1 / 23

Pension Plan Reporting in a Market Value World

Pension Plan Reporting in a Market Value World. April 15, 2008 CIA Pension Seminar. Graeme Robertson, Vice President Damon Williams, Vice President Phillips, Hager & North Investment Management Ltd.

maxime
Download Presentation

Pension Plan Reporting in a Market Value World

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Pension Plan Reporting in a Market Value World April 15, 2008 CIA Pension Seminar Graeme Robertson, Vice President Damon Williams, Vice President Phillips, Hager & North Investment Management Ltd.

  2. Market value of assets and market value of projected benefits and expenses should be used in all valuations for all purposes Reframe balance sheets for pension plans within a market value based framework Suggested Changes to Actuarial Reporting

  3. An “obligation” is a “real” or “nominal” cashflow owed in the future (e.g. a future benefit payment from a pension plan) A “liability” is a generic term for the present value of future obligations using a discount rate to price the obligation The “market value of liabilities” is the present value of future obligations priced using an appropriate current term structure of interest rates Some Definitions

  4. 6.0 5.0 4.0 Expected Benefit & Expense Payments ($Millions) 3.0 2.0 1.0 0.0 2008 2013 2018 2023 2028 2033 2038 2043 2048 2053 2058 2063 2068 2073 2078 2083 2088 Source: other\sample cashflows Typical Accrued Pension Obligations

  5. If a portfolio of assets can closely match the obligations in terms of Inflation characteristics (nature) Term structure (timing) Expected $ (amounts) Risk characteristics (uncertainty) Then it follows that the market value of those assets must be the market value of the obligations Market Value of the Pension Obligations

  6. Bond assets (real or nominal) can be structured to hedge the nature, expected timing and amount of the projected benefit and expense obligations with little residual investment risk Non-investment related risks affecting expected timing and amount that cannot be hedged in the markets should be explicitly identified and managed with a contingency reserve on the liability side of the balance sheet, e.g. Real salary growth (i.e. over and above inflation) Decrement risks (e.g. mortality) Market Value of the Pension Obligations

  7. Funded obligations should be priced with no market default risk premium (e.g. discounted at Government of Canada rates) Credit risk discount to obligation valuation is a circular argument Plans with ever lower funded ratios would use ever higher discount rates Market Value of the Pension ObligationsUse of Risk Free Interest Rates

  8. In an actuarial valuation, many plans have used a flat discount rate (say 7%) to value their plan obligations Keeping the discount steady through time gives the impression that the investment objective is to earn 7% per annum Focus on Funding ValuationsTypical Going Concern Valuation Balance Sheet Present value of obligations discounted @ 7% $1bn Market Value of Assets $1bn

  9. 20% 15% Returns 10% 5% 0% Dec-60 Dec-63 Dec-66 Dec-69 Dec-72 Dec-75 Dec-78 Dec-81 Dec-84 Dec-87 Dec-90 Dec-93 Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 • From a historical perspective 7% looks reasonable • Until we explore the drivers behind historical asset returns Focus on Funding ValuationsHistorical Return Perspective Annualized 10-year Returns: Balanced Portfolio Source: Graeme\foreign content\returngeneration v2

  10. Use of Market ValuesConsistent Asset and Liability Pricing • Now let’s compare apples-to-apples • Using a discount rate that reflects current market conditions substantially increases the value placed on the projected obligation “Market Value” of Liabilities (implied discount rate = 4.0%) $1.5B Market Value of Assets $1.0B

  11. Use of Market ValuesHistorical Return Perspective Annualized 10-Year Rolling Returns Balanced Portfolio versus MV of Liabilities 25% 20% 15% Returns 10% 5% MV of Liabilities Balanced Portfolio 0% -5% Dec-60 Dec-62 Dec-64 Dec-66 Dec-68 Dec-70 Dec-72 Dec-74 Dec-76 Dec-78 Dec-80 Dec-82 Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08

  12. Consistent pricing of asset cashflows and pension obligations Reduce risk of spending surplus/funding deficit that isn’t there Advantages of Using Market Values

  13. Pension plan has single obligation of $1bn in 20 years and $258mil in cash Interest rates are 7% We buy GOC strip paying $1bn in 20 years time for $258mil We will earn 7% p.a. for 20 years if we do not trade Funded ratio = 100% Year 5 interest rates are 4.5% and our asset is up 14.9% p.a. over 5 years (MV assets is now $517mil whereas we expected $362mil if we had earned 7% p.a.) Funded ratio (if discounting at 7%) = 143% Funded ratio (using MVs) = 100% $1bn cashflow from asset has not changed so unless $1bn obligation is priced at same value as matching asset then we will believe we have a surplus (of course we do not!!) Importance of Consistent Valuations An Example

  14. Pricing of expected obligations is consistent across all tests (eg. going concern, wind-up) Only differences come from benefits being projected and non-investment related assumptions used to project the benefits Fundamental economic similarities and differences between different tests better understood . . . Advantages of Using Market Value

  15. Investment problem is clarified Becomes clear that assets must keep pace or beat a portfolio that matches the investment characteristics of the obligations being considered (the minimum risk portfolio or “MRP”) over time Investment policy development would consider opportunities relative to the MRP Objective (in our example) becomes a dynamic market value based objective of “return on MRP + 3%” rather than a “constant 7% per annum regardless of market conditions” . . . Advantages of Using Market Value

  16. Reframing the Balance SheetCurrent Actuarial Practice Present Value of Expected Risk Premium $0.5B1 Common actuarial practice moves this to the liability side to reduce the reported liability “Market Value” of Liabilities $1.5B Market Value of Assets $1.0B 1 Equivalent to earning 3% per annum (i.e., 7% less 4%) in excess of return on MV of liabilities over expected life of obligations being valued

  17. Reframing the Balance SheetCurrent Actuarial Practice • Obscures true funding and investment challenges Present Value of Obligations Discounted @ 7% $1bn Market Value of Assets $1bn

  18. Actuarial Value of Liabilities (discount rate 7%) $1.0bn Market Value of Assets $1.0bn Reframing the Balance SheetProposed Market Value Approach vs Traditional Contingency Reserve $0.1bn Expected Value of Excess Returns $0.5bn “Market Value” of Liabilities (implied discount rate ~ 4%) $1.4bn “Market Value” of Liabilities (implied discount rate ~ 4%) $1.4bn Market Value of Assets $0.8bn Market Value of Assets $1.0bn

  19. Excess return assets are not excluded but put on the correct side of the balance sheet The existence of the excess return asset implies an acceptable level of underfunding on a market value basis within which the actuary is comfortable keeping funding unchanged Excess asset is explicit enabling magnitude and appropriateness of that asset to be scrutinized by stakeholders in the context of the particular valuation test being performed “Excess return” is return on assets in excess of replicating portfolio so historical analysis should be in this context Note: Market value of excess return asset is $0 Why Reframe the Balance Sheet“Excess Return Asset”

  20. Annualized 3-year Returns: Balanced Fund versus MV of Liabilities 35% Balanced portfolio outperforms MV of liabilities 30% 25% 20% 15% 10% Returns 5% 0% -5% -10% Balanced portfolio underperforms MV of liabilities -15% -20% -25% Dec-60 Dec-63 Dec-66 Dec-69 Dec-72 Dec-75 Dec-78 Dec-81 Dec-84 Dec-87 Dec-90 Dec-93 Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Reframing the Balance SheetExcess Return Asset (Historical Perspective)

  21. Excess MV of Net (Assets – MV of Assets Return Asset Liabil ities Liabilities) Value at beginning of year $1,000,000 $500,000 $1,500,000 $0 BoY yield on Government of +$20,000 N/a +$60,000 - $40,000 Canada securities Change in Government of Canada +$30,000 N/a +$225,000 - $195,000 spot rates Retur n earned due to other +$60,000 N/a N/a +$60,000 investment factors (e.g, credit spreads, equity values) Change in assumed excess returns N/a +$50,000 N/a +$50,000 over Government of Canada bonds Change in demographic N/a N/a +$150,000 - $150,0 00 assumptions Contributions +$75,000 N/a N/a +$75,000 Benefit accrual N/a N/a +$60,000 - $60,000 Value at end of year $1,185,000 $550,000 $1,995,000 - $260,000 Reframing the Balance SheetExample of Gain/Loss

  22. Pension Plan financial reporting standards should frame pension balance sheets with MVs of both assets and pension obligations Have explicit excess return amounts on the asset side of balance sheet Existence of regulatory/legislation hurdles should not deter changes in actuarial standards Conclusion

More Related