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

3 Classical ALM inconsistent with market value Fair-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”

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

6 Invest € 1 in equities or € 1 in bonds? € 1 in equities€ 1 in bonds 5% quantile€ 1.00€ 1.52 median€ 2.67€ % quantile€ 7.25€ 2.85 What is future value of investment after 15 years? Which of these two investments do you prefer?

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

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

9 Classical ALM mostly focused on averages Fair-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 Horizon 15 yearsUltimo 2005 P(FR < 100%)12.4% Average indexation100% Average contribution14%

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

13 Balance sheet for pension deal 1

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

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

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

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

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

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

20 Fair-value ALM compares euros in stead of different averages pension deal 1 pension deal 2 pension deal 3 P(FR < 100%)12.4%7.7%5.9% Average indexation100% 71% Average contribution14%11.8%10.7% Present value option deficit (euros) Present value pensions (euros) Present value contribution (euros)455146

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 EXTRA TRANSFERS PENSION DEAL 2

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

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

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 Source: “Leeftijdsolidariteit in de doorsneepremie” (Boeijen, Jansen, Tamerus, Kortleve) actuarial required actually paid (“doorsneepremie”) age contribution

35 “Doorsneepremie” leads to huge transfers Participant (salary € ) works between ages 46 and 65 Actuarial required contribution:€ Actually paid contribution:€ Gain:€ Participant (salary € ) works between ages 25 and 35 Actuarial required contribution:€ Actually paid contribution:€ Loss:€ << Source: “Leeftijdsolidariteit in de doorsneepremie” (Boeijen, Jansen, Tamerus, Kortleve)