2006 PARIS
Security in Pension Provision
Chairman:
Philip Shier
Presenters: Chinu Patel
Paul Thornton
Ireland
UK
UK
Groupe Consultatif Actuarial Europeen
2nd June 2006 11:00 – 12:30
Agenda
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•
•
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Chairman’s Introduction
Security Standards
Prudent Person Principle
Funding Methods and Assumptions
Solvency Requirements under IORP
Directive
• Solvency II and Pensions
• Discussion and Questions
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
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–
–
–
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
Book Reserve
Germany
backed by PSV - mandatory
insolvency insurance
Austria
no insurance
Sweden
compulsory credit insurance
(exist in other countries also)
Pension Funds
Ireland
Netherlands
Risk and investment reserves
Switzerland
Guarantee fund
UK
Pension Protection Fund
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
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Funding policy
Pension Assets

Duration
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Extent of credit risk
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Volatility
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Currency
Target Funding
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Possible availability of additional funding
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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, UK
chinu.patel@watsonwyatt.com
Groupe Consultatif reports
Actuarial methods and assumptions
• 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
Full reports at www.gcactuaries.org
Main purposes of a valuation
Funding
Accounting
Discontinuance
Statutory
Compliance
Budgeting cash flows
Reporting liabilities in
sponsor’s accounts
Legal liability on plan
termination
Tax / Supervision
Objectives
Smoothed contribution
rates
Consistency and
comparability between
companies and transparent
disclosure
What is the cost of
‘walking away’?
Practical
application
• Flexibility and
judgement in setting
discount rates
• How much risk is
affordable and what is
the expected return
from actual asset
portfolio?
• Subject to minimum
requirements in some
countries
• Method and assumptions
largely prescribed (in most
countries)
• Discount rate linked to
bond or government yields
• Volatile results if actual
investment policy involves
equity (and similar) assets
• What would it cost to
buy-out accrued
liabilities with a third
party?
• Usually an assessment
at a yield below
government bonds, and
a conservative mortality
assumption
Purpose
Minimum/maximum
funding; levies, etc
• Methods and
assumptions usually
prescribed.
• Influenced by local
practices and culture.
Today’s focus: Funding – how much pension security
through collateral in the pension scheme?
Methods for valuing assets
• 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
Actuarial perspective: the valuation of assets should be
consistent with the valuation of the liabilities
(technical provisions) and the expected return
on assets assumption.
Technical provisions
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
Pension security will vary accordingly
Funding methods
Two main families of actuarial methods:
Security driven - benefit allocation
Contribution driven – cost allocation
Objective: Maintain a target level of
funding:
Objective: Define certain level of
contribution:
•
Current Unit Method (CUM)
•
Entry Age Method (EA)
Projected Unit Method (PUM)
•
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.
•
Most commonly used
Projected
Unit
actuarial
funding methods
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
Generally different methods
for different purposes
Impact on pension security?
An example
300
250
CU
200
•
•
PU
150
100
Entry Age
1
50
Entry age
2
0
AGE
AGE
AGE
AGE
35
45
55
60
•
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
Factors affecting choice of method
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•
•
•
•
•
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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
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.
Main economic assumptions
These also dictate pace of funding:
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•
•
•
•
Rate of price inflation
Typical real (net of inflation) discount rates
for funding %
US
4 to 5
Canada
1.5 to 5.5
Japan
3 to 4
Australia
4 to 6
New Zealand
2 to 3
Mexico
3.5 to 5.5
Turkey
5 to 10
UK
2 to 4
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
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
Economic Assumptions:
How decided?
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.
Demographic assumptions
•
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
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)
4.86
4.22
4.07
3.98
3.97
3.97
3.95
3.70
Discount Rate (%)
3.42
3.22
3.00
3.00
2.84
A
B
C
D
E
F
G
H
I
J
Ireland
UK
K
2.52
2.49
L
M
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
What benefits are valued?
• 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
The extent to which these options/choices are built
into the calculation of the technical provisions will
affect the security provided to members.
Funding: Summary
Sources of variation in pension security
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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
Being fully funded could mean
different things in
different countries …..
Typical example currently in the UK
1000
900
800
Liability (€m)
700
600
500
400
300
200
100
0
Assets
Current Funding
IAS 19
AA Bonds
Ongoing
Govt Bonds
Govt Bonds
Buy-out proxy
Discontinuance
..... and even in the same country!
Security in pension provision
How will the IORP directive affect
pension security in Europe?
Minimum Solvency Requirements
What does the IORP Directive require?
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
Unfunded arrangements exempted
What does the IORP Directive require?
•
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
Member countries can lay down additional
detailed rules for improving member security,
but lots of flexibility.
What does the IORP Directive require?
Monitoring convergence (Article 15(6))
‘
...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 …..’
Will harmonisation of
discount rates be sufficient?
Groupe Consultatif survey
•
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
What was the practice prior to
the IORP Directive?
Groupe Consultatif survey
Principal observations
•
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)
Different practices = different pension security
and lack of consistency between countries
Groupe Consultatif survey
Principal observations
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
Method of reserving just as important
for pension security as assumptions
Groupe Consultatif survey
Principal observations
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
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
Minimum technical reserves vs. IAS19 liability obligation
120.00
100.00
Percentage
80.00
60.00
40.00
20.00
Belgium
Finland
Germany
Ireland
Luxemburg
Netherlands
Portugal
Spain
United Kingdom
Country
IAS19 Project Benefit Obligation
Pre 2005 minimum reserves
Notion of pension security varies vastly
between countries.
Will IORP change that?
What progress on implementation of minimum
solvency requirements of the IORP Directive?
1.
2.
3.
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.
No reason to expect convergence of
methods and assumptions.
Summary
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•
•
•
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
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
Solvency II and pensions
• 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
Objectives of Solvency II
• 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
Basel Agreement
• 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)
Solvency II – current proposals
• Calculation of technical provisions
– Discounted value using appropriate term structure of
risk free rates of best estimate future cashflows plus
explicit risk margin (75th percentile of probability
distribution) for non financial risks
• Solvency capital requirements
– Extra capital required to ensure with 99.5%
confidence that technical provisions and other
liabilities will be covered at following year end
• A minimum capital requirement
– Trigger for supervisory action
Solvency II and pensions
• Public policy question
– Should the level of security of a pension
promised under an occupational pension
scheme be as high as that applying to
payments under insurance contracts?
• If the answer is yes, then Solvency II
should be applied (and presumably many
employers would cease to operate
pension funds)
Impact of Solvency II on
occupational pensions
• Consider UK as an example
– FTSE 100 companies (87 DB pension schemes)
– Total assets €491 bn
– Total liabilities (IAS19 basis) €587bn
• Technical provisions increase to €672bn to
reflect Solvency II
• Solvency capital required €140bn to
€190bn to provide
99.5% confidence level
Alternative sources of solvency
capital
• Employer covenant
• Statutory debt on employer
• External (state backed) solvency
guarantee
– UK PPF
– German PSV
– PBGC in USA
Solvency II and pensions
• Groupe Consultatif has
– Met with DG Internal Market
– Prepared a draft position paper which has
been shared with the Commission
• Groupe Consultatif will
– Develop and finalise the position paper
– Continue to engage with DG Internal Market,
CEIOPS and others so as to inform and lead
the debate
Solvency II and occupational pensions
Philip S. Shier, FIA, FSAI
Hewitt Associates, Ireland
Chairman, Pensions Committee,
Groupe Consultatif Actuarial
Europeen
Security in Pension Provision
Chairman:
Philip Shier
Presenters: Chinu Patel
Paul Thornton
Ireland
UK
UK
Groupe Consultatif Actuarial Europeen
2nd June 2006 11:00 – 12:30