Pension Plan Reporting

Graeme Robertson, Vice PresidentDamon Williams, Vice PresidentPhillips, Hager & North Investment Management Ltd.

Pension Plan Reporting in a

Market Value World

April 15, 2008CIA Pension Seminar

Pension Plan Reporting

Suggested Changes to Actuarial Reporting

1. Market value of assets and market value of projected benefits and expenses should be used in all valuations for all purposes

2. Reframe balance sheets for pension plans within a market value based framework

Pension Plan Reporting

Some Definitions

• An “obligation” is a “real” or “nominal” cashflow owed in the future (e.g. a future benefit payment from a pension plan)

• A “liability” is a generic term for the present value of future obligations using a discount rate to price the obligation

• The “market value of liabilities” is the present value of future obligations priced using an appropriate current term structure of interest rates

Pension Plan Reporting

Typical Accrued Pension Obligations

Source: other\sample cashflows

0.0

1.0

2.0

3.0

4.0

5.0

6.02

00

8

20

13

20

18

20

23

20

28

20

33

20

38

20

43

20

48

20

53

20

58

20

63

20

68

20

73

20

78

20

83

20

88

Ex

pe

cte

d B

en

efi

t &

Ex

pe

ns

e P

ay

me

nts

($

Mil

lio

ns

)

Pension Plan Reporting

Market Value of the Pension Obligations

• If a portfolio of assets can closely match the obligations in terms of

• Inflation characteristics (nature)• Term structure (timing)• Expected $ (amounts)• Risk characteristics (uncertainty)

• Then it follows that the market value of those assets must be the market value of the obligations

Pension Plan Reporting

Market Value of the Pension Obligations

• Bond assets (real or nominal) can be structured to hedge the nature, expected timing and amount of the projected benefit and expense obligations with little residual investment risk

• Non-investment related risks affecting expected timing and amount that cannot be hedged in the markets should be explicitly identified and managed with a contingency reserve on the liability side of the balance sheet, e.g.

• Real salary growth (i.e. over and above inflation)• Decrement risks (e.g. mortality)

Pension Plan Reporting

Market Value of the Pension ObligationsUse of Risk Free Interest Rates

• Funded obligations should be priced with no market default risk premium (e.g. discounted at Government of Canada rates)

• Credit risk discount to obligation valuation is a circular argument

– Plans with ever lower funded ratios would use ever higher discount rates

Pension Plan Reporting

Focus on Funding ValuationsTypical Going Concern Valuation Balance Sheet

• In an actuarial valuation, many plans have used a flat discount rate (say 7%) to value their plan obligations

• Keeping the discount steady through time gives the impression that the investment objective is to earn 7% per annum

Market Value of Assets

$1bn

Present valueof obligations

discounted @ 7%

$1bn

Pension Plan Reporting

Focus on Funding Valuations Historical Return Perspective

Annualized 10-year Returns: Balanced Portfolio

• From a historical perspective 7% looks reasonable– Until we explore the drivers behind historical asset returns

0%

5%

10%

15%

20%D

ec-6

0

Dec

-63

Dec

-66

Dec

-69

Dec

-72

Dec

-75

Dec

-78

Dec

-81

Dec

-84

Dec

-87

Dec

-90

Dec

-93

Dec

-96

Dec

-99

Dec

-02

Dec

-05

Dec

-08

Ret

urn

s

Pension Plan Reporting

Use of Market ValuesConsistent Asset and Liability Pricing

Market Value of Assets

$1.0B

“Market Value” of Liabilities

(implied discount rate = 4.0%)

$1.5B

• Now let’s compare apples-to-apples

• Using a discount rate that reflects current market conditions substantially increases the value placed on the projected obligation

Pension Plan Reporting

Use of Market ValuesHistorical Return Perspective

Annualized 10-Year Rolling Returns Balanced Portfolio versus MV of Liabilities

-5%

0%

5%

10%

15%

20%

25%

Dec

-60

Dec

-62

Dec

-64

Dec

-66

Dec

-68

Dec

-70

Dec

-72

Dec

-74

Dec

-76

Dec

-78

Dec

-80

Dec

-82

Dec

-84

Dec

-86

Dec

-88

Dec

-90

Dec

-92

Dec

-94

Dec

-96

Dec

-98

Dec

-00

Dec

-02

Dec

-04

Dec

-06

Dec

-08

Ret

urn

s

MV of LiabilitiesBalanced Portfolio

Pension Plan Reporting

Advantages of Using Market Values

• Consistent pricing of asset cashflows and pension obligations

• Reduce risk of spending surplus/funding deficit that isn’t there

Pension Plan Reporting

Importance of Consistent Valuations An Example

• Pension plan has single obligation of $1bn in 20 years and $258mil in cash

• Interest rates are 7% • We buy GOC strip paying $1bn in 20 years time for $258mil• We will earn 7% p.a. for 20 years if we do not trade• Funded ratio = 100%

• Year 5 interest rates are 4.5% and our asset is up 14.9% p.a. over 5 years (MV assets is now $517mil whereas we expected $362mil if we had earned 7% p.a.)

• Funded ratio (if discounting at 7%) = 143%• Funded ratio (using MVs) = 100%

• $1bn cashflow from asset has not changed so unless $1bn obligation is priced at same value as matching asset then we will believe we have a surplus (of course we do not!!)

Pension Plan Reporting

. . . Advantages of Using Market Value

• Pricing of expected obligations is consistent across all tests (eg. going concern, wind-up)

• Only differences come from benefits being projected and non-investment related assumptions used to project the benefits

• Fundamental economic similarities and differences between different tests better understood

Pension Plan Reporting

. . . Advantages of Using Market Value

• Investment problem is clarified

• Becomes clear that assets must keep pace or beat a portfolio that matches the investment characteristics of the obligations being considered (the minimum risk portfolio or “MRP”) over time

• Investment policy development would consider opportunities relative to the MRP

• Objective (in our example) becomes a dynamic market value based objective of “return on MRP + 3%” rather than a “constant 7% per annum regardless of market conditions”

Pension Plan Reporting

Reframing the Balance SheetCurrent Actuarial Practice

Market Value of Assets

$1.0B

“Market Value” of Liabilities

$1.5B

Present Valueof Expected

Risk Premium

$0.5B1 Common actuarial practice moves this to the liability side to reduce the reported liability

1 Equivalent to earning 3% per annum (i.e., 7% less 4%) in excess of return on MV of liabilities over expected life of obligations being valued

Pension Plan Reporting

Reframing the Balance SheetCurrent Actuarial Practice

Market Value of Assets

$1bn

Present Value of Obligations

Discounted @ 7%

$1bn

• Obscures true funding and investment challenges

Pension Plan Reporting

Reframing the Balance SheetProposed Market Value Approach vs Traditional

Market Value of Assets

$0.8bn

“Market Value” of Liabilities

(implied discount rate ~ 4%)

$1.4bnMarket Value

of Assets

$1.0bn

Actuarial Valueof Liabilities(discount rate 7%)

$1.0bn

Contingency Reserve $0.1bn

Market Value of Assets

$1.0bn

“Market Value” of Liabilities

(implied discount rate ~ 4%)

$1.4bn

Expected Value of Excess Returns

$0.5bn

Pension Plan Reporting

Why Reframe the Balance Sheet“Excess Return Asset”

• Excess return assets are not excluded but put on the correct side of the balance sheet

• The existence of the excess return asset implies an acceptable level of underfunding on a market value basis within which the actuary is comfortable keeping funding unchanged

• Excess asset is explicit enabling magnitude and appropriateness of that asset to be scrutinized by stakeholders in the context of the particular valuation test being performed

• “Excess return” is return on assets in excess of replicating portfolio so historical analysis should be in this context

• Note: Market value of excess return asset is $0

Pension Plan Reporting

Reframing the Balance SheetExcess Return Asset (Historical Perspective)

Annualized 3-year Returns: Balanced Fund versus MV of Liabilities

-25%-20%-15%-10%-5%0%5%

10%15%20%25%30%35%D

ec-6

0

Dec

-63

Dec

-66

Dec

-69

Dec

-72

Dec

-75

Dec

-78

Dec

-81

Dec

-84

Dec

-87

Dec

-90

Dec

-93

Dec

-96

Dec

-99

Dec

-02

Dec

-05

Dec

-08

Ret

urn

s

Balanced portfolio outperforms MV of

liabilities

Balanced portfolio underperforms MV of

liabilities

Pension Plan Reporting

Reframing the Balance SheetExample of Gain/Loss

MV of Assets Excess

Return Asset MV of

Liabilities Net (Assets –

Liabilities)

Value at beginning of year $1,000,000 $500,000 $1,500,000 $0

BoY yield on Government of Canada securities

+$20,000 N/a +$60,000 -$40,000

Change in Government of Canada spot rates

+$30,000 N/a +$225,000 -$195,000

Return earned due to other investment factors (e.g, credit spreads, equity values)

+$60,000 N/a N/a +$60,000

Change in assumed excess returns over Government of Canada bonds

N/a +$50,000 N/a +$50,000

Change in demographic assumptions

N/a N/a +$150,000 -$150,000

Contributions +$75,000 N/a N/a +$75,000

Benefit accrual N/a N/a +$60,000 -$60,000

Value at end of year $1,185,000 $550,000 $1,995,000 -$260,000

Pension Plan Reporting

Conclusion

• Pension Plan financial reporting standards should frame pension balance sheets with

• MVs of both assets and pension obligations• Have explicit excess return amounts on the asset

side of balance sheet

• Existence of regulatory/legislation hurdles should not deter changes in actuarial standards

Pension Plan Reporting