Evaluating the UK and Dutch DB pension policies using the holistic

Evaluating UK and Dutch defined-benefit pension
policies using the holistic balance sheet
framework
Zhiqiang Chen (APG)
Antoon Pelsser (Maastricht University, Kleijnen Consultants)
Eduard Ponds (Tilburg University, APG)
Rethinking the Economics of Pensions II
London
March 20-21, 2014
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Why do we do this study?
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Pension policies vary across countries, making fair comparison
of the pension systems difficult
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European pension regulator EIOPA wants to harmonize the
framework of quantitative requirements for pension funds
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Holistic Balance Sheet (HBS) allows for a comparison of
different pension contracts
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We use HBS to compare UK and Dutch DB plans.
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Framework
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Comparison of UK-based company and Dutch-based company
which are similar in all aspects, including the pension plan,
but country-specific pension regulation
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ALM study in Q-world
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Market-consistent pricing of embedded options
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Key results
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Holistic Balance Sheet framework powerful instrument to
perform international comparison
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UK policy is a better deal for participants
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generous indexation
burden underfunding borne primarily by sponsor
external protection (UK Pension Protection Fund)
Dutch policy is a better deal for the sponsor
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indexation conditional
burden underfunding borne by sponsor and participants
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What is HBS?
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Pension deals can be viewed as a combination of embedded
options
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The payoffs are contingent assets or liabilities for the pension
scheme
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Adding the values of these embedded options to the
traditional balance sheet, we get the HBS
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A traditional balance sheet (TBS) looks like...
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An HBS looks like...
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An HBS looks like...
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An HBS looks like...
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Two pension scheme having the same TBS...
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...might have different HBS
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The study aims to...
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Build the HBS for typical UK and Dutch policies
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Compare the HBS for typical UK and Dutch policies
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Evaluation of same Pension Plan
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Consider UK and Dutch companies which have similar pension
plans, but country-specific regulation
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Characteristics Pension Funds in UK and the Netherlands
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Same plan
Same demographics
Same Funding ratio 118%
Closed fund, no new entries
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Value-based ALM model
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Value-based ALM:
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5000 scenarios under the risk-neutral measure Q
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Each embedded option can be valued as
T
X
V0 = E0Q [ (CFt · Dt )]
t=0
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Horizon 15 years
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Features of UK pension policies
1. Indexation
2. Sponsor guarantee
3. Pension Protection Fund (PPF) protection
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Indexation
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Full indexation
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Linked to Consumer Price Index
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Floor (0%)
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Caps for pensioners (5%) and active members (2.5%)
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The indexation option on the HBS
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Sponsor guarantee
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Full recovery of pension funding shortfall
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Several years
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If the sponsor is still solvent
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The sponsor guarantee option on the HBS
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Pension Protection Fund (PPF)
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2005
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Protect almost all DB schemes in UK
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Pension scheme pays Annual Premium (levy)
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PPF takes over a scheme when
1. The sponsor is insolvent
2. Pension assets not enough to cover the guaranteed liabilities
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Benefits are cut (10%) if PPF takes over the pension scheme
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Implied options are...
1. PPF guarantee option (PPF writes to participants)
2. PPF cut option (participants writes to PPF)
3. PPF levy option (pension scheme writes to PPF)
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The PPF options on the HBS
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Features of Dutch policies
1. Conditional indexation
2. Sponsor support
3. Sustainability cut
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Conditional indexation
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Linked to price level
Depending on the actual funding ratio
e.g. wage level increases by 6%
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Recovery plan
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Recovery plan when Funding ratio falls below 105%
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Recovery within 3 years
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no indexation
benefit cuts
additional contributions from sponsor and workers
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How the HBS looks like...
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Summary
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HBS approach allows to compare UK and Dutch pension
policies
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UK policy is a better deal for Participants because of generous
indexation, external protection if sponsor is insolvent
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Dutch policy is a better deal for the sponsor because
participants share the obligation of funding position recovery
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Ex post values of the PPF guarantee option and PPF levy
option mismatch
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Levy based on UK universe (diversification), value guarantee is
fund-specific
Underlying models differ in assumptions
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Discrepancy of the values of the PPF guarantee and levy
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inconsistency between
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levy calculation (PPF formula)
credit risk modelling (Merton’s framework)
insolvency probability, stressed underfunding, etc.
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Contradicting nature of the PPF guarantee and PPF levy
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