Report

Financial Economics and Canadian Pension Valuation

Task Force on Financial Economics

September 2006
Document 206102
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2006 Canadian Institute of Actuaries

Memorandum
To: From: Date: Subject: All Fellows, Affiliates, Associates and Correspondents of the Canadian Institute of Actuaries Robert Stapleford, Chairperson Task Force on Financial Economics September 20, 2006 Financial Economics and Canadian Pension Valuation

The Task Force on Financial Economics presented its final report at the June 28, 2006 meeting of the CIA Board. The report contains papers that address the application of financial economics to life insurance and defined benefit pension plans. The executive summary presents the key issues raised in the two papers that will be made available to CIA members.

Defined Benefit Pension Plans

The task force supports the adoption of financial principles in the valuation of defined benefit pension liabilities. A key factor in the task forces thinking is that employees provide their services with the expectation that they will receive the promised pension benefit. The value of this promise must be recognized with a high degree of certainty and should be determined using yields on high quality fixed income instruments with minimal expectation of credit loss. We believe that this position is consistent with the expectations of members and regulators. This position has the following implications: The valuation of pension liabilities on a wind-up basis needs greater prominence in pension valuation work. The role of the traditional going concern valuation would become a long-term contribution budget to recognize the need for more stable funding calculations than the wind-up basis would generate. Funding of pension plans would target the wind-up position with prescribed amortization periods to achieve full funding on a wind-up basis when deficits result. The basis for calculating pension transfer values that was adopted in February 2005 embodies the market principles of financial economics including the use of long-term yields on high quality fixed income instruments. This standard is under

review. The task force report supports the continued application of these principles to determine transfer values. Adoption of financial principles is made more difficult by the asymmetrical treatment of surplus which results in a position of those who accept financial risk are not necessarily the ones who benefit when such positions produce gains. The CIA should continue its efforts to work with pension stakeholders to develop a more consistent approach to the acceptance of risk and utilization of surplus as well as development of margins like Minimum Continuing Capital Surplus Requirements (MCCSR) for life insurance.

Life Insurance
The paper discusses alternate approaches to calculate reserves based on efficient market financial economics principles. The approaches are not consistent with or allowed within the current Canadian Generally Accepted Accounting Principles (GAAP) accounting framework. In particular, the task force supported the fundamental principle that the valuation of insurance liabilities should be independent of the underlying investments. This position is not consistent with current methods to value life insurance liabilities in Canada. During the course of its deliberations, the task force heard from several actuaries who have taken lead roles in the development of proposed new international accounting standards for life insurance. Many of the issues considered by the task force are being considered globally. Changes to international accounting standards are expected in three to five years. Although Canadian valuation standards will need to change when international standards are adopted, it would be premature to make changes before international standards are introduced. Accordingly, the task force does not propose any changes to the current basis for valuing Canadian insurance liabilities. The task force encourages the CIA to plan for the adoption of international standards that are expected to employ financial economics principles. Adoption of these principles will likely lead to concurrent changes in how MCCSR is determined. I would like to thank the members of the Task Force on Financial Economics, namely: John Duralia, Steven Easson, John Gilfoyle, Vivek Gupta, Larry Miller, William Moore, Robert Stapleford (chairperson) and Phillip Watson. RS

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1.

INTRODUCTION

The Committee on Pension Plan Financial Reporting asked the Task Force on Financial Economics (TFFE) to consider four pension valuation issues in the context of the tenets of financial economics. Specifically, the issues included: 1. Treatment of the equity risk premium, 2. Use of smoothing techniques, 3. Consistency of asset and liability values, and 4. Disclosure of funded status. This report summarizes the views of the TFFE on these four issues. The potential impact of financial economics on pension valuation and investment is broader than suggested by our views on these four issues. However, we have limited this report to only the four issues. 2. PENSION DEAL The interpretation and views of the TFFE as set out in this report follow from the premise that the fundamental rationale for pre-funding a pension plan is security of the pension promise. Defined benefit pensions are a component of compensation earned for current services performed for the employer but deferred and payable in the form of a lifetime pension after retirement. In Canada, the concept of a defined benefit pension plan has evolved to the status where it is now essentially viewed as being contractual in nature. As a minimum, we believe that regulators and the public hold this view. It is likely that our public expects our profession to be instrumental in securing the promise inherent in the pension deal. Hence, we believe that the critical public policy consideration is to ensure that sufficient assets exist to fully pay the benefits due, including those payable in the event of plan termination. We take the view that the role of the actuarial profession is to guide and inform the process. This report observes that actuarial standards may not have evolved to fully recognize the current pension deal or to adapt to the applicable tenets of financial economics. 3. THE EQUITY RISK PREMIUM Conventional actuarial practice as applied to pension valuations requires the actuary to determine a best estimate of the expected future return on the pension plan assets. The actuary then uses that estimate, with or without a Margin for Adverse Deviations (MfAD), to discount the future cash flows from the plan to determine the actuarial liability. Determination of this expected return involves estimating the expected rate of return on the fixed income and equity components of the plan assets. The expected return on the equity component would generally be viewed as the return on a long, risk-free asset plus a provision for the expected equity risk premium. The equity risk premium is the additional reward that an investor demands for assuming the volatility and forfeiture risk of owning an equity asset. In effect, the expected additional return on risky assets is equal in value to the risk assumed. Conventional

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actuarial practice in pension valuations and pension accounting is to anticipate the equity premium but, generally, the risk that is assumed is not valued in full. Financial economists1 note several violations of the tenets of financial economics which follow from the anticipation of the expected future equity risk premium: Transfer of risk to future generations; Underpricing pensions in compensation decisions; Biased investment decisions; Concealing risk by smoothing; and Amortizing the financial impact of gains or losses.

This paper examines some of these violations in the context of Canadian pension actuarial practice. Solvency Valuations2 The equity risk premium does not play a role in determining the solvency liability (i.e., wind-up liability) as currently defined in legislation. However, where a pension plan has a portion of its assets invested in the equity markets,3 the volatility of the market values does impact on the magnitude of the margin, or Provision for Adverse Deviations (PfAD), that would need to be added to the solvency liability to provide any desired level of security. The magnitude of the equity risk premium is also a relevant parameter in the stochastic models that would be used to determine the PfAD. History records the past levels and volatility of the equity risk premium but financial economists remind us that the magnitude of the equity risk premium cannot be known ex ante. Hence, it is not possible to precisely determine the frequency distribution of future solvency positions. It is likely impractical in the current environment4 to advocate adding a PfAD to the solvency liability where a plan is invested in risky assets. However, if security of the accrued benefit is the primary rationale for funding the pension plan, a risk-based PfAD, or contingency reserve, added to the solvency liability which reflects the mismatch between assets and the solvency liability and any operational risks would be necessary.5 We believe that it is primarily the role of the legislators/regulators to determine the degree of certainty to be afforded to the accrued pension promise. If our premise about the pension promise is correct, it is not obvious why an accrued pension promise should
See Reinventing Pension Actuarial Science, Bader and Gold, 2003 Solvency valuation refers to a wind-up valuation where all benefits payable by the plan are recognized and assets are held at liquidation value. 3 The TFFE has not addressed the implications of pension equity investment from the shareholder perspective. Notwithstanding the validity of the Modigliani & Miller irrelevance propositions, we believe that most plan sponsors will continue to invest a significant portion of pension assets in the equity markets for the foreseeable future if for no other reason than there is an inadequate supply of risk free assets. 4 Surplus ownership issues must be resolved and changes made to the Income Tax Act before it would be practical to impose this level of funding on plan sponsors. An appropriate transition period would be necessary to avoid undue impact on the cash flow of some corporations. 5 The TFFE has not considered the correct level of the equity risk premium to be used in determining the PfAD, the degree of certainty to be created by the margin or the applicable period of time over which the PfAD is to provide the desired degree of certainty.
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be any less secure than an annuity contract purchased from a Canadian insurer. The current risk-based solvency demonstration imposed on Canadian life insurers may be a suitable model for pension funding. We support disclosure of the magnitude of the risk that is created by investing pension assets in risky investments as an interim measure. This disclosure should likely be a requirement of the actuarial report and include more than a verbal description of the various risks. Most larger pension plan sponsors routinely commission stochastic asset/liability studies. These studies are easily adapted to produce assessments of the probability of future solvency deficits. The CIA might assist smaller plan sponsors and their actuary by developing risk disclosure data as a function of asset allocation and funded status for typical plans. Going Concern Valuations Financial economists demonstrate that pre-funding future pension liabilities in a tax sheltered fund is clearly to the shareholders advantage.6 Hence, in an environment where employers were not concerned about surplus leakage, many would want to fund in excess of the minimum solvency position. We view this as a budgeting exercise designed to manage the future demand for cash contributions to the pension plan. A going concern valuation would typically be used to guide a long-term funding policy. Given the nature of these budgeted or discretionary contributions, we see no reason why the actuary could not reflect the expected equity risk premium in determining the going concern liability in the same way that the actuary reflects the other expected parameters. However, conventional actuarial practice has evolved to the point where, for many pension plans, the solvency liability exceeds the going concern liability. In the case of many single employer private sector pension plans, this has been caused by the desire to minimize funding requirements in order to reduce the likelihood of creating surplus that might become at risk in the future. In earlier economic eras, the discount rate used in going concern valuations was generally of the same order of magnitude as, or even less than, the prevailing yield on long-term risk-free bonds. As a result, the going concern liability exceeded the solvency liability and a MfAD was implicit in the practice. Today, the discount rate is typically of the order of 200 basis points higher than risk-free yields and the margin between the going concern liability and the solvency liability largely has disappeared for many plans. Actuaries are anticipating a higher portion of the equity risk premium in current valuations. As a result, pension plan members have been exposed to higher risk. Disclosing the funded status in relation to a going concern valuation based on a risk free discount rate would reveal the degree of risk, or anticipation of future equity risk premiums, inherent in conventional going concern valuations. Other Going Concern Valuations The TFFE considered four other circumstances where an actuary may be commissioned to determine an actuarial liability or contributions to fund a pension liability based on going concern valuations, namely:
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At least, in the absence of any surplus leakage and assuming the corporation has taxable income.

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Valuation of public sector pension plans; Costing of benefit improvements, with or without union negotiations; Transfer of pension liabilities between pension plans; and Valuations of multi-employer pension plans.

Reflecting the equity risk premium in the discount rate for pension valuations performed on a going concern basis (where the scheme assets are partially invested in equity markets) results in advance recognition and credit for the expected additional return but does not put a value on the additional risk that is taken by investing in the equity markets. This practice has the following outcomes:

In valuations of public sector pension plans, risk is transferred from the current generation of taxpayers to future generations. Taxpayers and plan members of the current generation receive the certain benefit of lower contributions. Future generations bear the risk that the equity risk premium will not be realized or contribution levels will be volatile. In addition, the financial risk to future stakeholders is increased when previous generations utilize surplus (which will often be transitory) to augment benefits or reduce contributions. The economic value of a benefit improvement, whether or not negotiated, should be determined using a discount rate derived from a risk-minimized portfolio of assets. To do otherwise understates the economic value of the additional future benefit. The recipient of the additional benefit gains from the certainty of the benefit but the grantor of the benefit must bear the financial risk. Assets are commonly transferred between pension plans as a result of corporate mergers or acquisitions. Conventional practice is to transfer assets determined as a function of the going concern actuarial liability typically determined using a discount rate that reflects the expected return on the plan assets. This practice transfers risk from the exporting employer (who is credited with the full expected return) to the importing employer (who must now take the financial risk, but has only received a portion of the risk-free asset value). Multi-employer pension plans are characterized by fixed contributions (unless/until negotiated upwards) and a benefit structure set at a level that can be supported by the contribution level. If the benefit structure is determined as a function of the expected return on the plan assets, the current generation of plan members receives the certainty of a benefit, while a future generation bears the risk that the equity risk premium may not be realized and the future benefit accruals will be lower.

These violations of financial economics principles are understood and accepted by a growing number of clients, financial professionals and thought leaders in the actuarial profession. In these circumstances, we support the disclosure of the actuarial liability

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determined on a risk-free basis,7 irrespective of how asset transfers, contribution levels or benefits structures are actually determined. Pension Plan Surplus The conventional treatment of pension surplus in legislation and court rulings is also a violation of financial economics principles. The rewards to shareholders of equity investments in the pension plan are sometimes effectively expropriated by plan members. Forcing plan sponsors to fund to a minimum of the solvency liability plus a margin (either through legislation or actuarial standards) will be problematic unless surplus treatment is rationalized. Presumably such rationalization would recognize the common sense notion that the risk-taker should be the surplus owner. Perhaps we need to be clearer as to the meaning of surplus. For an active pension plan, surplus exists only if the plan is invested in risk-free assets and the market value of the assets exceeds the liability determined on a consistent basis. Financial economists would argue that surplus is not surplus unless the actuary evaluates both the expected equity risk premium and the risk associated with investment in the risky assets. The conventional practice of opining the existence of surplus based on a going concern valuation of a plan funded with risky assets is recognized as a violation of financial economics principles. The conventional notion of surplus is more in the nature of a budgeting variance. Disclosure of surplus or deficit determined on a risk-free basis would be consistent with our duty to guide and inform. Implications for Pension Cost Accounting The accounting profession has established accounting rules which adopt financial economics principles for the discount rate used to determine pension liabilities. The AA corporate bond yield is an approximation to the risk-free discount rate as modified to reflect the credit risk of the average corporation. The same rules, however, specify that the expected rate of return on the plan assets is to be incorporated into the pension expense for the fiscal year. In essence, the full amount of the expected equity risk premium is recognized in the current fiscal year even though not yet earned. The risk inherent in the equity investment is deferred to future accounting periods. Further, when deviations from the expected return are realized, the impact is further deferred by the smoothing mechanisms. Both of these practices violate the principles of financial economics. We are concerned that the actuarial profession runs the risk of impairing its credibility if it does not support the current move to mark to market accounting and full transparency. As an aside from the immediate purpose of this paper, the current accounting rules stipulate that the pension liability be determined on a going concern basis with immediate recognition of the financial impact of expected future salary increases. This is an issue to be resolved by the accounting profession but financial economists argue that recognition of the additional pension liability for expected future salary increases in the current accounts of a corporation is not consistent with the principles of financial economics. In
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We acknowledge that it is, in general, impossible to determine a risk-free liability because the exact immunizing asset is not available. Risk-minimized is perhaps a more appropriate term.

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support of this view is the observation that no liability is held for expected future cash compensation increases. 4. USE OF SMOOTHING TECHNIQUES Actuaries commonly determine the actuarial value of a pension plans assets as an average of past market values a smoothed value. The result of using these techniques is to defer recognition of a portion of current and past market value fluctuations to future valuation dates. The practice is in support of the well intentioned effort to smooth contribution requirements. However, the practice has the unfortunate consequences of obfuscating the market value of the plan assets8 and giving the impression that the actuary has higher knowledge of the true market value than the capital markets. If smoothing of contribution requirements is a desirable goal, we submit that this should be accomplished by a smoothing mechanism built into the liability determination. Assets should always be reported at market value. 5. CONSISTENCY OF ASSET AND LIABILITY VALUATIONS It has long been a tenet of pension actuarial practice that assets and liabilities should be valued on a consistent basis. Presumably this view evolved from a time when the value of the plan assets was determined as the discounted value of the future capital, interest and dividend payments based on the liability discount rate. Financial economics defines the value of a liability as the market value of the portfolio of assets that replicates the liability obligations. The value of the assets is unambiguously equal to the market value of the assets determined in the capital markets. On the other hand, conventional actuarial practice seeks to achieve consistency by reporting a smoothed asset value and determining the going concern liability using a discount rate that is a function of the expected return on the plan assets. From a financial economics perspective, both these actuarial values are inappropriate and therefore not consistent. 6. DISCLOSURE Transparency and disclosure are essential attributes of efficient capital markets. Corporations now operate in a world of increasing scrutiny and requirements for greater disclosure. We do not believe that pension plan reporting and disclosure can be exempt from these transparency initiatives. Specifically, with respect to disclosure of funded status, we promote the disclosure of the funded status measured as the relationship between the market value of the assets and the going concern liability determined on a risk-free basis. Solvency disclosure should include an assessment of the risk to the plan members of the mismatch between the assets and liabilities and any operational risks. 7. SUMMARY If our premise about the pension promise is correct, then the pension liability is a debt of the corporation and the shareholders. Recent presentations9 from financial analysts and
This is particularly an issue in a declining market where the actuarial value is higher than the actual market value. 9 For example, Society of Actuaries webcast March 16, 2006
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rating agencies confirm their view that the pension liability is a debt of the corporation or at least is debt like. In these circumstances, it is difficult to argue that the tenets of financial economics do not apply to valuation of defined benefit pension plans. It is likely that the dichotomy between financial economics and conventional actuarial practice has arisen in large part because: The pension deal has evolved from a best efforts basis (an environment where financial economics has not much to offer) to a contractual deferred compensation promise (where the pension liability is a debt of the corporation); and The uncertainties created by surplus ownership have led many private sector pension plan sponsors to adopt a minimum funding policy.

Conventional actuarial practice results in the measure of the going concern liability being a function of the asset allocation of the plan. This has produced the perverse result that the magnitude of the going concern liability decreases as the plan takes on more risky assets. Financial economists define a liability as the market value of the replicating assets - the value of the economic liability is independent of the type of assets actually held in the plan. The legislated solvency liability, in most Canadian jurisdictions, has provided somewhat of a safety net. Yet the minimum funding practices combined with high equity allocations have resulted in significant solvency deficiencies in many plans and exposed many employees to the risk of losing part of their accrued pension entitlement. For many public sector and multi-employer plans, the issue is not solvency but, rather, the allocation of cost and risk to current and future generations of employees and employers or taxpayers. Yet many of these types of plans are valued using essentially the same economic assumptions as currently in use for single employer private sector pension plans. As a result, actuarial valuations permitted by our current standards will result in large intergeneration risk transfers. Actuaries are the profession that aspires to See Beyond Risk. We can now take the opportunity to focus more of our activity on analyzing and disclosing the risks of investing pension assets in risky investments to the major stakeholders. Analysis of financial risks is one major intersection of financial economics and actuarial disciplines. Actuaries, in general, have the skills and training to evaluate the risks inherent in our conventional actuarial pension practice. Future opportunities exist to use our skills to find ways to mitigate some of the financial risks. In the short term, our profession must exhort our regulators to eliminate the asymmetric treatment of surplus ownership in pension plans where the shareholder clearly assumes the financing risk. Fully analyzing and disclosing the risks to employees and shareholders inherent in the current funding standards is one step in expediting the process.

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