Implicit pension debt
David McCarthy
Presentation to the Indicators Working Group
NTA Conference
15th June 2010
1
Outline
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Implicit vs explicit debt
Two main approaches to valuation
Valuing implicit debt
Types of implicit pension liabilities
Alternative definitions of IPL
Crucial assumptions
• (Thanks to Holzmann, Palacios & Zviniene (2001), although
some ideas are my own!)
Implicit vs. Explicit debt
• Public mandatory pension systems are typically not
contractual arrangements
• Therefore the arrangements are not subject to the (full)
protection of contract law
• This is in marked distinction to, for instance, government
bonds which are contracts between borrowers and lenders
• Most notable advantage is that this makes the
arrangement more flexible (and hence possibly more
resilient over the very long timescales required by
pensions)
• Governments have substantial (but far from total)
discretion to alter the liability, with attendant risks
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Two main approaches to valuation
• Actuarial (e.g. annuity factors, commutation functions)
• Values risky payments at their expected discounted
present value
• Struggles with conditional payments (e.g. Guarantees)
• Financial (e.g. Black-Scholes etc)
• Values risky payments as the price of a replicating portfolio
of financial assets
• [Equivalent to altering the discount rate to allow for risk]
• Struggles with payments which cannot be replicated and
requires some brave assumptions
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Valuing implicit debt
• Flexibility of implicit debt makes it hard to value
• Some argue that it is not appropriate to use discount rates
derived from explicit debt when valuing pension liabilities
• Explicit debt is a harder promise, therefore less risky, and
therefore should attract a lower discount rate and a higher
present value
• Values of implicit debt calculated using treasury yields or
their equivalents are therefore upper bounds
• This may accord with individual perception of pension
values (e.g. Feldstein)
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Types of IPL
• Guarantees for voluntary private pension schemes (US
PBGC, UK PPF etc)
• Guarantees for compulsory private pension schemes
(Chile, Mexico, Hungary)
• Unfunded public DB pension schemes (US Soc Sec)
• Unfunded public DC schemes (Latvia, Poland, Sweden)
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Alternative definitions of IPL (I)
• Accrued-to-date liabilities (ATDL)
• Liability to current workers of the benefits they have
accrued to date assuming that the system as a whole is
shut down and no future contributions are collected and no
more benefits accrued
• Projected liabilities of current members (PL)
• No new entrants, but current rules of benefits and
contributions continue until the last current contributor dies
• Equals ATDL plus present value of future benefit accrual to
current members less present value of future contributions
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Alternative definitions of IPL (II)
• Open system liabilities
• Present value of all future benefits paid by the system less
present value of all future contributions collected
• Equals PL plus present value of PL for all future cohorts of
members
• [Private sector DB pension plans have their
corresponding analogues to all of these measures,
although open system liabilities are rarely measured]
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Crucial assumptions
• Once an appropriate definition is chosen, calculation
requires assumptions
• Most crucial is the real valuation rate of interest (i.e. the
nominal rate less the assumed rate of growth of the
liabilities)
• For guidance, can examine the rate of return on
government bonds, projected rates of growth of GDP /
productivity, but estimates of sufficient term are rarely
available or robust
• Demography (including, if necessary, labour force
participation), as well as projections are next.
• Options-based approaches needed for conditional
payments such as guarantees
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