Should Private Pension funds be subject to capital requirements? A Debate........................ •Chairperson - Irene Paterson BSc FFA with Speakers......................... •Chinu Patel,BSc(Econ),FIA àà à The European Perspective •Frank Todisco FSA, MAAA, EA ààThe Perspective from USA •Denis Plouffe, FCIA, FSA àà àà The Canadian Perspective •Martin Stevenson BSc FIA FIAA à The View from Australia with a DC Twist? 1

Should Private Pension funds be subject to capital requirements? § What does this mean? – Your views after our presentations § We consider Private Pensions and NOT Public Pensions § Questions § Should there be capital requirements for Private Pensions? § What form should this take – cash only or???? § Does the form depend on whether the pension is guaranteed? § Do members of pension funds need better communication on pension benefit risk? § 4 Speakers – different country perspectives

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Should private pension funds be subject to capital requirements? Chinu Patel, Bsc(Econ),FIA Independent Consulting Actuary, UK [email protected] +44 (0)754 547 1314

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What purpose does solvency capital serve?

Security

Fair competition

Do pensions and insurance compete?

against failure to deliver benefits

Could take different forms: • Explicit fund • Better risk management

Objective matters

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Is risk management of pension funds fundamentally different from management of insurance liabilities (1)?

Context is fundamentally different: • Pension deal involves a balance between cost, security and amount of benefit,

Cost

• Greater social policy element to pensions than insurance; sponsors seek protection against political risk. Amount

• Balance usually struck at scheme level, and security may well be the balancing item

Security

Non-participating insurance is contract driven, with security as an external feature factored into the price of the product. A uniform requirement easier to implement.

Consequently ……

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Is risk management of pension funds fundamentally different from management of insurance liabilities (2)? ….. in pensions there is an implicit element of risk sharing, leading to a different risk appetite and different risk behaviors: •

Pension schemes more inclined to take investment risks which insurance companies might not entertain eg equities

•

Pensions schemes (used to) have more relaxed views on some guarantees and options….

•

Product design less aligned to risk management and more towards HR or social objectives (LPI, discretionary practices etc) – matching assets not always available

•

Pension schemes have been more relaxed about data risks (eg marital status or spouses DOB rarely known) …. but changing

•

Downside is that pension schemes can (and have) side-stepped some risks (insolvency risk of sponsor or risk of sponsor voluntarily walking away from an under-resourced scheme)

Different context requiring a different approach to risk management … & new risks

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Is risk management of pension funds fundamentally different from management of insurance liabilities (3)? But DB pensions have more synergy with ‘participating’ insurance contracts: •

Policyholders have paid a ‘bonus loading’ and are entitled to certain expectations …….cf expectations of members in a pension scheme (deferred pay)

•

Risk appetite of with profit funds is different …….cf pension funds (more risk taking, risk sharing)

•

Concept of guaranteed and discretionary benefits in participating insurance (latter dependent on investment performance) …….cf discretionary and conditional benefits in pensions

•

SII capital adequacy standard applies to participating insurance, with the different context recognised by greater emphasis on the role of ‘internal models’ …….cf each pension fund as an internal model.

Isn’t this the right comparison?

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Should there be a minimum solvency capital requirement for pensions (1)? Most pension schemes already have some form of solvency capital: • •

Explicit risk based capital in some cases (eg Netherlands) … with safety valves Non-cash capital elsewhere –

External security in the form of • • •

–

Governance (checks and balances, carrots and sticks to promote desired behaviors) • • • •

–

Sponsor covenant Contingent assets Capital in independent external vehicles (eg PPF, PGBC)

Regulatory powers Regulatory oversight Scheme governance Sponsor governance

Disclosure (power to challenge undesirable behaviors and effect change) • • •

To regulator To members To other stakeholders

In principle yes, but form varies

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Should there be a minimum solvency capital requirement for pensions (2)? In theory non-cash capital could also be presented on a balance sheet for a mathematical comparison …… with some measurement challenges: –

Sponsor capital and contingent assets: Could models be developed, allowing for prior claims of other in investors on the sponsor’s business?

–

Guarantee schemes: A form of pooled insurance funds?

–

Ways needed to measure effectiveness and value of – Governance requirements (regulatory, scheme and sponsor levels) – HR and social policy paybacks.

Not beyond actuaries?

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What is the most effective form of regulation for pension capital?

Explicit capital

Supervisory process

Insurance regime

Disclosure

Pensions regime

• Primary focus on getting requisite amount of solvency capital into company

• Primary focus on promoting right behaviours through arms length supervision with checks and balances, sticks and carrots

• Works better with a clean slate?

• Works better with legacy situations?

Supervision needs to be fit for purpose

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Would you take a different view if benefits were guaranteed? •

The fundamental difference between insurance and pensions (risk sharing) would no longer be there, therefore the pension deal would change to be more like insurance: – –

– – –

•

Risk appetites would be governed by security requirements, and these could be dictated externally (eg a Solvency II type standard) There would be greater scope for a mathematical solvency standard consistent with an externally decided uniform security standard (subject to clarity about ownership of solvency capital). Pricing of pensions would factor cost of risk as well as cost of solvency capital (rather like insurance) The level of benefits provided would then be chosen to suit available budgets (by sponsors and members) An insurance type regulatory regime would then make a great deal of sense

But, in practice this can only happen with respect to new pension schemes or future pension accruals in existing pension schemes. The legacy problem still remains to be dealt with in other ways.

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What’s the bottom line? Illustration for UK final pay schemes: Ø

TP, say 100% IAS 19

Ø

Risk free rate

Ø

+

15%-20% 40% - 50%

Solvency capital 99.5%

Well in excess of buy-out levels

Source: Risklab (on behalf of OECD)

But, this may be the wrong comparison: ¾Its not necessarily new capital ¾1:200 security level may not be appropriate for pensions ¾If you believe the risk sharing argument then required capital needs to be reduced

to reflect employer’s credit risk (and the political risk buttoned down)

¾With an explicit capital requirement of this nature, asset strategies should

immediately change towards lower risk, requiring less capital.

Should Private Pension funds be subject to capital requirements? Perspectives from the USA Frank Todisco FSA, MAAA, EA American Academy of Actuaries [email protected] The views presented herein include alternative viewpoints found in various policy debates in the US and do not necessarily reflect positions of the American Academy of Actuaries.

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Reminder…

The pension agreement involves a balance among cost, security, and the amount of benefit.

Capital requirements are directly associated with benefit security, but also indirectly associated with expected costs and benefit amounts.

Cost

Amount

Security

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Effects of more stringent capital requirements

More stringent capital requirements à • • • And: •

Cost

Higher perceived cost Greater benefit security Lower benefit amounts Greater taxpayer security Amount

Security

But what about: • Effect on coverage, in a voluntary system ??? 15

Some forms that capital can take for a pension plan: Benefits lost Taxpayer bailout

Insurance coverage (PBGC) Bankruptcy priority

Future sponsor contributions -- timing Side fund (NA in US)

Dedicated assets -- amount -- allocation Pension Promise

Capital

Different types of capital are levers that can be varied in amount and structure to get a total package that works 16

How stringent are the various capital / benefit security levers in the US? (private sector plans)

Dedicated assets § Amount § ABO-type measure (benefits accrued to date, no salary projection) § Bond yield curve

§ Allocation § Few investment constraints § Little or no liability matching

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Side fund concept (not used in US) § In US, limited ability to recapture any surplus from dedicated assets -- incentive not to add a funding cushion § Side fund concept § A cushion whose size is tied to amount of risk § A recoverable surplus

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Future sponsor contributions § Tougher funding laws (2006) § Current push for relief from funding rules

§ Key issue is timing: § How soon should the target level of dedicated assets be reached? § To what degree should funding rules be countercyclical?

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Bankruptcy priority § Relatively low priority for pension plans § What if pensions moved to front of line, ahead of general creditors? § Enhanced benefit security § Creditors might insist on changes in asset allocation before lending

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PBGC guarantees § Government sponsored agency § Funded by premiums paid by sponsors § Premiums only minimally risk-related § Higher if plan in deficit, but other risk factors not taken into account § Program facing significant actuarial deficits

§ Limits on amount of benefits insured -- benefits have been lost

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Disclosures / reporting § An indirect effect on pension capital

§ Enhanced disclosures of risks § Enhanced actuarial disclosures to employees beginning in 2009 § Mark-to-market (MTM) accounting § Both accounting and funding rules have moved in a mark-tomarket direction.

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Mechanisms for making capital requirements more stringent § Base capital requirements on level of risk § Risk factors: § Funded status of plan § Allocation of plan assets § Size of plan relative to size of plan sponsor § Correlation between plan financials and sponsor financials § Financial health of plan sponsor § Risk-based requirements could be applied to one or more of the forms of capital (amount of dedicated assets, size of side fund, timing of future contributions, level of PBGC premiums)

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Mechanisms for making capital requirements more stringent (cont’d) § Higher bankruptcy priority

§ Restrictions on asset allocation

§ Enhanced disclosures of risks § Further movements to mark-to-market (MTM) measurements

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Reminder: Effects of more stringent capital requirements

More stringent capital requirements à • • • And: •

Cost

Higher perceived cost Greater benefit security Lower benefit amounts Greater taxpayer security Amount

Security

But what about: • Effect on coverage, in a voluntary system ??? 26

Threshold question: In a voluntary system, what effect would more stringent capital requirements have on plan sponsorship? § More stringent capital requirements could effectively force a shift out of equities and into liability-driven investments (LDI)

§ What type of DB system is more viable long-term: § “Risk-based” (significant equity allocations) ? § “De-risked” (LDI) ?

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Threshold question (cont’d) Two opposing views:

(A) DB plans have been disappearing because of too much MTM Stringent rules ® too much volatility ® preference for DC, or Stringent rules ® de-risking ® -perceived cost ® preference for DC

(B) DB plans have been disappearing because of not enough MTM Flexible rules ® risk-based ® inevitable crises ® abandonment of DB

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Threshold question (cont’d) Two opposing views -- optimistic counterparts: (A) DB system can be revived with more flexible capital and other requirements More flexible and coherent rules (greater countercyclical funding; recoverable surplus; adequate PBGC premiums devoid of legacy costs; fewer plan design and other constraints; level playing field with DC) ® an attractive system with manageable volatility

(B) DB system can be revived with more stringent capital requirements More stringent rules ® de-risking ® -perceived cost ® ¯promised benefits, but more stable plans

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Should Private Pension funds be subject to capital requirements? The Canadian Perspective Denis Plouffe, FCIA, FSA Global Benefit Consulting 001 514 274 1964 [email protected] 30

What purpose does solvency capital serve? 1.

Increase Security to Schemes’ members -

No guarantee under current Canadian regulations that all retirement benefits be honored upon plan termination;

-

Limited insolvency insurance protection (only in one province and within certain limits);

-

Bad stories of underfunded plan terminations upon bankruptcies hit the news with adverse consequences for the pension industry and the expansion of defined benefit schemes.

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Is risk management of pension funds fundamentally different from management of insurance liabilities? 1. 2. 3.

4.

Pension schemes are part of employment contract (it’s one element of the total compensation package provided by employers) Various stakeholders such as employee representatives (eg. Unions) bring different perspectives into risk management and risk tolerance; The majority of Canadian private pension schemes are contributory (for tax reasons) leading to risk sharing of the total pension promise between employers and employees. The financial crisis brought another perspective to risk management (need increased transparency, governance and better employee education)

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DB pensions have more synergy with “participating” insurance contracts?

1.

More similarities because the participating contracts’ promises are dependant on investment performance;

2.

In Canada, the savings elements of Universal Life Policies compare better to DC pensions than DB pensions since these contracts are reevaluated periodically and any cost increases are borne by policyholders during market downturns.

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Should there be a minimum solvency capital requirement for pensions? 1. Ongoing developments and discussions in Canada around other forms of “’security mechanisms” than “formal” cash funding – Asymmetrical risk borne by plan sponsors makes additional cash based capital non attractive (i.e. under current regulations plan sponsors bear entire plan deficit while they usually share ownership of actuarial surplus with employees) – Non-cash capital requirements to enhance benefit security can have more appeal to sponsors - Letter of credits to finance solvency liabilities (or a portion) in certain jurisdictions - Proposals are under discussions for some forms of contingency funding – Pension Security Trusts to fund solvency deficiencies where funds could be released back to sponsors if it is shown that such funds are no longer necessary (add on flexibility) – Priority claims upon insolvency – Target solvency margins to reflect risks of underlying assets and liabilities » Risk-based approach to set up the solvency margins 34

What is the most effective form of regulation for pension capital? 1. 2.

As mentioned, it depends on the form of capital adequacy standard Additional observations for Canada: – Canadian pension system is regulated at provincial level (except federal institutions) with federal fiscal regime – Quebec recently introduced a law where the regulator can take over a pension scheme’s administration during bankruptcy to protect retirees’ pensions from any downside risk for a temporary period from the wind up date

– Ownership of capital requirement regulations between federal and the provincial levels - Who would own this? - Harmonization across provincial regulations has always been an issue (each province control their own backyard with local regulators) - A common framework of pension legislation to enhance benefit 35 security should be aimed at but it is complex to implement

Would you take a different view if benefits were guaranteed? 1. 2.

Yes, the pension deal would become much more like insurance However, there is no “Free Lunch”: - Main risks are interest rates and mortality/longevity leading to significant risk premiums - No evidence in Canada that there is a market for pension buyouts from private equity firms – Such market exists in the UK and Continental Europe - Annuity purchases with Insurers provide complete immunization to plan sponsors but at excessive costs

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Should Private Pension funds be subject to capital requirements? The Australian perspective Martin Stevenson BSc FIA FIAA Mercer

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Original approach to security “However it must be recognised that a final salary plan must, in the interests of the employer, stop short of absolute security of the defined benefits and permit amendment if the benefits become too costly (e.g. if salary inflation is very severe without offsetting improvements in investment results). Finally, every plan should enable the employer to cease contributions if absolutely necessary in which event the trust deed should provide for an appropriate share in its accrued fund to be secured for each member.” E S Knight + Others 1972

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Later developments in security § Accountants used concept of “constructive obligation” to force liability onto entity balance sheets § Society has moved away from “it is better to be approximately right rather than precisely wrong” § Regulator has concept of: – Unsatisfactory financial position – restore within three years – Technically insolvent – effectively place fund under actuarial management

§ As in other jurisdictions there is an issue about who owns the surplus.

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Present situation §

Public sector funds – large liabilities – government guarantees

§

Majority of defined benefit corporate funds – Small – Closed – Regulatory oversight – proactive, continuous but persuasion rather than mandatory – Actuarial Institute guidelines

§

Small number of corporate funds – Large – Generally closed – Regulatory oversight – proactive, continuous but persuasion rather than mandatory – Actuarial Institute Guidelines – Generally valuable employer covenant

Conclusion: Capital requirements are either not necessary or would be counter productive 40

Capital in the defined contribution environment § Public offer defined contribution funds required to have capital of $5 million § Many defined contribution funds are concerned about operational risk § It is now common for such funds to have an operational risk reserve in the range of 0.2% to 0.6% of assets – essentially provided by members § This is not dissimilar to capital requirements

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Financial Condition of a Defined Contribution Fund § § § §

The level of reserves held in the Fund The business strategy of the Fund The financial strength of the Trustee Financial Strength of major Service Providers; including § The level of capital held § The level of professional indemnity insurance § The limits of liability imposed by any contractual agreement § Sound Risk Management practices

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Should Private Pension funds be subject to capital requirements? § Should there be capital requirements for Private Pensions? § What form should this take – cash only or ???? § Does the form depend on whether the pension is guaranteed? § Do members of pension funds need better communication on pension benefit risk?

43

Should private pension funds be subject to capital requirements? A Debate........................ •Chairperson - Irene Paterson BSc FFA with Speakers......................... •Chinu Patel,BSc(Econ),FIA àà à The European Perspective •Frank Todisco FSA, MAAA, EA ààThe Perspective from USA •Denis Plouffe, FCIA, FSA àà àà The Canadian Perspective •Martin Stevenson BSc FIA FIAA à The View from Australia with a DC Twist? 44

Contact Details

Chinu Patel, Bsc(Econ),FIA Consulting Actuary Junipers, Croydon Lane Banstead, Surrey SM7 3AT UK Email

[email protected]

Tel

+44 (0) 754 547 1314 45