumptions
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2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Going Concern Discount Rate
What rate of return can we reasonably
expect the pension fund to earn over the
long-term?
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Not a prediction
But as much as possible, a reading of the
market
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2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Going Concern Discount Rate
Historically, the typical approach for a
Mercer actuary was:
• Stable long term economic views
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Based largely on empirical evidence
Little emphasis placed on market rates
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2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Going Concern Discount Rate
Mercer’s current approach
• Provide actuaries with a market based
model to assist in determining the going
concern discount rate
• The actuary must assess the
appropriateness of the assumptions for
each valuation in the context of the
particular case and the prevailing
economic environment
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2006 General Meeting
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Setting Reasonable Assumptions
Going Concern Discount Rate
First Step: Establish long-term expected
return for each asset class
• Bonds
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Based on current market yields in effect on
valuation date
Split by Universe, Long and Real Return
Bonds
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Setting Reasonable Assumptions
Going Concern Discount Rate
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Equities
2006 General Meeting
Assemblée générale 2006
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Long bond yields plus equity risk premium
Equity risk premium considers expected
GDP, dividend yield, growth in corporate
earnings
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Model provides 3 equity risk premium scenarios
Combine expected returns based on target
policy mix
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Setting Reasonable Assumptions
Going Concern Discount Rate
2006 General Meeting
Assemblée générale 2006
Adjustments to expected return
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Provision for active management
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Based on portion of fund that is actively
managed
Provision for expenses
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Expenses charged to the fund not already
explicitly included in the current service
cost
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Setting Reasonable Assumptions
Going Concern Discount Rate
2006 General Meeting
Assemblée générale 2006
Adjustments to expected return
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Margin for adverse deviations
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Based on portion of fund that is invested in
equities and underlying equity risk
premium
Consider any margins (positive or
negative) inherent in other actuarial
assumptions
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2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Going Concern Discount Rate
An example,
Expected Return
Active Management
Expenses
Margin for adverse deviation
Going Concern Discount Rate
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6.98%
0.30%
(0.50%)
(0.68%)
6.10%
2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions Other
Going Concern Assumptions
Other assumptions
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Economic assumptions (inflation,
YMPE, salary scale)
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Based on market yields
Demographic assumptions
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Best estimate approach
Future mortality improvements
Otherwise, further adjustments to the
margin in the discount rate
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2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Expected Return on Assets (CICA)
Actuaries often asked to provide input on
accounting assumptions including the
Expected Return on Assets (EROA)
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Same approach as setting the going
concern discount rate
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No margin for adverse deviations since
it is a best estimate assumption
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Setting Reasonable Assumptions
2006 General Meeting
Assemblée générale 2006
Is 6.5% still reasonable for a plan that is
invested 40% bonds and 60% equities?
6.84%
7%
6%
6.78%
6.65%
6.51%
1.1%=
= 1.8%
5%
5.72%
5.45%
5.15%
4.69%
4%
Going Concern Discount Rate (FSCO Stats) 4.22%
3%
Long Canada Benchmark Bonds
2002
2003
2004
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2005
2006
January 1st
2006 General Meeting
Assemblée générale 2006
Setting Reasonable Assumptions
Let’s assume,
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Discount rate is before expenses
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Margins for adverse deviation = 0.5%
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Yield on universe bonds = 4.6%
Roughly speaking,
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Implies equity return of 8.6%
[(6.50% + 0.50%) - (40% times 4.6%)]/60%
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Implies an equity risk premium of 4.4%
(Assuming government bonds are 4.2%)
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2006 General Meeting
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Setting Reasonable Assumptions
Wrap-up
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Challenging times for pension actuaries
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Actuaries must be able to justify their
assumptions
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Leads to assumptions that are largely
driven by observed market conditions
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