Security in Pension Provision Chairman: Philip Shier Ireland Presenters: Chinu Patel UK Paul Thornton UK Groupe Consultatif Actuarial Europeen 2nd June 2006 11:00 – 12:30
Chairman’s Introduction Security Standards Prudent Person Principle Funding Methods and Assumptions Solvency Requirements under IORP Directive Solvency II and Pensions Discussion and Questions Agenda
Security in Pension Provision Paul Thornton
Survey of Security Standards by the Groupe Consultatif • Survey of 20 countries • First carried out 1995 / updated 2005 • Wide variation in practice
Security in Pension Provision “Security” is provided by a combination of • Method of pension provision • Minimum criteria for reserving
Meaning of “Security” • The extent to which members are guaranteed to receive their benefits regardless of external events such as • Insolvency of the employer • Failure of a provider • Fraud • Normally implies • Continuation of benefits • Deferred pensions will be paid • Rights earned from past service protected • Priority to vested rights
Pay-as-you-go France • only major example • Mandatory
Conclusion • Security is provided by a combination of • External funding, with appropriate standards • Prudent investment and good governance • Guarantee funds • Insolvency insurance • Effect of Pensions Directive yet to be seen
Groupe Consultatif Guidelines on the Implementation of the Prudent Pension Principle • Prepared between 2003 and 2005 • Intended to clarify the interpretation of “prudent” in the European Pensions Directive • Indicates an approach to setting minimum reserves for funded pension commitments
Actuarial and Operational Proposes an Actuarial Operational Memorandum to cover: • Actuarial matters • Liabilities • Reinsurance • Valuation basis • Contributions/funding plan • Cost of living adjustment • Operational matters • Accountability for benefits, investment, funding • Consultation • Risk management
Capital Adequacy Proposes both long-term and short-term tests • Long-term • Long-term solvency • Safety capital/buffer • Short-term • Minimum solvency
Pension Liabilities • Method to determine discount rate • Duration • Guarantees/discretions/conditions • Cost-of-living or other indexation • Re-insurance • Funding policy
Pension Assets • Duration • Extent of credit risk • Volatility • Currency
Target Funding • Possible availability of additional funding • Degree of volatility to be accepted from asset allocation • Trade-off between more stable results and lower contributions • Target funding level
Conclusion • The Prudent Pension Principle is aligned with the principles of good professional practice • The Groupe Consultatif Guidelines are a set of implementation principles recommended to the member associations
Security in Pension Provision Paul Thornton
Security in pension provision Funding methods and assumptions for defined benefit pensions Chinu Patel, F.I.A.Watson Wyatt, UKchinu.firstname.lastname@example.org
Commentary and overview of second pillar retirement benefits and funding vehicles, actuarial methods and assumptions Country by country description European countries - Dec 2001 Non European countries – Sept 2005 Groupe Consultatif reports Actuarial methods and assumptions Full reports at www.gcactuaries.org
Main purposes of a valuation Today’s focus: Funding – how much pension security through collateral in the pension scheme?
Market value - Austria, Belgium, Netherlands (some funds), Norway (accounting purposes), Portugal, Spain, UK, Australia, NZ, Japan, US, Mexico Discounted income value - Cyprus, Ireland, UK (use is generally declining) Average market value - Cyprus, Ireland, UK(not common), Canada, US Book value - Denmark, Finland, Germany, Japan Methods for valuing assets Actuarial perspective: the valuation of assets should be consistent with the valuation of the liabilities (technical provisions) and the expected return on assets assumption.
The amount of the technical provisions is dependent on: Actuarial funding method Economic assumptions (discount rate, salary inflation, price inflation, social security inflation) Demographic assumptions (pension age, mortality, turnover, disability, partner’s issues etc) The benefits valued eg discretionary benefits Implicit or explicit solvency margins, expenses etc Technical provisions Pension security will vary accordingly
Two main families of actuarial methods: Funding methods • Security driven - benefit allocation • Objective: Maintain a target level of funding: • Current Unit Method (CUM) • Projected Unit Method (PUM) • Contribution driven – cost allocation • Objective: Define certain level of contribution: • Entry Age Method (EA) • Attained Age Method (AA) Principle: to fund for each employee’s benefits whilst they are economically active. But pace of funding and hence pension security is a function of the method used.
Projected Unit Belgium, Cyprus, Germany (commercial accounting), Ireland, Netherlands (commercial accounting), Spain, UK, Australia, NZ, Japan, US, Canada, Turkey, Mexico, and for IAS/US GAAP Current Unit Finland, Netherlands, Norway, Switzerland, Canada, Japan Attained Age Austria, Germany (infrequent), Ireland (infrequent), Australia, Canada, NZ, US Entry Age Germany and Austria (Infrequent), Australia, Canada, Japan Most commonly used actuarial funding methods Generally different methods for different purposes
Impact on pension security?An example • All 4 of these approaches are used in the OECD countries • Entry age method can be the strongest or weakest, depending on how it is applied • Under Entry age 2 increases in benefits are funded over the remaining service period-a common approach in insured plans At age 35, the strongest method has a funding level approximately 4 times the weakest; at higher ages the differential gets smaller
Scheme’s legal documents Minimum and maximum funding rules Disclosure requirements Accounting standards - international/domestic Nature of fund eg 'open' or 'closed' Funding vehicle eg pension fund or life insurance Professional judgement – purpose, guidance, custom and practice Factors affecting choice of method The role and responsibilities of the actuary varies across the OECD, with significant variation in the extent to which actuaries have professional freedom or must follow detailed rules and regulations.
These also dictate pace of funding: Rate of price inflation Rate of increase in salaries Rate of increase in pensions in payment Rate of increase in deferred pensions Rate of increase in State pension benefits Main economic assumptions Actual net discount rates used will depend on plan design (salary related, price related, fixed, cash/annuity, discretionary benefits, etc) Wide variation between and within countries, resulting in wide variations in pension security
Three distinct approaches: Full prescription : usually where insurance tariffs apply. Flexibility within minimum and maximum limits set by supervisory or tax authorities (eg, US, UK, Belgium, Spain, Netherlands). Freedom of choice but with specific aims, eg all assumptions together to represent a best estimate for future (UK, Ireland, Australia, Canada, New Zealand). Often supplemented by actuarial professional guidance. Economic Assumptions: How decided?
Practice ranges from complete set of demographic assumptions to use of mortality and retirement decrements only using standard tables specified in regulations etc to complete freedom of choice for actuaries (eg UK/Ireland) In most countries standard mortality tables developed either through population or other censuses are used; frequency of updates varies Future mortality improvements are allowed for in some countries but not in others; considerable uncertainty about what the level of future improvements should be Demographic assumptions A significant source of variation in pension security between countries, and sometimes within
Mortality – how different are typical assumptions?City University research in conjunction with GCAE on international mortality comparisons Discount rate compared to 3% for the UK, equivalent to change in mortality table (male age 65, includes reversionary widow's pension) Many reasons why they should be different. More work needed on:- • whether such big differences are justified; • what is appropriate for future mortality improvements? Wide range to compound further differences in pension security from funding methods and financial assumptions
Under many pension plans there are options available for the employee eg retirement age Under many pension plans there are options available for the employer/trustees eg discretionary pension increases What benefits are valued? The extent to which these options/choices are built into the calculation of the technical provisions will affect the security provided to members.
Different actuarial funding methods Different approaches to setting actuarial assumptions Different assumptions used Different approaches to valuation of assets Different approaches to setting demographic assumptions Different approaches to valuing options and choices Funding: SummarySources of variation in pension security Being fully funded could mean different things in different countries …..
Typical example currently in the UK ..... and even in the same country!
Security in pension provision How will the IORP directive affect pension security in Europe?
Main features of the Directive: Sufficient technical reserves to protect members and beneficiaries Under funding permitted, subject to recovery plans (except for cross border arrangements) Member States have freedom to determine their own pension system structure Minimum Solvency Requirements What does the IORP Directive require? Unfunded arrangements exempted
Minimum Technical Reserves must cover: Benefits in payment, Members' accrued pension rights and Any other guarantees Assumptions and Method Prudent assumptions and method recognised by competent authorities Assumptions: Economic: Discount rates based on actual assets holdings and expected future returns OR the market yield on high-quality corporate or government bonds Demographic: Based on the plan membership and risk characteristics What does the IORP Directive require? Member countries can lay down additional detailed rules for improving member security, but lots of flexibility.
‘ ...with a view to further harmonisation …in particular interest rates and other assumptions influencing the level of technical provisions …. The Commission shall propose any necessary measures to prevent possible distortions caused by different levels of interest rates …..’ What does the IORP Directive require?Monitoring convergence (Article 15(6)) Will harmonisation of discount rates be sufficient?
Objective to document Principal differences in methodology for calculating minimum technical reserves Sources of variations in interest rates and related financial assumptions Annual updates to monitor trends (first study at 31 Dec 2003) Demographic assumptions important, but not considered at this stage Countries covered: Belgium, Finland, Germany, Ireland, Luxembourg, Netherlands, Portugal, Spain and UK Excluded : Austria (no data), Denmark (DC or insured), Italy (DC or insured), France (not much DB, mainly insured), Greece (no DB schemes yet), Sweden (insured) Others : maybe included later Groupe Consultatif survey What was the practice prior to the IORP Directive?
Strength of the minimum technical reserves depends on: benefits valued relative to those guaranteed and method and assumptions used to value them Additional reserves typically included in technical provisions: generous member options (early retirement option in Belgium) self insured risk benefits (Belgium) explicit solvency cushions (Netherlands, Spain and Germany) winding-up expenses reserve (Germany, Ireland, Netherlands, UK) Groupe Consultatif survey Principal observations Different practices = different pension security and lack of consistency between countries
Three reserving targets: Vested Benefit Obligation (VBO)< Accumulated Benefit Obligation (ABO)< Projected Benefit Obligation (PBO) Two countries use VBO (Germany and Netherlands) Majority use ABO (Belgium, Finland, Portugal, Luxembourg, Ireland and UK) Only Spain uses PBO Need to interpret in context of benefit design, but typical differences could be large Groupe Consultatif survey Principal observations Method of reserving just as important for pension security as assumptions
Financial assumptions: Most prescribe fixed maximum discount rate. Range 2.75% - 6% A full set of assumptions applied in Ireland, Spain, UK (narrower range of net discount rates) Only UK (old MFR) and Ireland link the assumptions to prevailing market conditions Not common practice to link assumptions to actual asset or liability profiles No appreciable change between Dec 2003 and Dec 2004 Groupe Consultatif survey Principal observations Considerable variability in methods by which financial assumptions are set; wide range of discount rates leading to wide variation in pension security between countries
Aggregate effect for typical schemes Notion of pension security varies vastly between countries. Will IORP change that?
Little or no changes expected in some countries, but many countries have yet to decide or communicate their approach! Three distinct approaches so far: Ireland: Continue with the MFR approach for all schemes, with a strengthened reserving basis as a consequence of financial market changes. Netherlands: Fully prescriptive approach with market based technical reserves (based on prescribed term dependant discount rates), plus additional risk based solvency capital and strict deficit correction periods. UK: Each scheme to decide for itself. No rigid min or max but strong on principles, governance and disclosure, with Regulator intervening if trustees and sponsors cannot agree a funding strategy. Strong expectation for trustees to behave like major creditors, threat of intervention otherwise. What progress on implementation of minimum solvency requirements of the IORP Directive? No reason to expect convergence of methods and assumptions.
Majority of countries have to date made no adjustments to their local legislation to reflect IORP Directive requirements. Often those changes made have not been made as a result of the IORP Directive Pre-2005 practices show that convergence of discount rates by itself may not be enough: Wide range of methods Wide range of discount rates Suspected wide range of mortality assumptions; more work needed on assumption for future mortality improvements Financial assumptions linked to market conditions in only two countries No link between discount rates for minimum technical reserves and actual asset portfolio Only a weak link between discount rate and liability profile Mixed picture on explicit solvency margins, member options, non insured risk benefits and expenses of winding up. Three very distinct approaches so far in compliance of IORP minimum solvency Except for the UK, Ireland and Netherlands, we would expect major changes in the area of market related assumptions to comply with the IORP Directive Summary Notion of pension security varied between country prior to the IORP and will probably continue to do so.
Solvency II and occupational pensions Philip S. Shier, FIA, FSAI Hewitt Associates, Ireland Chairman, Pensions Committee, Groupe Consultatif Actuarial Europeen
Current focus on insurance The EC will consider whether and to what extent Solvency II should apply to occupational pension schemes Initial discussion by EIOPC in April 2006 Some in favour, some opposed, some in favour of an amended Solvency II structure No further action until end 2007/2008 Solvency II and pensions
Adoption of Three Pillar approach similar to that under the Basel Agreement for banks Focus on a more risk sensitive approach with incentives for proper risk management Consistency between financial sectors Harmonisation of standards across EU Development in parallel with international accounting standards Objectives of Solvency II
The three pillars of the Basel Agreement are minimum capital requirements (including the definition of technical provisions) supervisory review process market discipline (including disclosure requirements) Basel Agreement