1. Implicit pension debt David McCarthy Presentation to the Indicators Working Group NTA Conference 15 th June 2010 1

2. Outline Implicit vs explicit debt Two main approaches to valuation Valuing implicit debt Types of implicit pension liabilities Alternative definitions of IPL Crucial assumptions (Thanks to Holzmann, Palacios & Zviniene (2001), although some ideas are my own!)

3. Implicit vs. Explicit debt Public mandatory pension systems are typically not contractual arrangements Therefore the arrangements are not subject to the (full) protection of contract law This is in marked distinction to, for instance, government bonds which are contracts between borrowers and lenders Most notable advantage is that this makes the arrangement more flexible (and hence possibly more resilient over the very long timescales required by pensions) Governments have substantial (but far from total) discretion to alter the liability, with attendant risks © Imperial College Business School

4. Two main approaches to valuation Actuarial (e.g. annuity factors, commutation functions) Values risky payments at their expected discounted present value Struggles with conditional payments (e.g. Guarantees) Financial (e.g. Black-Scholes etc) Values risky payments as the price of a replicating portfolio of financial assets [Equivalent to altering the discount rate to allow for risk] Struggles with payments which cannot be replicated and requires some brave assumptions © Imperial College Business School

5. Valuing implicit debt Flexibility of implicit debt makes it hard to value Some argue that it is not appropriate to use discount rates derived from explicit debt when valuing pension liabilities Explicit debt is a harder promise, therefore less risky, and therefore should attract a lower discount rate and a higher present value Values of implicit debt calculated using treasury yields or their equivalents are therefore upper bounds This may accord with individual perception of pension values (e.g. Feldstein) © Imperial College Business School

6. Types of IPL Guarantees for voluntary private pension schemes (US PBGC, UK PPF etc) Guarantees for compulsory private pension schemes (Chile, Mexico, Hungary) Unfunded public DB pension schemes (US Soc Sec) Unfunded public DC schemes (Latvia, Poland, Sweden) © Imperial College Business School

7. Alternative definitions of IPL (I) Accrued-to-date liabilities (ATDL) Liability to current workers of the benefits they have accrued to date assuming that the system as a whole is shut down and no future contributions are collected and no more benefits accrued Projected liabilities of current members (PL) No new entrants, but current rules of benefits and contributions continue until the last current contributor dies Equals ATDL plus present value of future benefit accrual to current members less present value of future contributions © Imperial College Business School

8. Alternative definitions of IPL (II) Open system liabilities Present value of all future benefits paid by the system less present value of all future contributions collected Equals PL plus present value of PL for all future cohorts of members [Private sector DB pension plans have their corresponding analogues to all of these measures, although open system liabilities are rarely measured] © Imperial College Business School

9. Crucial assumptions Once an appropriate definition is chosen, calculation requires assumptions Most crucial is the real valuation rate of interest (i.e. the nominal rate less the assumed rate of growth of the liabilities) For guidance, can examine the rate of return on government bonds, projected rates of growth of GDP / productivity, but estimates of sufficient term are rarely available or robust Demography (including, if necessary, labour force participation), as well as projections are next. Options-based approaches needed for conditional payments such as guarantees © Imperial College Business School