ISSA Technical Commission on Statistical, Actuarial and Financial Studies

1. Comments by Steve Goss on “Optimal Funding level of a Public Pension Scheme” Authored by Pierre Plamondon and Denis Latulippe ISSA Technical Commission on Statistical, Actuarial and Financial Studies Tuesday, 14 September 2004

2. This is an extremely interesting paper that addresses many important topics • Many countries are struggling with choices between DB and DC schemes, and between PAYGO and Advance Funding • This paper considers the balance between PAYGO and advance funding for a public DB scheme, including the effects of variability in wages and returns on financial assets • However, issues related to who bears the risk of variations under DB versus DC schemes are not addresses here

3. Goals of a Public Pension Scheme (Section 1) • 1) Stability of Contribution rates---Primary goal in this paper • 2) Minimizing required contributions----this tends toward advance funding if yield on financial assets is higher than growth rate in total payroll base • 3) Solvency----- Note that this raises the issue of “political risk” that target replacement rate may be changed over time through legislation for a DB if solvency is in question. This fundamental issue that separates public DB from “pure” DC plans is not specifically adressed in this paper, but is important

4. Sensitivity of Contribution Rates to Demographic and Economic Trends ---Section 3 • Authors observe that a fully funded plan is less sensitive to demographic changes. This is true for fertility changes, but not for mortality changes. • Possibly MOST fundamental observation • “…pensions have to be paid out of total current income (from either wages or capital income) no mater how it is financed” • True for DB,DC,PAYGO,advance funding !!!!! • Unless assume effect on national investment and returns • For developed countries, assume investment is not affected • But for developing countries, this is less true • Thus, I would disagree with the authors observation “..reduced funding is preferred in the context of of under developed capital markets”, as advance funding in this case can be a means to developing capital markets

5. Financing Options for a Public DB (Section 4) • 1) Pure PAYGO---annual reevaluation of contribution rate • 2) Partial Advance funding---target reserve to expenditure ratio of 3 at end of 50-year valuation • 3) Full advance funding--- target reserve to expenditure ratio of 25 at end of 50-year valuation • Thus, in options 2 and 3, the authors assume a 50-year amortization of deviations due to variation in experience • Because a stable population and investment returns higher than average wage growth are assumed, the base scenario shows that lower contribution rates are expected to be needed with more advance funding----this without variation in economic parameters

6. Sensitivity to Fluctuating Investment Returns • For partial and full advance funded plans, authors assume contribution rate is recomputed only every 5 years, precisely at end of alternating 5-year periods of good and bad returns • This sets level of assets for each revaluation at a maximum or minimum, as assumed 50-year yields for valuations are not changed • It would be useful to include an alternative analysis assuming reversion to mean for investment valuations. This would likely show substantially less variation in needed contribution rates and would be more realistic.

7. Financial Point of View --- Section 5 • Attempt to determine optimal mix between PAYGO and advance funding using capital asset pricing model (CAPM) • Treat PAYGO “returns” at the rate of average wage growth as an alternative investment option in CAPM • CRITICAL ASSUMPTION– average wage growth rate is equal to risk-free rate of return on capital • This allows the CAPM equation to simplify to------- Weight on financial assets (advance funding) = var(wages) / [ var(wages) – covar(wages,fin asset yield) ]

8. But, this reduced CAPM equation is questionable • If “wage returns” are like a financial investment with an expected return equal to the riskless rate of return, then variance should be low or nil • But, in the United States, at least, long-range average real wage growth is expected to be 1.1 percent, even lower than the expected riskless real rate of return of about 2 percent • Finally, the reduced form requires that the covariance between wage growth and financial asset returns be negative

9. Correlation between wages and financial assets • Nominal returns on stocks and bonds have been negatively correlated with nominal average wage growth in U.S. and Canada over past 50 years • However, real returns have generally been positively correlated this occurs because ---- nominal wages and price inflation are positively correlated but nominal investment returns (stocks and bonds) and inflation have generally been negatively correlated -- Which makes sense, real or nominal??? -- More analysis of this is needed

10. Conclusion--------- • While use of CAPM here is intriguing, it is not clear that it is a valid construct for assessing PAYGO versus advance funding. • Financial risk and political risk must be considered for public pensions. • Further thought and development are needed to assess this and other approaches to contrasting DB, DC, PAYGO, advance funded plans and how they distribute risk.