Cross-border IORP growth slowing

In its third Report on Market Developments, CEIOPS provides an update of recent developments in cross-border pension funds. Net growth has dwindled to a mere 9% in the reporting period. Notably, there were 4 discontinuations of cross-border activities of IORPs. The report includes little conclusive evidence of the reasons for the slow growth. In particular, the discontinuations were not attributed to the regulatory framework, but anecdotally to reasons specific to the institution in question. Nevertheless, our assumption would be that the uncertainty surrounding the pending revisions of the pensions directive are certainly not encouraging strong growth at this juncture.

Linking pensions to longevity

The OECD has issued an interesting working paper Life-Expectancy Risk and Pensions: Who Bears the Burden?, which looks into a number of OECD countries' relatively recent policy changes to share part of the longevity risk with pensioners. Given the proportions of the risk and the massive inter-generational skew in cost/benefit, this is perfectly reasonable and should be adopted universally.

For some undisclosed reason, Switzerland is virtually omitted from the scope of the analysis, even though there clearly is no linkage between longevity risk and pensions whatsoever. In the Swiss three pillar system, longevity risk is borne in the first pillar by the tax payer, by employers in the second, and by individuals in the third pillar.

Farewell America

Bank Wegelin's most recent investment commentary by the same title is remarkable. It provides an extensive explanation of the US taxation risks involved when investing in US securities as a non-US person. The fact that the status of US-person is left (intentionally?) unclear is of particular concern to Qualified Intermediaries (i.e. foreign banks) because they assume liability for their clients' putative tax liability. This is the reason why Wegelin is actively advising its clients to exit all US securities and may not sign the more rigorous QI Agreement. Wegelin's move receives particular attention in Switzerland because its Managing Director is also Chairman of the Swiss Private Bankers Association.

Non-US pension funds (and listed entities) may be eligible to an exemption from a new 30% compulsory withholding tax on US securities held by non-US companies, as explained by the Green Book.

Discounting pensions

The IASB proposes to modify the discount rate applicable to the valuation of pension liabilities in IAS19. The proposal would eliminate the requirement to apply government bond yields instead of high quality corporate bond yields where there is no deep and liquid market for such securities. The proposed modification is triggered of course by the massive expansion of the spread between corporate and government bonds in the wake of the crisis, which serves as an excuse for yet another instance of accelerated due process...

While I agree that applying government bond yields to discount pension liabilities makes sense in only a very limited set of circumstances, and definitely not as a generic fall-back position in the absence of a deep corporate bond market, the proposed discount rate suffers one important flaw. The Board argues (BC4) that comparability is served by reducing the range of rates used. Yet, the motive for not just fixing a single rate (maximum comparability in that sense) is probably that this would not reflect economic reality in any sense. But this purpose is not served by choosing high quality corporate bonds, either. What if the reporting entity is not of high quality (which is the rule rather than the exception nowadays)? The liability is overstated.

The economically correct discount rate to apply to the valuation of pension liabilities in my opinion is WACC. Cost of capital is calculated for each entity separately and thus cannot be compared uniformly, but it reflects the economic reality of financing decision making. As an analyst knowing about the many arcane ways in which pension liabilities are valued, I don't take the nominal amount of pension liabilities at face value anyway, so that comparison is of little interest.

No return on closing DB plans

The July/August issue of FAJ has an intriguing article looking at empirical evidence of whether freezing DB pension plans would increase company value. Since cost and volatility impact on earnings are the justifications most often referred to for closing DB plans, the default expectation should be that it would. Yet, the authors cannot find any significant evidence of that.

They have been looking at the price reaction in four different event windows of 82 US announcements of frozen / closed DB plans between 2003 to 2007 in various industries. Interestingly, there seems to be a correlation between closure events and the generic business cyclicality of the firm's industry sector. Event firms exhibited stock market underperformance compared to their peers in the years leading up to the event.

Results indicate no systematic empirical evidence for positive abnormal returns associated with DB plan freezes / closes. Separating freezes and plan closures exhibits a small, yet unexpected diversion: Plan freezes generated a negative abnormal return, whereas the (small) sample of closures (for new employees) produced a more pronounced positive return.

In sum, it seems that DB pension plan closures / freezes tend to be short-term, ineffective measure adopted by managements to counter performance pressure.

Victims IV: The real crisis

The Economist deserves praise for having featured a special report on the impact of ageing populations in this time of crisis, which overrides longer term requirements with its fiscal profligacy. The majority of industrialised countries were already on an unsustainable fiscal path before the crisis struck. It is difficult to see how government finances will ever be able to return to a trajectory that is stable longer-term.

It goes without saying that the foreseeable instability of public finances has a dramatic impact on capital funded retirement systems. At this juncture, the jury is still out on the prefix of instability, i.e. whether we will see inflation or deflation. Either way, the contradictory demands on the investment strategy of individual funds are anything but trivial and may need to be implemented consistently in very short order once the dust settles. Scenario analysis and preparation is the name of the game. I look forward to a workshop producing a Shell/Oxford-method scenario analysis on Switzerland 2030, to which I have been invited by the federal crisis management education unit.

Impact of accounting and prudential regulation on pensions

"A long-term view involves short-term risk, whereas a short-sighted strategy involves increased risk over the long term."

EDHEC just released its impressive report Impact of Regulation on the ALM of European Pension Funds. Even though we disagree in some instances, we think this is mandatory reading for anyone in the pensions investment space because it highlights those areas of regulation which will be of increasing consequence for pension funds' investment strategies in the near future, as we have continued to stress over the recent past.

At the core of the report is the development of an asset allocation model in the presence of liability constraints. The solution involves the components cash, risky assets and the liability hedging portfolio. The state of the art model takes inflation and longevity risk management into account as well.

There is not enough space nor time for an in-depth review of this valuable piece. Nevertheless, I would like to mention two issues that have slightly moderated my enthusiasm for the report:

• There seem to be a few at least implicit factual inaccuracies in the parts describing the regulatory environment. The most glaring of which may be the assumption that the EU pensions directive is applicable in Switzerland - it is not.
• Accounting standards seem to be understood to effectively determine investment action. While it is not unheard of that managements structure transactions in such ways as to optimise their reporting, this clearly goes one step too far. We are well aware of the interdependence between perception (qua accounting standards) and (economic) reality, but at least in an academic report, the latter needs to retain some vestige of predominance over the former. Remember: pension funds' long-term time horizon, as accounting standards can and do change.

The tyranny of the present

In a recent issue of its flagship publication Sigma, SwissRe described Scenario analysis in insurance, identifying scenario analysis as a key tool to analyse fat-tail risks and their impact on profitability and competitive position of insurers. One of the pioneering sources of scenario analysis is the approach developed by Shell. Whereas scenario analysis is referred to as a key tool for both strategic planning as well as enterprise risk management of insurance, Sigma reports with some degree of astonishment that banks do not use it to assess their total enterprise risk exposure.

Applying the concept of scenario analysis to pension funds should be self-evident, not least if you think of a pension fund as the insurance subsidiary of your firm. It faces a set of opportunities, threats and parameters quite similar to those of an insurance, yet scenario analysis is not common in the pensions industry. Nevertheless, a number of pensions-specific scenarios easily come to mind: a jump in longevity due to unexpected medical progress, prolonged negative real interest rates, a pandemic (as explained in Sigma), regulatory changes to the competitive landscape ...

The Economist Intelligence Unit has just come up with its own bleak exercise in scenario analysis (hat tip Global Guerrillas). Its central forecast of stabilisation is assigned a probability of just 60%, whereas the more disruptive instability scenarios are assigned 30% (de-globalisation) and 10% (collapse in USD) respectively. Scenario analysis has been posted as a means to escape the tyranny of the present, but being where we are today, we are not so sure this is a good thing.

CEIOPS State of Pensions Report

CEIOPS'�Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors has a good section (starting p. 22) about recent developments in the European pension funds market, giving insights into last year's changes in a number of countries and a statistical overview, based on Eurostat.

CFA Institute Code for Pensions

The CFA Institute has published a Code of Conduct for Members of a Pension Scheme Governing Body. The Code is intended to guide the behaviour of individuals sitting on governing bodies of pension schemes worldwide (ASIP has contributed, among others), which is why its principles are worded rather generically (see IPE story). Go to the comments section for more detailed explanation.

I find Fi360's Periodic Table of Standards of Excellence to provide a great complementary overview of best practice.

Pensions webcast

In yet another effort to increase its accessibility, the IASB makes its first ever recorded webcast about its recent pensions DP available to the public on its pensions project site. The webcast had about 120 participants and the included Q&A session was rather good.

I think that the IASB ought to add public webcasts to its ongoing projects due process. The ease of (global) participation and dialogue would enhance the reach of the IASB's due process to a new group of users (of financial statements) which was hitherto unreachable due to lack of time and attention.

Multilocal pensions?

While not at all intended for that particular function, the McKinsey Quarterly Managing Cross-border Functions is a useful stimulus to consider the different organisational options in setting up a pan-European pensions operation. Clearly, the regulatory context may play a more prominent role than in many other industries, but this is not a qualitative differentiator.

Don't miss!

On Thursday, 27 March the IASB is going to release its long expected discussion paper on post employment benefits. Don't miss IASB member Steven Cooper's live web presentation introducing the discussion paper from 1200h to 1230h (UTC). You can register for the event here.

It may be interesting to compare the IASB's position to the previously released paper of the UK ASB on the same topic. My guess is that the ASB's position will prove to be more aggressive, especially with regards to the highly controversial use of risk free interest rates to discount pension plan liabilities.

New pensions accounting to raise volatility

CFO.com reports Georgia Tech Financial Analysis Lab's research on�The Effects of Enacted and Proposed Pension Accounting Changes On Leverage, Profitability and Earnings Volatility, in which researchers simulate the impact of probably forthcoming accounting for pensions changes in the US on the DJIA components' income statement, extrapolating FAS 158 numbers to be run through the income statement. Unsurprisingly, they find a huge impact on the volatility of reported earnings, among other items and ratios. In the 2002-2006 period, volatility effectively doubles.�

As FAS 158 is likely to inform the ongoing work on the revision of IAS 19, this kind of research is valuable for European users, too because it allows us to get used to different accounting treatments resulting from fair value accounting. It is important to keep in mind that these accounting rule changes will bring reported numbers much closer to economic reality than current accounting treatment ever can. If this increasing transparency leads to more sustainable risk management policies in enterprise sponsored retirement plans, then so much the better. Users of financial statements will be able to adapt their interpretations of the numbers in any case.�

The future of public pensions

Richard Ennis' article�in the current issue of the Financial Analysts Journal may be aimed at the�ailment�of US public pensions, �but its tenets are equally applicable to European (including Swiss) public pension plans as well. A key issue is that of valuation, where current actuarial valuations are traditionally predominant under the pretext of perennial solvency of the state sponsor. Ennis convincingly demonstrates that the "issues are the value of the obligation, the cost to extinguish it, and on whom the burden of that cost falls. In a word, the concern is accountability." From a Public Choice perspective, his tenets are unlikely to be put into action just now, unfortunately. The increasing gulf between public and private pensions will have to get wider before this can be addressed fundamentally.�

IZS conference documentation

IZS has made available the presentation slides from its recent annual conference about cross-border retirement provision from a Swiss perspective. It's a pity that the most interesting presentation seems to be missing: Klaus Stiefermann of a.b.a. talked about the Pensions Directive: godsend or letdown? As he was speaking from a distinctly German perspective, it will not come as much of a surprise that he tended towards the latter.

Impact of funding risk

Interesting material our way comes! Watson Wyatt has had a close look at the funding status of Fortune 1000 companies 2004 - 06 with effective numbers becoming available for 2006 thanks to FAS 158. WW has developed a Pension Risk Index, which estimates the loss of the pension plan in percent of the corporate's market cap at a 5% probability of unfavourable market conditions, given the plan?s asset allocation, liability structure and sensitivity to interest rates.

An excellent article in the current issue of the Financial Analysts Journal goes an important step further: The author estimates the correlation between pension fund deficits and associated credit spreads. The results are statistically significant and show interesting characteristics: The sensitivity of spreads to unfunded pension liabilities is about five times larger for junk bonds than for investment grade bonds. Also, the sensitivity to pension liabilities is much larger than to ordinary long term debt - double for investment grade, triple for junk. The model was also run for samples from the UK and Japan, but those results only confirmed a generic sensitivity.

This is where the relevance of pensions for corporate finance becomes evident. We expect that the relevance will increase thanks to better, more relevant accounting information and increasing market attention.

A directive formerly known as portability

The Commission has presented a revised proposal for what was known as the Portability Directive. The project for the portability of pension rights has met opposition from several quarters and therefore had to be tuned down considerably, especially removing portability and harmonisation.

Valuation of Swiss IORPs

Well known Swiss accounting and pensions expert Carl Helbling has a highly relevant piece on the valuation of Swiss pension schemes. In it, he comes to a rather disturbing conclusion: "Accounting standards IFRS and Swiss GAAP FER are too undifferentiated and can only be a limited basis for valuation [of pensions]." He lists a substantive number of instances, where, for legal reasons, apparent over- or underfundings of Swiss plans cannot be utilised as expected economically. Thus, accounting numbers may be substantially different from effective values.

Now, this is not exactly news as IAS 19 is hardly known to reflect economic reality thanks to its built-in shortcomings. But the instances listed do not even appear to be related to IAS 19 features to start with, but rather to what needs to be considered as accounting artefacts in the light of (legal) reality. One wonders how such numbers can be presented as true and fair?

European pensions in Korea?

CFA Korea Society has been so kind to invite me to talk to them about pan-European pensions and the conclusions to be drawn from European experience in the light of the very recent introduction of occupational pensions in Korea. Here are the slides of that presentation.

Occupational pensions in Switzerland

The Federal Office of Statistics has published key figures about occupational pensions in Switzerland. Unfortunately, the latest numbers available date back to 2005. Nevertheless, it is interesting to note that the 2nd pillar's assets have grown to over CHF 540 bio by 2005. That's 117% of GNP. Since 2000, the number of iorps has declined by 19% to 2770. The average number of members per iorp is just shy of 1200.

These statistics have several deficiencies. Available numbers are not timely. Furthermore, we know little about the effective structure of overall liabilities, nor about interest rate sensitivities of assets.

CFA Pension Code of Conduct

The CFA Institute Centre is asking for comments on its Code of Conduct for Members of a Pension Scheme Governing Body until 15 August. The draft has been prepared with the assistance of the OECD and major trade associations from the Hong Kong, the Netherlands, Switzerland, the UK and the USA.

Pensions in Central & Eastern Europe

Allianz Global Investors has published a 96-pages comprehensive report about the pension systems and markets in Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovenia, and Slovakia with individual country profiles. This report is very useful due to the changing landscape in that region of the continent, combined with the unconventional pillar terminology utilised.

UK pensions to become mandatory?

In the first ever Summer Statement outlining the formal Gracious address which in turn contains the legislative programme of HM Government, Gordon Brown said the following:

The new Pensions Bill will ensure that for the first time not just some but all working people have the right to a workplace pension with a duty on every employer to contribute towards it.

We can only interpret this to mean that occupational pensions will go from contingent to mandatory for everyone in the UK. The implications of this change for the European first and second pillar classification, which critically relies on the non-mandatory nature of occupational pensions in contradistinction to social security, may be huge. This criterion, which is dispensable in our view, would be a major technical impediment to the eventual application of the Pensions Directive to Switzerland with its mandatory occupational pensions system.

Actuaries hedging

Pension liabilities heavily depend on forecasts of the mortality of the pension plan beneficiaries. These forecasts are produced by actuaries. Until quite recently, the actuarial science was deemed to be capable of coming up with a reliable point estimate (if you can speak of point estimates in the context of large cohort mortality tables) of future mortalities. This expectation does not survive under closer scrutiny of course. That is not a bad thing, because point forecasts of the future are necessarily inaccurate, therefore such expectations were never realistic.

The British actuarial profession is leading the pack again with its publication of a draft library of mortality projections, indicating that it may be reasonable to utilise a number of scenarios in mortality projections. But more closely to home, and indicative of imminent changes to current mortality assumptions and thus liability valuations, they warn that currently employed mortality tables may considerably underestimate improvements in future mortality. We understand this to imply that more realistic tables will assume higher average life expectancies and, consequently, higher pension liabilities.

DNB on pensions

In a recent speech, the president of the Dutch central bank has presented a concise and well structured comparison between US and Dutch occupational pensions. He particularly focused on the benefits of a legal separation between sponsor and pension fund as well as on the advantages of professional asset management which is supported by the more collective approach in the Dutch system.

New interpretations for IAS 19

IFRIC, the International Financial Reporting Interpretations Committee has issued an important interpretation of the limit on an asset recognised in the surplus of a defined benefit plan under IAS 19. Especially the treatment in the presence of minimum funding requirements is of interest in the European context. IFRIC 14 is only available to eIFRS subscribers, but its draft is openly available.

39 cross border IORPs

Already in early March, CEIOPS reported the status of cross-border IORPs that were active by the end of January 2007. For some reason, this has escaped our attention to date, which is quite unforgiveable since it is an interesting statistic.

Of the 39 institutions reported, 77% have been in operation prior to the Pensions Directive's entry into legal force. Only 9 are "new" IORPs, located in Finland (1), Germany (1), Ireland (4), Luxemburg (1) and the UK (2). Notably absent from that list are Belgium and Liechtenstein, but we would wager that the "many new cross-border IORPs" anticipated by CEIOPS should change that ranking fairly soon, especially since Belgium is a relatively late arrival in terms of directive transposition. We hope that this statistic is updated periodically, for instance quarterly.

CEIOPS also notes that the Budapest Protocol of supervisory cooperation works well, but that "some features of the IORP Directive might benefit from further clarification".

640% of GDP

That would be the steady state equilibrium size of a Finnish model pension fund, assuming an elderly dependency ratio of 44% by 2050, up from currently about 23%. This is one of the interesting numbers that yet another central banker, Mr Erkki Liikanen of the Bank of Finland, has quoted in his recent address to the Conference of Social Security Actuaries and Statisticians.

There is a lot of interesting food for thought in that speech. I have just one question mark concerning the conclusions, where Mr Liikanen claims that "the volumes needed for financing pensions mean [that] the system will always have to be based on a public PAYG scheme". We think that always is an awfully long time. Mr Liikanen does not specify why funded systems should be unable to reach the required level of funding in the course of a generation or so.

Incentives for DB plans

The Governor of the Bank of Canada, Mr David Dodge, has been singing defined benefit pension plans' praises in a recent speech. He recognised that "an effective defined-benefit pension system is a tremendous asset for individuals, for employers, and for our society as a whole", but is currently hampered by a number of disincentives, which favour DC over DB for sponsors. Specifically, he lists

uncertainties over the legal status of actuarial surplus

overly restrictive solvency requirements,

transition from smoothed accounting numbers to fair value accounting

group longevity risk

insufficient transparency about cost / financing of newly introduced benefits

lack of large multi-employer DB plans.

We agree with both parts of the analysis, namely that DB plans are preferable to DC, and that there is currently a lack of incentives for DB plans. We strongly disagree however with Mr Dodge's opposition to fair value accounting. He claims, essentially, that we are not interested in today's values, but in expected values far into the future. We think that analysts of pensions are very much interested in today's values. For one, every expected future value can be discounted to a current present value (assuming that the term structure holds). Thus, Mr Dodge's distinction would essentially become moot.

More importantly however, it is not at all clear at which specific point "far into the future" the expected value would need to be formed - surely that cannot be discretionary? How about changes to those expected future values, based on variations of underlying assumptions? Finally, the volatility introduced to sponsors' balance sheets is not artificial, it's an economic fact. Cognition of that fact is a prerequisite of sponsors' ability to manage the inherent economic risk of their DB plans and, therefore, an enabler of an effective defined-benefit pension system.

Pensions in Russia

On Tuesday this week, I had the pleasure to give a presentation on occupational pensions to the members of CFA Russia in Moscow. The presentation has been recorded and will be made available on their soon to go live website. Meanwhile, the slides are available here.

Draft Swiss pension law

Swiss pensions association ASIP has published a concise draft of a revised occupational pensions law to assist the ongoing debate about simplifying the overly complex current law. Surprisingly, this draft still does not refer to the prudent person rule in its asset management section. Encouragingly, the draft does away with politically set rates such as the conversion rate or the guaranteed minimum return.

At the same time, ASIP has published the executive summary of a research paper examining the alleged over-capitalisation of the Swiss second pillar with a view to reducing the full coverage requirement. Some of the arguments proffered are truly surprising: foreign investments are used as evidence of an over-abundance of capital. Unsurprisingly, the authors conclude that there is no indication for too much saving and that it is reasonable to maintain the full coverage requirement.

Annuities: a private solution to longevity risk

Its title may appear a bit facetious, but the latest issue of SwissRe's Sigma is anything but. It contains a comprehensive overview of the challenges to capital based retirement provision arising from increasing longevity. The prime focus of the publication is on insurers and insurance products, naturally, but most of its considerations and precepts are directly applicable to non-insurance pensions providers. A very worthwhile read for everyone in the retirement business!

IAS 19 to enter the risk-return continuum?

epn has an fascinating article about a possible approach to new pensions accounting, based on deconstructing any plan's risks into four distinct risk categories, accounting for them separately:

asset value risk

interest rate risk

mortality risk

compensation risk.

This way, it should be possible to move away from the current standard's black or white approach to classifying pension plans as DB if they do not match distinct DC criteria. Much of the article is dedicated to the analysis of Swiss and Belgian plans which by law feature a mix of DB and DC characteristics that force such plans to be accounted for as DB.

Faithful representation of the economic reality of plan liabilities appears to be much better warranted under such a structured approach. Furthermore, corporate sponsors' risk management towards pensions liabilities will be much improved, if not enabled, since the industry has built a lot of experience in structured instruments. Some preparers may be fazed by the approach's additional complexity, but once they realise that it might actually help them to better mitigate risk, they ought to embrace it.