Pension Plan Reporting Graeme Robertson, Vice President Damon Williams, Vice President Phillips, Hager & North Investment Management Ltd. Pension Plan Reporting in a Market Value World April 15, 2008 CIA Pension Seminar

Pension Plan Reporting Suggested Changes to Actuarial Reporting 1.Market value of assets and market value of projected benefits and expenses should be used in all valuations for all purposes 2.Reframe balance sheets for pension plans within a market value based framework

Pension Plan Reporting Some Definitions An “obligation” is a “real” or “nominal” cashflow owed in the future (e.g. a future benefit payment from a pension plan) A “liability” is a generic term for the present value of future obligations using a discount rate to price the obligation The “market value of liabilities” is the present value of future obligations priced using an appropriate current term structure of interest rates

Pension Plan Reporting Typical Accrued Pension Obligations

Pension Plan Reporting Market Value of the Pension Obligations If a portfolio of assets can closely match the obligations in terms of Inflation characteristics (nature) Term structure (timing) Expected $ (amounts) Risk characteristics (uncertainty) Then it follows that the market value of those assets must be the market value of the obligations

Pension Plan Reporting Market Value of the Pension Obligations Bond assets (real or nominal) can be structured to hedge the nature, expected timing and amount of the projected benefit and expense obligations with little residual investment risk Non-investment related risks affecting expected timing and amount that cannot be hedged in the markets should be explicitly identified and managed with a contingency reserve on the liability side of the balance sheet, e.g. Real salary growth (i.e. over and above inflation) Decrement risks (e.g. mortality)

Pension Plan Reporting Market Value of the Pension Obligations Use of Risk Free Interest Rates Funded obligations should be priced with no market default risk premium (e.g. discounted at Government of Canada rates) Credit risk discount to obligation valuation is a circular argument –Plans with ever lower funded ratios would use ever higher discount rates

Pension Plan Reporting Focus on Funding Valuations Typical Going Concern Valuation Balance Sheet In an actuarial valuation, many plans have used a flat discount rate (say 7%) to value their plan obligations Keeping the discount steady through time gives the impression that the investment objective is to earn 7% per annum Market Value of Assets $1bn Present value of obligations 7% $1bn

Pension Plan Reporting Focus on Funding Valuations Historical Return Perspective Source: Graeme\foreign content\returnge neration v2 Annualized 10-year Returns: Balanced Portfolio

Pension Plan Reporting Use of Market Values Consistent Asset and Liability Pricing Market Value of Assets $1.0B “Market Value” of Liabilities (implied discount rate = 4.0%) $1.5B Now let’s compare apples-to-apples Using a discount rate that reflects current market conditions substantially increases the value placed on the projected obligation

Pension Plan Reporting Use of Market Values Historical Return Perspective Annualized 10-Year Rolling Returns Balanced Portfolio versus MV of Liabilities -5% 0% 5% 10% 15% 20% 25% Dec-60Dec-62Dec-64Dec-66Dec-68Dec-70Dec-72Dec-74Dec-76Dec-78Dec-80Dec-82Dec-84Dec-86Dec-88Dec-90Dec-92Dec-94Dec-96Dec-98Dec-00Dec-02Dec-04Dec-06Dec-08 Returns MV of Liabilities Balanced Portfolio

Pension Plan Reporting Advantages of Using Market Values Consistent pricing of asset cashflows and pension obligations Reduce risk of spending surplus/funding deficit that isn’t there

Pension Plan Reporting Importance of Consistent Valuations An Example Pension plan has single obligation of $1bn in 20 years and $258mil in cash Interest rates are 7% We buy GOC strip paying $1bn in 20 years time for $258mil We will earn 7% p.a. for 20 years if we do not trade Funded ratio = 100% Year 5 interest rates are 4.5% and our asset is up 14.9% p.a. over 5 years (MV assets is now $517mil whereas we expected $362mil if we had earned 7% p.a.) Funded ratio (if discounting at 7%) = 143% Funded ratio (using MVs) = 100% $1bn cashflow from asset has not changed so unless $1bn obligation is priced at same value as matching asset then we will believe we have a surplus (of course we do not!!)

Pension Plan Reporting... Advantages of Using Market Value Pricing of expected obligations is consistent across all tests (eg. going concern, wind-up) Only differences come from benefits being projected and non-investment related assumptions used to project the benefits Fundamental economic similarities and differences between different tests better understood

Pension Plan Reporting... Advantages of Using Market Value Investment problem is clarified Becomes clear that assets must keep pace or beat a portfolio that matches the investment characteristics of the obligations being considered (the minimum risk portfolio or “MRP”) over time Investment policy development would consider opportunities relative to the MRP Objective (in our example) becomes a dynamic market value based objective of “return on MRP + 3%” rather than a “constant 7% per annum regardless of market conditions”

Pension Plan Reporting Reframing the Balance Sheet Current Actuarial Practice Market Value of Assets $1.0B “Market Value” of Liabilities $1.5B Present Value of Expected Risk Premium $0.5B 1 Common actuarial practice moves this to the liability side to reduce the reported liability 1 Equivalent to earning 3% per annum (i.e., 7% less 4%) in excess of return on MV of liabilities over expected life of obligations being valued

Pension Plan Reporting Reframing the Balance Sheet Current Actuarial Practice Market Value of Assets $1bn Present Value of Obligations 7% $1bn Obscures true funding and investment challenges

Pension Plan Reporting Reframing the Balance Sheet Proposed Market Value Approach vs Traditional Market Value of Assets $0.8bn “Market Value” of Liabilities (implied discount rate ~ 4%) $1.4bn Market Value of Assets $1.0bn Actuarial Value of Liabilities (discount rate 7%) $1.0bn Contingency Reserve $0.1bn Market Value of Assets $1.0bn “Market Value” of Liabilities (implied discount rate ~ 4%) $1.4bn Expected Value of Excess Returns $0.5bn

Pension Plan Reporting Why Reframe the Balance Sheet “Excess Return Asset” Excess return assets are not excluded but put on the correct side of the balance sheet The existence of the excess return asset implies an acceptable level of underfunding on a market value basis within which the actuary is comfortable keeping funding unchanged Excess asset is explicit enabling magnitude and appropriateness of that asset to be scrutinized by stakeholders in the context of the particular valuation test being performed “Excess return” is return on assets in excess of replicating portfolio so historical analysis should be in this context Note: Market value of excess return asset is $0

Pension Plan Reporting Reframing the Balance Sheet Excess Return Asset (Historical Perspective)

Pension Plan Reporting Reframing the Balance Sheet Example of Gain/Loss MV of Assets Excess Return Asset MV of Liabilities Net (Assets– Liabilities) Value at beginning of year $1,000,000 $500,000 $1,500,000 $0 BoY yield on Government of Canada securities +$20,000 N/a +$60,000 -$40,000 Change in Government of Canada spot rates +$30,000 N/a +$225,000 -$195,000 Return earned due to other investment factors (e.g, credit spreads, equity values) +$60,000 N/a +$60,000 Change in assumed excess returns over Government of Canada bonds N/a +$50,000 N/a +$50,000 Change in demographic assumptions N/a +$150,000 -$150,000 Contributions +$75,000 N/a +$75,000 Benefit accrual N/a +$60,000 -$60,000 Value at end of year $1,185,000 $550,000 $1,995,000 -$260,000

Pension Plan Reporting Conclusion Pension Plan financial reporting standards should frame pension balance sheets with MVs of both assets and pension obligations Have explicit excess return amounts on the asset side of balance sheet Existence of regulatory/legislation hurdles should not deter changes in actuarial standards

Pension Plan Reporting