2006 General Meeting Assemblée générale 2006 Chicago, Illinois 2006 General Meeting Assemblée générale 2006 Chicago, Illinois Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

A Practical Approach To Considering The Possible Impact Of Asset Allocation On Funded Status For The Regulation Of Pension Plans Doug Andrews October 2006

Purpose Describe construction of Minimum Risk Portfolio (MRP) Consider impact of asset allocation on future funded position when investments deviate from MRP Propose an approach to be used by regulators

ONT Supervisory Regime Going-concern and solvency actuarial valuations required at least every 3 years PBGF provides limited protection in the event of sponsor and plan insolvency Annual PBGF fees based on Ont membership and the excess of solvency liabilities over solvency assets FSCO is testing a revised monitoring model and form and plans to implement this program in spring 2006

Duration and MRP Ideally all cash flows would be matched with respect to amount and timing, but this is impractical Duration could be easily incorporated in valuation cycle Solvency basis should be used for regulatory purposes “Dual duration” can be used to recognize inflation Plans in surplus can select Govt bonds to match duration

Problems In Constructing MRP There is not a unique way to construct the MRP resulting in different expected returns In the absence of CF matching, yield curve changes will disturb the match Matching very long liabilities may be difficult/impossible within risk guidelines Many plans have more liabilities than assets

The Stochastic Forecast Purpose – estimate likely change in funded position due to asset mix Regulators would specify annually the probability that the return on various asset classes will be less than on a portfolio of Govt bonds Sponsors/administrators would calculate the probability of any funding shortfall The results could be used in setting PBGF fees and determining the need for scrutiny

Examples Durn 8 portfolio with 60% equity/40% bonds has 48.9% probability of shortfall Durn 12 portfolio with 50% equity/50% bonds that is only 90% funded has 52.4% probability of shortfall Asset ClassDurn 8Durn 12 Cdn Equity39.9%41.4% Universe Bonds62.3%61.4%

Some Problems With Approach Requires regulators to publish annually a table of probabilities of expected shortfalls The weighted average of the prob of shortfall is not equal to the prob that the weighted average will fall short The calculation does not recognize the potential severity of the shortfall

Some Problems (Continued) The calculation does not recognize the potential benefits of diversification Method cannot be applied without adjustment when liabilities exceed assets In many circumstances, there is a greater likelihood that forecast returns will fall short over a 1 year period than over longer periods

Responding To These Difficulties It is suggested that regulators seek input from interested researchers and professionals The approach is simple enough to be applied by all plans which would not likely be the case for more accurate methods The method may subject more plans to scrutiny which is probably not a drawback for regulatory purposes

Responding (Continued) Although severity is important for calculating PBGF fees, this method is an improvement over the current calculation Assuming that any excess of liabilities over assets is invested in universe bonds is a practical solution Supervisory cycles are typically 1 year

Directions For Future Consideration - Norton A calculation like MCCSR used by OSFI for insurers might be a better basis to assess risk I agree and suggest this as an area for research by the CIA It is surprising that funding snapshots show little consideration for asset quality, potential volatility due to asset mix, and financial strength of sponsor

Directions For Future Consideration - Guerin Regulator would provide a set of 1000 scenarios of 1 year returns taking into account expected returns, volatilities and correlations. This would be available online to sponsors/administrators to do calculations This would be more accurate and could be applied by larger plans but would be too complicated for most plans It is unlikely that regulators would wish to maintain a system to be used by plans

Directions For Future Consideration - Williams To address severity, create a table of point scores or weights that take into account both the probability and potential severity of underperformance Points systems can be subject to criticism of being arbitrary and lacking a sound theoretical basis. In this respect the system used by OSFI for insurers may be a good example to follow

Features Of This Approach Simple and relatively inexpensive for plans to implement Introduces a way of measuring the impact that asset allocation may have on funded position Provides a stochastic modeling approach to enhance the quality of supervision It will likely increase the understanding of many sponsors/administrators of the risks inherent in the current asset mix