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Enhancing Pension Deals through Fair-Value ALM

Learn how Fair-Value ALM provides better understanding of pension investments, ensuring accurate stakeholder analysis and fair policy changes impact measurement.

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Enhancing Pension Deals through Fair-Value ALM

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  1. Better pension deals with fair-value ALM UvA, Netspar, AG - 2 november 2006 Niels Kortleve

  2. Better pension deals with fair-value ALM Classical ALM has shortcomings • Inconsistent with market value • Does not give correct weight to downside • High cash flows can have low present value • Mostly focused on averages only Fair-value ALM is easy to understand • Comparing euros in stead of different averages • Measuring impact of policy changes on stakeholders 1 2 2 3

  3. Classical ALM inconsistent with market valueFair-value ALM attaches more weight to downside 1 Introduction

  4. Choice between two deals • Suppose you have no control of your own future • Probability of 50% to become millionaire • Probability of 50% to become unemployed • Someone is offering you two deals • Deal one: receive € 1000 when millionaire • Deal two: receive € 1000 when unemployed • For which deal are you willing to pay most? • Classical ALM says: both deals are equal • Fair-value ALM attaches more weight to downside • Scenario of becoming unemployed has high “state price” • Scenario of becoming millionaire has low “state price”

  5. Fair-value ALM: more weight to downside 0.00005 state price value (euros) 0.005 time = Equities

  6. Invest € 1 in equities or € 1 in bonds? What is future value of investment after 15 years? Which of these two investments do you prefer?

  7. State prices reveal what we already knew:Both investments have same present value 0.00005 state price value (euros) 0.005 time = Equities = Bonds

  8. Economic scenario set Set state prices scenarios scenarios Fair-value ALM: Balance sheet(in euros)Stakeholder analysis time time Cash flows per scenario Classical ALM: P(underfunding) Average indexation Average contribution scenarios Pension deal time

  9. Classical ALM mostly focused on averagesFair-value ALM compares euros in stead of different averages 2 Example

  10. Example: fictitious pension fund • Pension deal 1 • Average pay DB • Fixed contribution: 14% of salary • Unconditional indexation with wage inflation • 50% equities, 50% bonds • Adapting this deal step by step • What happens to classical ALM results? • What happens to fair-value ALM results? • Our horizon is 15 years Initial funding ratio: 130% (nominal)

  11. Classical ALM results for pension deal 1

  12. Funding ratio for pension deal 1 Verloop van de dekkingsgraad Fair-value ALM: more weight to downside probability present value 6 87.6% 12.4% 30 time

  13. Balance sheet for pension deal 1

  14. Policymaker’s control panel: pension deal 1 Average contribution: 14% Average indexation: 100% P(FR < 100%): 12.4% deal 2 deal 3

  15. Pension deal 2: contribution ladder 14% contribution 100% 130% 160% funding ratio

  16. Pension deal 2: contribution ladder Lower average but higher present value Classical ALM:average contribution = 14% Classical ALM:average contribution = 11.8% Fair-value ALM:value of contribution = 45 Fair-value ALM:value of contribution = 51

  17. Policymaker’s control panel: pension deal 2 Average contribution: 11.8% Average indexation: 100% P(FR < 100%): 7.7% deal 1 deal 3

  18. Pension deal 3: indexation ladder indexation 100% 160% funding ratio

  19. Policymaker’s control panel: pension deal 3 Average contribution: 10.7% Average indexation: 71% P(FR < 100%): 5.9% deal 2 deal 1

  20. Fair-value ALM compares euros in stead of different averages

  21. Fair-value ALM measures impact of policy changes on stakeholders 3 Stakeholder analysis

  22. Which stakeholders pay for policy changes? • Cohort = stakeholders of same age group • Transfers between cohorts because of policy change • > 0: cohort profits from change • < 0: cohort loses from change • Assumptions • Range of cohorts is 5 years • Our horizon is 15 years • Initial funding ratio: 130% (nominal)

  23. Fair-value generational accounting computes transfers between cohorts: zero sum game cohort loses 8 cohort gains 5 cohort gains 3

  24. Example: pension deal 1 >>

  25. Example: pension deal 1

  26. Example: pension deal 1

  27. Result: transfers in pension deal 1

  28. Young participants lose in pension deal 2(contribution ladder) PENSION DEAL 1 PENSION DEAL 2 EXTRA TRANSFERS

  29. Retirees lose in pension deal 3(contribution ladder and indexation ladder) PENSION DEAL 1 PENSION DEAL 3 EXTRA TRANSFERS

  30. Young participants lose when initial funding ratio is 100% in stead of 130% (pension deal 3) INITIAL FR: 130% INITIAL FR: 100% EXTRA TRANSFERS

  31. Concluding remarks

  32. Better pension deals with fair-value ALM Classical ALM has shortcomings • Inconsistent with market value • Does not give correct weight to downside • High cash flows can have low present value • Mostly focused on averages only Fair-value ALM is easy to understand • Comparing euros in stead of different averages • Measuring impact of policy changes and initial funding ratio on stakeholders

  33. Appendix

  34. Because of Dutch “doorsneepremie” young participants pay too much contribution actuarial required contribution actually paid (“doorsneepremie”) age Source: “Leeftijdsolidariteit in de doorsneepremie” (Boeijen, Jansen, Tamerus, Kortleve)

  35. “Doorsneepremie” leads to huge transfers Participant (salary € 50 000) works between ages 46 and 65 Actuarial required contribution: € 350.000 Actually paid contribution: € 290.000 Gain: € 60.000 Participant (salary € 20.000) works between ages 25 and 35 Actuarial required contribution: € 22.000 Actually paid contribution: € 36.500 Loss: € 14.500 << Source: “Leeftijdsolidariteit in de doorsneepremie” (Boeijen, Jansen, Tamerus, Kortleve)

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