A Safari of DC SystemsDanger: wild guarantees

Mike Orszag

May 2003

Safari Orientation

• DB not riskless for individuals.

• Some forms of DB indeed may be riskier for individuals than traditional DC plans (change of job, job tenure)

• DB not secure unless backed by government guarantees

DB Guarantees in the UK

• Pensioners paid first • Others paid next

Example: pension scheme 75% funded, 50% of liabilities pensioner liabilities

Pensioners are paid in full, others get 50% of benefits

Level of Exposure to Risk

• FTSE100 returns for 2001• Pension liabilities / market cap:

– average = 40% in 2001– 8 companies over 100%

01

23

4D

ensi

ty

0 .2 .4 .6 .8pension_liability__market_cap

Deficits

01

23

4D

ensi

ty

-.6 -.4 -.2 -5.55e-17 .2 .4pension_surplus__deficit___pensi

2001 FTSE100: £11bn

By end of 2002 much, much worse (£170bn in equities in 2001)

Exposure

• Pension liabilities relative to market cap is one measure – Elasticity is -0.26 – statistically insignificant

from 0

• Pension deficits relative to pension liability is another– Elasticity is -0.13 – again statistically

insignificant

Pension Surplus/Pension Liability

Vodaf one Group Plc

WPP Group

Amersham PLC

Compass Group

GKN

As traZeneca Plc

BG Group

P & O Princess Cruises

Northern Rock

Britis h American Tobacco

Dixons Group Plc

Scottish & Newcastle PlcCapita Group

Wolseley Plc

Centric a

Kingf isher Plc

Hil ton Group PlcHSBC Holdings Plc

Reckitt Benckiser Plc

J Sainsbury PlcBunzl

GlaxoSmithKline

Land Securi ties Plc

Smith & Nephew

TescoRolls -Roy ce Plc

Next Plc

Pearson Plc

Granada Group Plc

National Grid PlcMark s and Spenc er Plc

Reuters Group Plc

Alliance and Leicester

BAE Sy stemsBT PlcBradf ord & BingleyGus Plc

3I Group Plc

Imperial Chemical Industries Plc

Man Group Plc

Abbey National

Standard Chartered

Royal & Sun Alliance Insurance Plc

Cable and Wireless Plc

Anglo American PlcAllied Domecq PlcSix Continents

HBOS Plc

Inv ensy s Plc

Hay s Group

United Utilities PlcDaily Mail and General Trust PlcSc ottish Power Plc

Rentok il Init ial Plc

EMI Group Plc

Lattic e Group Plc

Barclay s PlcSevern Trent Plc

Roy al Bank of ScotlandBHP Bill iton Plc

Lloy ds TSB Group Plc

Bri tish Land Co Plc

WM Morrison Supermarkets Plc

Gallaher Group Plc

Scottish and Southern Energy Plc

Av iv a (f ormerly known as CGNU)

Safeway Plc

Cadbury Schweppes

Boots Company Plc

Bri tish Airways Plc

BOC Group Plc

Legal & General Group Plc

Unilev er Group

BP

Reed Elsev ier

Old Mutual PlcSmiths Group

Rio Tinto PlcHanson Plc

Prudential Plc

Imperial Tobacco Group PlcInternational Power Plc

Corus Group

Johnson Matthey

Diageo

Schroders Plc

Associated British Foods Plc

Exel

BAA PlcFriends Prov ident

0.2

.4.6

.81

equi

ty_s

hare

-.6 -.4 -.2 -5.55e-17 .2 .4pension_surplus__deficit___pensi

bandwidth = .8

Pension Risk

Pension Liabilities/Market Cap

Vodaf one Group Plc

British Land Co Plc

Reuters Group PlcLand Securities Plc

BG Group

International Power Plc

Compass Group

P & O Princess Cruises

Man Group Plc

WM Morrison Supermarkets Plc

WPP Group

Capita Group

3I Group PlcGlaxoSmithKline

Old Mutual PlcAs traZeneca Plc

Northern Rock

Next PlcHays Group

Smith & Nephew

BHP Bill iton Plc

Amersham PLC

Hilton Group Plc

Anglo American Plc

Standard Chartered

Legal & General Group Plc

TescoGus Plc

Dixons Group Plc

BunzlRentokil Initial PlcHBOS Plc

BPHSBC Holdings Plc

Reckitt Benckiser Plc

Rio Tinto Plc

Friends Prov ident

Wolseley Plc

Schroders PlcAbbey National

Bradf ord & Bingley

Diageo

Cadbury Schweppes

BAA Plc

Alliance and Leicester

Pearson PlcSix ContinentsJohnson Matthey

Prudential Plc

Kingf isher PlcLloyds TSB Group Plc

Reed Elsev ierGallaher Group Plc

Saf eway PlcScottish and Southern Energy Plc

Royal Bank of ScotlandAv iva (f ormerly known as CGNU)

CentricaCable and Wireless Plc

EMI Group PlcBarclays Plc

BOC Group Plc

National Grid Plc

Severn Trent Plc

British American Tobacco

Boots Company Plc

Associated British Foods PlcMarks and Spencer Plc

Granada Group Plc

Hanson Plc

J Sainsbury PlcScottish & Newcastle Plc

Imperial Tobacco Group Plc

Scottish Power PlcDaily Mail and General Trust PlcUnited Utilities PlcAllied Domecq Plc

Smiths Group

Unilever Group

Exel

Invensys Plc

Royal & Sun Alliance Insurance PlcGKNBAE Systems

BT Plc

Lattice Group Plc

Rolls-Royce Plc

Imperial Chemical Industries Plc

British Airways Plc

Corus Group

0.2

.4.6

.81

equi

ty_s

hare

0 1 2 3 4pension_liability__market_cap

bandwidth = .8

Pension Risk

Public Awareness

• Watson Wyatt/YouGov survey of 2989 individuals (May 2 – May 6) of which 862 are members of DB pension

• Do you know what would happen to your pension if your employer became bankrupt?

• My pension is protected and I would keep all that I have saved (44%)• My pension is partly protected and I would keep some of what I

have saved (3%)• I could lose all my pension unless I have already retired (5%)• My pension is not protected at all and I could lose all that I have saved

(2%)• Don't know (46%)

% of DC funds which offer a choice

0 20 40 60 80 100

Switzerland

Denmark

Australia

Canada

UK

Sweden

US

Hong Kong

Chile

Yes NoSource: Watson Wyatt GAS

Number of options typically offered

0

0

2

5

6

6

8

10

15

0 2 4 6 8 10 12 14 16

Denmark

Switzerland

Chile

UK

Hong Kong

Australia

Canada

US

Sweden

Number of choicesSource: Watson Wyatt GAS

Overseas Bond Investments

Asset Allocation

DC Assets

DC Plans

• Lots of talk about risk in DC and it is there… but DC plans are often guaranteed….

• … and there are many types of guarantees:– Guaranteed interest rates– Guaranteed annuity rates (Equitable Life)– Smoothing (implicit guarantees)– Guarantees offered by governments

• … so a vast majority of DC assets in Europe are in funds which have guarantees

DC Plans in the UK

• UK is complex• Flat pension (full pension currently

about £80/week)• Minimum Income Guarantee + pension

credit • Many types of DC – occupational,

personal, contracted-in, contracted-out

Nature of open plans

58%

4%1% 1% 1%

23%

5% 7%

0%

10%

20%

30%

40%

50%

60%

Finalsalary

Finalsalary

with DCunderpin

Final salary

with DC addition

Revaluedcareer ave

Cash balance

Occup’lDC

GPP Stakeholder

% o

f ope

n pl

ans

Current Occupational Pension Provision

Source: Watson Wyatt

Final salary plan becomes…

62%

15%

21%

3%

0%

10%

20%

30%

40%

50%

60%

70%

Occupational DC GPP Stakeholder Career ave

What type of plan, if any, was introduced after review

Source: Watson Wyatt, 2002

UK Personal Pensions

• Stakeholder pensions (max. charge 1%)• Tax relief (max( £3600/year, age-related

percentage of income)• Mandatory annuitisation by age 75• …. Up until recently with profits 50% or

more of business

With profits

• Reversionary bonuses• Terminal bonuses• Case of Equitable Life

Switzerland

• 1985 BVG• Minimum contributions 7-18%, value

increased at minimum interest rate (historically 4%)

• Many employers historically chose DB provision for BVG

Denmark

• 4-7% contribution rate• Little if any investment choice for

individuals• Most products are minimum interest

rate guarantee insured products

Denmark

Grosen and Jorgensen, Journal of Pension Economics and Finance,1(3), 2003

Germany

• Vehicles: book reserves (50%), Pensionskassen (20%), insurance contracts (15%), new pension funds

• 0% guarantee on new funds, other guarantees on existing funds

• Government guarantees on book reserve

Guarantees are Expensive

• Guaranteed Interest Rate Problems: Denmark, Japan, Switzerland, UK

• Guaranteed Annuity Rates: UK• Solvency Guarantee Problems: Finland

• How expensive? Lots of opinions. Smetters (JPEF), Haberman (2002), Mitchell et. Al. (2002) are indications of how expensive things might be.

Cost of Interest Guarantees

• DB is just DC with interest rate equal to aggregate wage growth (career average) or individual wage growth (final salary)

• DC with minimum guarantee might involve more risk to guarantor if interest rate is not much lower than wage growth

Valuing Guarantees

• Haberman (2002) has done a variety of formal analyses – option pricing approach

• Grosen and Jorgensen (2001, 2002)• Smetters (JPEF, 2002) – overfunding

not effective in reducing the cost of the guarantees

Lessons from the Safari

• Avoid guarantees• Poorly structured guarantees are

interesting to look at … when visiting another country

• If used need to be structured very carefully. Costs could be immense.