Fair Value Implications for the Asset Mix of a Pension Fund

Résumé du document

Pension funds serve to collect and manage an amount of capital, which is sufficient to make all payments to which participants of the fund are entitled, based on the pension plan they have chosen. The Akzo Nobel Pension Fund (APF) is responsible for the provision of pensions for all employees of Akzo Nobel in the Netherlands. It is the task of the Pensions and Insurance Supervisory Authority (PVK) to provide rules and regulations which guarantee that pension funds are able to fulfill their pension promises. In response to economic and demographic changes in the environment in which pension funds operate, the PVK drafted a new Financial Assessment Framework (FTK) that became effective as of January 1st 2006. Essential in the new FTK is the fact that the pension liability resulting from a defined benefit pension plan has to be calculated using market value interest yields as discount rates, as opposed to the current practice which uses a fixed rate for discounting pension liabilities.

Extraits

[...] More important however, is the fact that conditional indexation significantly lower the probability of under funding. If the current asset mix is regarded as presented by portfolio the probability that the funding ratio is below 1 on the 5 year horizon drops by more than one half as a result of granting indexation conditionally. The same holds for the longer horizon. Figure compares the distribution of the funding ratio in the cases 60 Approaches to a stable funding ratio conditional and unconditional indexation grants on the five year horizon. [...]

[...] Other methods can contribute to stabilize the funding ratio under the new FTK as well. I Management Summary A duration match of the fixed income part of the portfolio to the duration of the liabilities implies that the effect of small interest rate changes will be exactly similar thus reducing funding ratio volatility. This approach has no effect under the current liability valuation method since liabilities are presently not affected by interest rate changes. A cash flow matching strategy in which the APF enters into a swap contract with a counter party that provides a fixed return in exchange for an agreed upon floating return results in an exact cash flow match for the pension fund, hence eliminating the interest rate effect on the volatility of the funding ratio. [...]

[...] The capital entrusted to the pension funds is enormous. In fact, Dutch pension fund assets total to 113% of GDP (see figure Investing such an amount of capital does not only influence the earnings of the pension fund, but also has major impact on society as a whole. collective management of a large capital requires extreme prudent behavior to prevent a tragedy of the commons.” (Bovenberg, 2001). In other words, pension funds have to be supervised closely and accurately to ensure that they practice fair business in the interest of all stakeholders. [...]

[...] After a certain number of years, indexation can no longer be granted at all. Probability density function of simulated funding ratio unconditional indexation conditional indexation Funding Ratio Figure 6.4 .2: Distribution of the funding ratio on a five year horizon compared for conditional and unconditional indexation grants Approaches to a stable funding ratio In section 6.2 two portfolios were constructed based on the requirements of the PVK in the new FTK. A conditional indexation policy also has a positive effect on the performance of the pension fund for these two portfolios, but the conditional indexation policy may also give rise to a different portfolio composition. [...]

[...] Unfortunately, a stable funding ratio is not the only requirement of the stakeholders of the pension fund. Participants do demand compensation for changes in the general price level and therefore the inflation has to be taken into account. On the one year horizon this does not have very significant effects, however if the simulation results for the distribution of the funding ratio after five years are examined (Table 5.3 it is obvious that inflation does cause problems for the pension fund. [...]