Pension Funds &
Value-Based Generational Accounting
Eduard Ponds
13th international AFIR Colloquium
18-19 september 2003
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Contents
1. Background
2. Method
3. Evaluation two pension deals
4. Conclusions paper
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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)
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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
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Aim paper
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Framework to evaluate a DB-plan with intergenerational risksharing 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
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Mismatchrisk and Economic Value
•
Pension fund taking more mismatch risk produces no Economic
Value
•
Taking more mismatchrisk
• Higher Expected Return
Hence :
• Lower Contributions:
• Higher Indexation:
• Lower Funding ratio:
•
but more volatile
but more volatile
but more volatile
but more volatile
No change in economic value when better results pension fund
variables are adjusted for risk
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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
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Value-based Generational Accounting
Unraveling value transfers
1.
D value per cohort =
Value future benefits -/- value future contributions -/- value current
benefits
2.
D value intergenerational contract =
Value future funding residu -/- value current residue
3. Zero-sum game:
D value all cohorts + D value contract = 0
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Evaluation Pension Deals (1):
Asset Mix and Contribution Rate
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Actuarial Approach (traditional)
–
–
–
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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
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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
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Results variants contribution rate
Results after one year
Contribution rate
Expected Funding ratio
Transfers of value
D V[Workers]
D V[pensioners]
D V[contract]
economic
actuarial
19.5%
100.9%
13.4%
100.0%
0.0%
0.0%
0.0%
+1.0%
0.0%
-1.0%
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Evaluation Pension Deals (2):
mimic Dutch case 1980-2002
Settings pension deal
1. Mix: moderate risky asset mix;
2. Contribution rate:
•
•
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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%
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Results mimic Dutch case 1980-2002
Transfers of value between stakeholders in Dutch pension funds
____________________________________________________
Initial funding ratio
Stakeholders
90%
100%
110%
____________________________________________________
D V[workers]
D V[Pensioners]
D V[Contract]
Sum
+ 0.4%
- 0.5%
+ 0.1%
0%
+ 1.3%
- 0.2%
- 1.1%
0%
+ 2.4%
0.0%
- 2.4%
0%
____________________________________________________
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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
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Sidenote
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Complete evaluation pension fund policy also needs
welfare analysis.
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–
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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.
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Value-based (1)
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Capital market = arbitrage-free:
–
–
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High expected return is market-compensation for risk-taking
Value Riskfree investment = Value Risky investment
Economic value = Risk-adjusted discounted value of future
outcomes
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Method:
•
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Deflators (UK actuaries)
Risk-neutral valuation (financial economics)
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Generational Accounting (1)
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Public Finance:
– method of Generational Accounting in use to judge
sustainability government finance in the long run
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Similarities Public Finance and Pension Funds:
– Overlapping cohorts
– Closing balance by adjusting tax rate resp. contribution
and/or indexation
– Zero-sum game
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