planning your way out of the financial crisis
TRANSCRIPT
Planning your way out of the financial crisisA roadmap to derisking
Jeroen J.J. Bogers
2
Table of contents
1 Introduction 3
2 The‘deriskingdilemma’–whythetimeisneverquiteright 4
3 Therisingcostofrisk 6
4 Theimpactofthecreditcrunchonsponsoringcorporations 7
5 Theroadmaptoderisking 1 1
Conclusion 16
Acknowledgements 17
Appendix1 Pensionfundingratioassumptions 18
Appendix2 Referencesandnotes 19
1 Introduction
Planning your pensions out of the crisisFewpeople could have foreseen the severity and impact of the presentfinancial crisis. Back
in2007,theheadlineswerefullofcompanypensionplansmoving intotheblackorreporting
healthyreserves.Oneandahalfyearslater,thesesamecompanypensionplansareinthenews
3
again–thistimewithdirewarningsofunderfundingandthefreezingofindexation.Pensionfund
trusteesandregulatorsarepressingsponsoringcorporationstoincreasepensioncontributions
ortomakelargecashinjections,andallthetimetherisingpensionfunddeficitsareweighing
downcorporatebalancesheets.
Somepensionfundmanagerswillhaveseenthestormcomingandreducedtheirrisks,butmany
didn’t. The reasons for this are various, but the consequenceshavebeenpainful.Whydidn’t
morecorporationsandtheirpensionfundstaketheopportunitytoderisk–andwhatcanthey
donow?
This time, things are differentThiswhitepaperlooksatwhypensionfundshavebecomesuchanimportantissueforCFOsand
whycompanies–andpensionfundtrustees–shouldbeplanningtoderisktheirpensions.We
showwhytheeffectofthecurrentcrisisonpensionsinternationallydiffersfrompreviouscrises.
Usingastandardisedmulti-countrypensionmodel,wewillexplainhowthechangedcorporate
reporting regulations, combinedwithdifferentnational and international regulations,make it
increasinglydifficultfortheCFOsofinternationallyoperatingcompaniestoforecastandmanage
theimpactoftheirpensionfundsonthecorporatebalancesheet.
Regaining control of the corporate balance sheetPayingparticularattentiontotheUK,theUSAandtheNetherlands(someofthelargest,most
maturesecondpillarpensionmarkets),thispaperexplorestheeffectofthefinancialcrisison
thepensionfundsofmultinationalcorporations,andthesubsequentimpactonthesponsoring
corporations.Inconclusion,werevealhowderiskingcanhelpcorporationstoregaincontrolof
theirbalancesheetsandtheirpensionfunds,offersomeusefulguidelinesonhowtodrawup
aneffectiveroadmaptoderisking(makingderiskingmoreaffordableintheprocess)andshow
whichactionscan–andshould–betakennow.
4
2 The ‘derisking dilemma’ – why the time is never quite right
Pensionshavenotusuallymadeforexcitingreadingmaterial.Recently,however,pensionfunds
havebeenhittingthenewsmorethanever.FormostCFOsconcerned,thishasnotbeenawelcome
development.
2008 headlines• USA–RetirementBlues:Financialcrisispullsbillionsfrompensionplans,crimpingconsumers’
dreamsandcorporateprofits.1
• NETHERLANDS–ThesolvencycrisisamongDutchfundsisthemostsevereintheindustry’s
history.2
• UK–UKfundsdrop11%inOctober.3
Itishardtobelievehowdifferentthingswerein2007–withtalkofincreasingassetsandshrinking
deficits.
2007 headlines• USA–ImprovementinU.S.chemicalsector’spensionfundingshortfallbodeswellforcredit
quality.4
• NL–Shellgivesitselfpensioncontributionholiday.5
• UK–Pensiondeficitsshrinkbymorethan90%inayear.6
• GLOBAL–EquitystrengthseesdeficitscuttoGBP21bn.7
Whilesomepensionfundmanagerssawthegatheringstorm,plannedahead,andhedged8their
risks,manyothersdidn’t.Itiseasynowtospeakwiththebenefitofhindsightbutabriefhistorical
surveyshowsthatmanypensionfundscouldhavederiskedmorefully.Sowhydidn’tmorepension
fundsandtheirsponsoringcompaniestakeadvantageoftheopportunitywhileitwasthere?
Pension investment management – balancing short term volatility against long term returnsPensionfundingratiosimproveddramaticallyin2007,sowhydidn’tpensionfundshedgetheir
riskswhentheywereabletodoso?Inadditiontothefactthatnotallpensionfundshadsuccess-
fully increased their funding ratios by the time the financial crisis hit, there is an important
additionalreasonwhypensionfundswereunwillingtohedgetheirrisks–thederiskingdilemma.
Thismeansthatwhenderiskingwasaffordable,itwasnotgenerallyperceivedasbeingdesirable.
Inthecurrentclimate,however,deriskingisseenasdesirablebutisalsolessaffordable.Figure1
illustratesthisissue.Thegraphshowsthefundingratioofamodelpensionfundoverthelastten
years,asaffectedbyequitymarketsandinterestratesovertime.9
5
Ifthefundingratioofapensionfundishigh,deriskingbecomesmoreaffordable.Atsuchatime,
however,itisveryhardtopersuadeallthestakeholderstoderisk,asequitymarketsarerising,
interest rates are low and derisking seems expensive and unnecessary.Once equitymarkets
starttofall,thedesiretohedgeriskrapidlyincreases,buttheabilitytofundderiskingmeasures
decreases.10
Thisdilemmahighlightsanissueofjudgementandincentives–howshouldsponsoringcompanies
andtheirpensionfundsapproachrisk?Andhowshouldtheyweighupshort-termgainsagainst
bothshort-termandlong-termrisks?Whatlevelofriskshouldsponsoringcompaniesandtheir
pensionfundsbewillingtotakewiththeirpensionschemes,andonwhatprinciplescanthese
decisionsbebased?
Governance and commitment are essentialCommitmentisessentialwhenhedgingrisks:ifthemomentisrightbutdecision-makerscannot
reachagreement,thewindowofopportunitywillpass.Navigatingbetweenthedifferentinterests
ofthesponsoringcompany,thepensionfundtrusteesandthepensionfundmembersmakesit
evenmoredifficulttohedgerisksattherighttime.Inaddition,itisnotalwayseasytodecide–or
toexplain–whichrisksareacceptableinordertogeneratereturns,andwhichrisksarenolonger
acceptable.
For multinational companies, getting commitment is even more difficult, since pension fund
governanceisarrangeddifferentlyindifferentcountries,thusintroducingextracomplexityinto
thedecisionmakingprocess.Itisthereforeunderstandablethatmanysponsoringcorporations
havenotderiskedtheirpensionfunds,eveniftheyhadplans(orintentions)todoso.
1998 1999 2000 2001 2002 2003 2004 2008200720062005
Figure 1. The derisking dilemma
Source: AEGON Global Pensions
Affordable Affordable
Desirable Desirable
Fun
din
g r
atio
Funding ratio 100%
6
Thispaperisintendedtohelpsponsoringcompaniestoalignallstakeholdersinordertobeable
toderisktheirpensionfundattherightmoment,andalsotomakederiskingmoreaffordable.
It offers guidelines for determining the appropriate moment and appropriate level to derisk
theirpensions,andprovidesclear argumentsforwhyderisking isessential insomecasesbut
unnecessaryinothers.
3 The rising cost of risk
Priortothefinancialcrisis,creditmarketswereliquid,riskwasinexpensiveandroutinerefinancing
arrangementswerecommon.Thismeantthatlargepositionscouldbedisposedofquickly.Investor
focusshiftedtoshort-termrisk,anddebtwasseenasaresidualofbalancebooks.Companies
thathoardedcashwereseenasinefficientandviewedwithsuspicion.
Afterthestartofthefinancialcrisis,thefreezingofinter-bankliquidityforcedthebanks,quickly
followedbythemorehighlyleveragedcompanies,toscrambleforcash.Indoingso,theyhadto
getridoftheirdebtholdingsinilliquidmarkets,increasingtheriskofdefaultandloweringshare
pricesintheprocess.
In retrospect, corporate debt was traded at unrealistically low spread levels, while lending
standards declined and excess leverage built up across the system. Essentially, Greenspan’s
conundrumturnednasty.11
The bursting of another bubble: the risk premium of corporate bonds Theeffectofthenewlyacquiredriskawarenessshowsitselfintheexplodingriskspreadsabove
therisk-freerate,asshowninFigure2.12Asthemarketpriceofthedefaultriskofoncehighly
ratedcompaniesincreasedsharplyovernight,corporateborrowingbecamemoreexpensive.At
thesametime,duetoaflighttoqualityandthereductionofshort-termcentralbankinterest
rates,theyieldoflong-termgovernmentbondsisnowdecreasing.
Asthespreadbetweencorporatebondsandgovernmentbondshas increased, ithasbecome
harder andmore expensive for companies to borrowmoney, and revenues have been hit by
higherinterestpayments.Onecanarguethattheincreaseofthisspreadandthedecreaseof
companyequityvaluesgohand-in-hand,asshowninFigure3.13
Theeffectsofthecurrentmarketturmoilareclear:investorsaredemandingahigherriskpremium
fortheirinvestmentsandfordebtfromcorporations,whiletheinterestrateofgovernmentbonds
isdecreasing.Thesuddenchangesinthreecoreelements–equityreturns,corporatebondyields
andgovernmentbondyields–hashadadramaticeffectonpensionfundsandtheirsponsoring
companiesonaglobalscale.
7
4 The impact of the credit crunch on sponsoring corporations
2008 headlines:• US–Companieswillneedto injectmorethanUSD100bn intotheirpensionfundstocover
marketlosses,puttingtheminacashsqueezeatatimewhenitisdifficulttoraisemoney.14
• GERMANY–SiemensAG,Europe’slargestengineeringcompany,mighthavetomakeacash
injectionintoitsEUR2.5bnunderfundedpensionschemeifstockmarketsfallfurther,analysts
said.15
• BELGIUM–Belgianpensionfundsachieveanegativereturnof–15.5%overfirstninemonthsof
2008,forcingcorporatesponsorstoinjectcashintotheirplans,accordingtoconsultantMercer.16
8.0%
7.5%
7.0%
6.5%
6.0%
5.5%
5.0%
4.5%
4.0%
3.5%
3.0%
1998 1999 2000 2001 2002 2003 2004 2008200720062005
Risk-free rate AA corporate yield curve
Figure 2. Exploding risk spreads
Source: MLX®
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
4500
4000
3500
3000
2500
2000
1500
1000
500
0
AA corporate yield spread MSCI World
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 3. Falling equity markets
Source: Datastream
8
• NETHERLANDS–Listedcompanieswithdefinedbenefitpensionarrangementsmayhaveto
forkoutmillionsofeurostomakeupforthepresentshortfalloftheircompanyschemes.17
• GLOBAL–AustralianairlineQantastodayidentifiedproblemsconnectedtoBritishAirways’
pensionfundasoneofthe‘significantmatters’thatstillneedtoberesolvedbeforeamerger
withBritishAirwayscanbeachieved.IPEunderstandsconcernaboutpensionfundliabilities
hasalsodelayedprogressonBritishAirways’proposedtieupwithSpain’sIberiacarrier.18
This time, it’s differentFollowingthestockmarketcrashof2001,corporateCFOsdidnotyethavetodisclosetoanalysts
whatwashappeningwiththeirpensionfunds.BothFASandIFRSaccountingrulesdidnotrequire
reportingthefundedstatusofapensionfundonthebalancesheet.Pensionfundswerelittlemore
thanafootnoteintheannualreport.Evenifanalystscheckedthisfootnote,thefundedstatus
ofapensionfundwasburiedunderassumptionsthatcouldincreasereportedassetreturnsand
decreaseliabilitiesmoreorlessatwill.19
Inaddition,creditrateswererelativelyhighandstableatthetimeofthestockmarketcrash,
effectively keeping liabilities low,and funding ratiosmoreor less intact.The relatively stable
spreadsbetweengovernmentandcorporatecreditsmeantthatthereportingandforecastingof
pensionfundingratiosovermultiplecountriesdidnotintroducemanyambiguitiesfortheCFOof
asponsoringcompany.
Those days are over. Not only are local regulators demanding more stringent measures to
decreasepensionfundrisk,butinternationalaccountingruleshavealsochangedsothatpension
fundingvolatilityismuchmorevisiblebothonthebalancesheetandinacompany’sprofitand
lossstatement.In2009,pensionsareamajorconcernforCFOs,sincethefundingshortfallof
pensionsispostedonthebalancesheetasdebt.20Eventhoughmanycompanieshavetriedto
reduce theirexposure topension fundsbyclosingDefinedBenefitschemes,pension legacies
(benefitrightsthathavebeenbuiltupinthepast)usuallystillrepresentalargepartofthebalance
sheetofapensionfund.Sponsoringcompaniesarethereforestillcontinuouslyconfrontedwith
thevolatilityoftheirunhedgedrisks.
Ontopofotherissues,CFOsarenowfacinganadditionalproblem:whiletheircompany’sstock
valueandrevenueshavebeenhitbyadramaticdownturn intheeconomiccycle,thepension
fundtheysponsorhasalsobeenhitbythecrisisanditsfundingratiohasdropped.Asaresult,
many pension fund trustees are now demanding higher contributions from their sponsor, or
evenworse,immediatecashinjections.Therefore,whilethefundingshortfallitselfis(only)an
accountingissue,theneedforadditionalfundingcreatesextracashflowdemandatatimewhen
cashisalreadyscarce.
9
In a global world, pension fund regulation is still localTherequestsfrompensionfundtrusteesmightcomeasanunwelcomesurprisetosomeCFOs.
Thereasonforthisisthatthesponsoringcompanymaywellvalueitsliabilitiesdifferentlyfrom
itslocalpensionfunds.Thisrangeofwaystoaccountforpensionliabilitiescombinedwiththe
unprecedentedcorporatebondspreadimpairstheCFO’sviewoftheactualpensionfundingratio.
UnderFASandIFRS,sponsoringcorporationsdiscounttheirliabilitiesagainstahighqualityrate
orAAratebondcurve.SincetheAAbondcurvehasincreasedtremendously,asshowninChapter
3,thishasledtoadecreaseinpensionfundliabilities.Fundingratioshavethereforebeenmainly
resilientorevenincreased,despitethedownturninthestockmarkets.Figure4showsthiseffect
on the funding ratioofourpension fundmodel fromChapter2 ,now fullydiscountedat the
increaseddiscountrateofAAbonds.Thisfundingscenarioprovidesanexampleofhowcorporate
entitiesviewthefundingratioofpensionfunds.
1998 1999 2000 2001 2002 2003 2004 2008200720062005
Funding ratio 100%
Figure 4. Funding Ratio under FAS/IFRS
Source: AEGON Global Pensions
Fun
din
g r
atio
However,unlikeaccountingrulesforcorporations,pensionschemefundingregulationsarestilla
nationalmatter.Thismakesitdifficulttocreateauniformaccountoftheeffectsofthefinancial
crisis on the combined pension funds of amultinational corporation. In Figure5 the funding
ratiosofthreesimilarnationalmodelpensionfunds(US,UK,NL),havebeenplotted.Thefunding
ratiosofthesepensionfundsarevaluedusingthereportingrequirementsofthenationalpension
regulators.Dependingontheirregulator,thesepensionfundsmighteitherreportthattheyare
underfunded(NL),almostfunded(UK),orfullyfunded(US).21Thisdifferencebetweennational
pension fund reporting and corporate accounting creates misalignment between perceived
fundingatcorporatelevelandtheactualcallforfundingatanationallevel.
Theunprecedentedeventsonthecreditmarketsandthesubsequentconsequencesonpricing
have effectively distorted the valuations of pension liabilities, highlighting the misalignment,
especiallyformultinationalcompanies.
10
1998 1999 2000 2001 2002 2003 2004 2008200720062005
\
Figure 5. Funding ratio according to US, UK and Dutch local pension regulator
Source: AEGON Global Pensions
100%USA Pension Fund UK Pension Fund NL Pension Fund
Fun
din
g r
atio
Things will get worse before they get betterUnfortunately,themismatchbetweencorporatebalancesheetsandlocalpensionfundreporting
is not theendof the story. It is useful tounderstandwhatwill happenwhenmarkets return
to ‘normal’ again.Using themodel pension fund,we canmakea simulationof the impactof
such ‘normalisation’on IFRS/FASfundingratios,reportedonthebalancesheetof sponsoring
corporations.
Givenaspreadtighteningtotenyearaveragesoverthenexttwoyears,asshowninFigure6,
andanaverageincreaseoftheMSCIWorldof10%annually,theIFRS/FASfundingstatusofthe
pensionfundwouldstilldramaticallydecreasefromapproximately130%to90%intwoyears,as
showninFigure7.
Becausesponsoringcorporationsdiscounttheirpension liabilitiesagainstahighqualitybond
rate curve, thedecreasingAAbond ratehasadramaticeffecton thepension liabilities they
8.0%
7.5%
7.0%
6.5%
6.0%
5.5%
5.0%
4.5%
4.0%
3.5%
3.0%
2000 2001 2002 2003 2004 2005 2006 2010200920082007
Risk-free rate scenario AA corporate yield curve scenario
Figure 6. Interest rate scenarios
Source: AEGON Global Pensions
11
report.Duetoamismatchintheliabilityduration,whichworksasalever,thisdecreasemore
thanoffsetstheincreaseinstockmarketsandgovernmentbonds.
Given these differences between pension funding calculations and the increased influence
of international accounting standards, sponsoring a pension fund has made balance sheet
forecastingandcontrolmoredifficultthanever.
5 The roadmap to derisking
Thefinancialcrisisandthesubsequentdeteriorationofpensionfundinglevelshaveincreasedthe
importanceofacorequestion:‘Whichrisksshouldapensionfundtake?’Inordertoanswerthis
question,pensionfundstakeholdersshouldfirstbeawareoftwothings:
1. Knowyourlimits
2.Itisnevertoolatetoderisk
Know your limitsNotallriskisbadrisk.Inthelongerterm,equityhasmoreupwardpotentialthanrisk-freebonds,
anddiversificationcanlowerriskwhileretainingreturn.Ifasponsoringcompanyiswillingand
able tobear the riskof a suddendecrease in theplan funding ratio, then the long term risk
premiumonriskyassetscanstructurallydecreasepensioncontributions.However,ifacompany
isnotwillingorabletobearthisshortfallrisk, it isbetteroffto increaseyearlycontributions
and lowerpension fundrisk, improvingpensioncost forecastingandbalancesheetcontrol in
theprocess.Forthesponsoringcompany,alarge,unhedgedpensionfundrepresentsabalance
sheetliabilityandapotentialcashflowriskthatisverydifficulttomanage.Inordertoregain
somebalancesheetcontrol,itisimportanttolimitthemaximumpossibleshortfallandtoremove
2000 2001 2002 2003 2004 2005 2006 2010200920082007
Figure 7. IFRS/FAS funding ratio scenario
Source: AEGON Global Pensions
Funding ratio 100%
Fun
din
g r
atio
12
unrewardedrisksfromthepensionfund,whileretainingitsabilitytoprovidepensionbenefits,
onceemployeesareretired.
It’s never too late to deriskAlthoughmostpensionfundsmaynotbeabletoaffordderiskingatthistime,itisnevertheless
theperfectmomenttodrawupplansandtoreachagreementonhowandwhentoderisk.Inother
words,nowthatpensionfundsandtheirsponsoringcompanieshavethedesiretoderisk,they
shouldmakeplanstodosoforwhenitbecomesaffordable.Inordernottobecometrappedby
theaffordable/desirabledilemma,itisessentialtoseparatedecisionmakingfromtheexecution
ofthedecisions.
Insteadofhavingtogothroughthedecisionmakingprocesswithadiversegroupofstakeholders
everytimeanopportunitypresentsitselforacrisishits,themostimportantdecisionsshouldbe
madenow.Executioncanthenbemadedependentonpredeterminedfactorsthatallowforlong
termplanningandcontinuouscommitment.Thefollowingguidelinesaredesignedtosupportthe
sponsoringcompanyinimplementingsuchaforward-lookingdecisionmakingprocess.
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Figure 8. Separate decision and execution
Source: AEGON Global Pensions
Decide
Execute
Fun
din
g r
atio
Guideline 1: Perfect timing is impossible. Plan for good timing insteadInmost circumstances, derisking instruments will costmoney, and impact the funding ratio.
However,historytellsusthatpricehasnotalwaysbeenthemostimportantfactorwithderisking,
butratherthecommitmenttoderiskattherightmoment.Ifalldecision-makersarefullyinformed
andinagreement,whenawindowofopportunityopens,theappropriateactionscanbetaken
immediately,beforethewindowcloses.Onewaytoachievethis istoplanaroadmaptowards
thedesiredrisklevel.Thisroadmapmightconsistofdifferentelementsforeachcountry,since
deriskingoptions,pricesandthedeterminationoffundinglevelsdifferpercountry(asshownin
13
Chapter4).Pensionfundsare,inessence,long-termvehicles,andhistoryalsotellsusthatthere
willbetimeswhenapensionfundwillonceagainhavesufficientfundingtoderisktothedesired
level.
Itisalsoimportantnottofocuscompletelyonperfecttiming.Therearesomanydifferentfactors
involvedthatperfecttimingisimpossibletoachieve.Instead,companiesshouldaimtoestablish
whichcostisaffordableandreasonable,andplantoderiskatthepointatwhichderiskingisboth
reasonableandaffordable.
Guideline 2: Agree on the targeted risk level nowBoththesponsoringcorporationandthepensiontrusteesshouldbecomfortablewiththerisk
level that isretained. It is therefore important toagreeonwhichrisksshouldbehedged, the
maximumallowedshortfall and itseffectonboth thepension fundand thekeyperformance
indicatorsofthesponsoringcorporation.
Itshouldbenotedthathedgingrisksatpensionfundleveldoesnotalwaysmeanthatthisriskis
alsohedgedatacorporatelevel,sincereportingrequirementsmightdiffer,asshowninChapter
4.ThemoststraightforwardexampleofthisisthefactthatevenifaDutchpensionfundhasfully
hedgeditsinterestrateriskagainsttherisk-freerate,itstillrepresentsaninterestrateriskon
thecorporatebalancesheet,as,intheNetherlands,pensionliabilitiesarediscountedagainstthe
AAbondcurve.Volatilityinspreadsbetweenthetwowillthereforealsoneedtobehedgedata
corporatebalancesheetlevelinordertoremoveallinterestraterisks.
Guideline 3: Derisk segments Especiallynow,notallpensionfundsandtheirsponsoringcorporationscanaffordtoderiskin
asingle transaction.However, itmaybebothpossibleandmore efficient toderisk instages,
segmenting liabilities according to affordability over time while retaining solidarity between
pensionschememembers.Inthisway,deriskingiscarriedoutinmanageable–andaffordable–
phases,accordingtoaderiskingroadmap.
Risksinapensionfundcanbesplitupintoseveralmajorelements:
• Marketrisk
• Interestrisk
• Inflationrisk
• Longevityrisk.
Thepriceofhedgingriskschangesovertimeanddifferspermembergroup(activemembers,
deferredmembers,pensioners),or,onamoredetailedscale,peragegroup(orcohort).Bysplitting
thescheme’sliabilitiesintoindividualcohorts,and,foreachcohort,reviewingwhichelementsto
derisk,riskcanbeidentifiedandprioritisedforremoval,whereitismostneeded.Aseachlayer
14
ofbenefitissecured,investmentgainscanbe‘lockedin’andfuturefundingvolatilityreduced.
Figure9showsanon-exhaustiveexampleofapossiblederiskingscenario.Differentriskscanbe
hedgedatdifferentstagesfromthoseshowninthisexample,dependinguponcircumstancesand
thecharacteristicsofthepensionfund.
Guideline 4: Set ambition levelsIn order to strengthen the commitment to the derisking roadmap, derisking levels should be
agreedonbeforehand.Byusingpresetambitionlevels,thedecisionmakingprocessiscleartoall
partiesbeforehandandensuresthatderiskingcanoccurquicklyonceawindowofopportunity
arises.
Figure 10 shows an example of how ambition levels can be used to bring this into practice.
Overthelasttenyears,theaverageinterestratehashoveredaround4.75%.Thepensionfund
stakeholderscandecidetosettheinterestrateambitionlevelatthataverage:oncetheinterest
Fun
din
g r
atio
Hedgemarket risk
Hedgedeferred risk
Hedgeinterest rate
risk
Hedgepensioners
risk
Increasecontribution
Hedgeinflation risk
Decide Execute and communicate
Lowercontribution
Figure 9. Segmenting risks; an example
Source: AEGON Global Pensions
7,0%
6.5%
6.0%
5.5%
5.0%
4.5%
4.0%
3.5%
3.0%
1998 1999 2000 2001 2002 2003 2004 2008200720062005
EU Risk-free rate Average interest rate
Figure 10. An example of using ambition levels
Source: AEGON Global Pensions
Hedge interest rate risk
Do not hedge
Average interest rate
15
ratemeanrevertsandisabove4.75%thetrusteescanstarttohedgetheinterestrisktothe
desiredrisklevel.Thesameapproachcanbeusedtodeterminethelevelofinflationriskorthe
levelofmarketriskbysettinganambitionlevelat–forinstance–thecostofaninflationhedge
andthepriceofputoptionsonequitymarkets.
Guideline 5: Select providers earlyFrom the start, a consultant can expedite the decision making process, functioning as a
knowledgeablemediatorbetweenthesponsoringcorporationandthepensionfund.Inaddition
toconsultants,providers likebanks, insurancecompaniesandassetmanagersshouldalsobe
includedearlyintheprocess.Providerscangiveyouanoverviewofallopportunities,andhelp
youdeterminethebestpricingofthehedgeatanygiventime.Someriskhedges,likelongevity,
areparticularlydifficulttoprice,andagoodconsultantorproviderwillbeabletogiveyouaprice
indicationonafrequentbasis.
Itisalsoimportanttoinvolvealegaladvisorfromthestart.Differentderiskingsolutionsmight
havedifferentlegalimpacts,whichshouldbefullyunderstoodbeforeanydecisionsaremade.
Alegaladvisorcanhelpyouunderstandthepossiblelimitationsandtimelinesthataderisking
constructionmightinvolve.
Guideline 6: Communication is keyOncetheroadmapisdeterminedandthereisagreementbetweenallstakeholders,thisshouldbe
communicatedtoallpensionschememembers.Thiscommunicationisanongoingeffortuntilthe
aspiredrisklevelhasbeenreached.Itisessentialtoensurethat,oncederiskingisaffordable,all
stakeholdersarestillawareofwhyitwasdesirableinthefirstplace.Continuouscommunication
ensurescommitmenttothiscommongoal.
The world changes, change with itWhile these guidelineswill help in building a roadmap towards derisking, they should not be
implementedrigidly.Theworldwillchangeinwayswewillnotbeabletoforesee.Thismeans
thattheroadmapwillhavetobereviewedonafrequentbasisinordertokeeppacewithchange.
Thiscanbedonewithoutimpairingtheeffectivenessofthisroadmapaslongastheprincipleson
whichitisbasedaresolidandarebeingfollowed.
16
Conclusion
Theguidelines inChapter5donotofferan instantcuretothe instabilitiesoftoday’smarket,
andthefuturewillprobablynotworkoutassmoothastheexampleimplementationinFigure9.
However,theguidelinesdogiveinsightintostructuringamorerisk/returnefficientpensionfund
designandthewaytoattainit.Goodgovernanceisanessentialelementformakingthiswork.
Knowingthemaximumriskasponsoringcompanyiswillingandabletobearisfundamental.The
segmentationofrisksandtheuseofthelong-termcharacteristicsofapensionfundcanhelpto
makestrategicdecisionsthatbenefitallstakeholders.
So,whatcanyoudonowalready?
Insequentialorder,thesearethefirststepstotake:
• Talktoyourconsultantandpreferredsuppliers
• Makeanoverviewofyourmostimportantlocalpensionfundsanditsstakeholders
• Inviteallimportantdecisionmakerstothetable
• Decideonthecorporatebudgetandredesignpensionbenefitswithinthatbudget
• Agreeonanaspiredderiskinglevelandambitionlevels
• Setatimeframeforderiskingtheschemes,withcleardecisionpoints
• Implementacommunicationsprogrammetosupporttheemployerandemployees.
And,overtime:
• Deriskaccordingtopre-establishedambitionlevels
• Manageinvestmentandlongevityrisksofretainedrisks
• Managethepensionsbudgetinordertoreduceexpensesandmaximisefunding.
As markets recover, balance sheet control can be restored Marketswillriseagainandtheywillalsoexperiencefurtherhighsand lows. Thependulumof
affordabilityanddesirabilityhasswungtowardsdesirability–butthependulummayfinallyhave
stopped.Thistime,thepensionfundenvironmenthaschangedinsuchawaythatitsupsand
downsarevisibletoeverybody.Byusingknowledgeavailablenow,itispossibleforcompaniesto
usetheswingtowardsaffordabilitytotheiradvantage,andtoregaincontrolovertheircorporate
balancesheet.
17
Acknowledgements
Iwouldliketothankthefollowingpeopleforcontributingandsharingtheirmuchvaluedinsight.
JeroenJ.J.Bogers
Name Organisation Office Location
F.Randall AEGONGlobalPensions UnitedKingdom
F.vanderHorst AEGONGlobalPensions TheNetherlands
G.A.Moerman AEGONAssetManagement TheNetherlands
H.E.Waszink WaszinkActuarialAdvisoryLtd. TheNetherlands
I.vanderVeen AEGONCorporate&InstitutionalClients TheNetherlands
J.Rico TransamericaRetirementServices UnitedStates
M.Haddad TransamericaRetirementServices UnitedStates
M.Leeijen AEGONAssetManagement TheNetherlands
M.Tans AEGONGlobalPensions TheNetherlands
P.Westland AEGONAssetManagement TheNetherlands
R.Baird AEGONActuarialServices UnitedKingdom
R.Pater TKPInvestments TheNetherlands
T.Read AEGONTrusteeSolutions UnitedKingdom
W.vanEttinger IPENCOBVInternationalPensionConsulting TheNetherlands
Y.Vermaes AEGONAssetManagement TheNetherlands
18
Appendix 1 Pension funding ratio assumptions
Pension model assumptions
Initial liabilities
Initial assets
Asset allocation
World equity
Fixed income
Duration fixed income assets
Duration liabilities
Duration portfolio
Indexation
100
110
70%
30%
8
12
2.4
NL UK US IFRS/FAS
1.50% 2.50% 0% 1.50%
Fixed income indicesCredits 10 year: Euro aggregate corporate AA spread 10 yearRisk free 5 year: Euro government Spot-conv 5 yearRisk free 15 year: Euro government Spot-conv 15 year
Equity index MSCI world € total return index
19
Appendix 2 References and notes
1 MoneyMorning,29January2009.
2 GlobalPensions,7January2009.
3 WealthBulletin,28November2008.
4 SandPcreditresearch,6August2007.
5 DeTelegraaf,2October2007.
6 PersonalFinanceEditor,3December2007.
7 EPN,13August2007.
8 Inthispaper,“hedging”referstotheexplicitremovalofrisksbyusingmarket
orinsuranceinstruments.
9 Thepensionfundingratioassumptionsofthemodelpensionfundcanbefound
inAppendix1.
10 Inmoretechnicalterms,duringgood(lowvolatility)times,existingriskmodels
underestimate tail risk and imply that underfunding is extremely unlikely.
Unsurprisingly, this underestimation of risk increases the risk appetite of
pensionfundinvestors.However,asthemodelsarenotabletotakeaccountof
unknownrisksandasthecorrelationbetweendifferentassetclassesindown
marketsismuchhigherthanisassumedinthemodels,ithasbecomeclearthat
diversificationaloneisnotasufficienttoolformanagingrisk.Someriskshave
tobemitigatedevenatthecostofforgoinganamountof(uncertain)returns.
11 ‘Forthemoment,thebroadlyunanticipatedbehaviourofworldbondmarkets
remainsaconundrum,bondpricemovementsmaybeashort-termaberration,
butitwillbesometimebeforeweareabletobetterjudgetheforcesunderlying
recentexperience.’AlanGreenspan,beforeCongress,16February2005.
12 Euro aggregate corporate AA spread 10 year, Euro government Spot-conv
15year.
13 MSCIworld€totalreturnindex.
14 FT.com,29October2008.
15 IPE.com,13November2008.
16 Mercer,14November2008.
17 SNSSecurities,9December2008.
18 IPE.com,8December2008.
19 ‘TheGerstnerEffect:ManagerialMotivationsandEarningsManipulation’,Daniel
Bergstresser,MihirA.Desai,JoshuaRauh,December2003.
20 CFOEurope,‘TopTenConcernsofCFOs’,February2009.
21 Themodelusedisintendedtoshowtheeffectofdifferentaccountingregulations
anddoesnotnecessarilyreflecttheactualfundingratiosofrealpensionfunds
intheUK,USAorTheNetherlands.
DisclaimerThiswhitepapercontainsgeneralinformationonlyanddoesnotconstituteasolicitationoroffer.
Norightscanbederivedfromthiswhitepaper.AEGONGlobalPensions,itspartnersandanyof
theiraffiliatesoremployeesdonotguarantee,warrantorrepresenttheaccuracyorcompleteness
oftheinformationcontainedinthiswhitepaper.
AEGON,March2009
Contact details
AEGONGlobalPensions
LochsideCrescent
Edinburgh
EH129SE
UnitedKingdom
Telephone:+44(0)1315495375
E-mail:[email protected]
Website:www.aegonglobalpensions.com