ebook img

Impact of Regulations on the ALM of European Pension Funds PDF

200 Pages·2009·4.51 MB·English
by  
Save to my drive
Quick download
Download
Most books are stored in the elastic cloud where traffic is expensive. For this reason, we have a limit on daily download.

Preview Impact of Regulations on the ALM of European Pension Funds

An EDHEC Risk and Asset Management Research Centre Publication Impact of Regulations on the ALM of European Pension Funds January 2009 with the support of Table of Contents Executive Summary .........................................................................................................................5 Résumé ...............................................................................................................................................15 Introduction ....................................................................................................................27 1. The General Context of Pension Funds ........................................................................31 1.1. The “Three-Pillar Structure” of the European Retirement System ....................................................32 1.2. Pension Funds ....................................................................................................................................................33 1.3. Types of Sponsors ..............................................................................................................................................34 1.4. From Defined Contributions to Defined Benefits: Main Types of Pension Plans ..........................34 1.5. Defined Benefit Plans Improve Employee Welfare .................................................................................38 1.6. Indexing of Defined Benefits (and Hybrid DB) ........................................................................................38 2. The Regulatory and Accounting Context ....................................................................41 2.1. Accounting Standards .....................................................................................................................................43 2.2. Prudential Regulations ....................................................................................................................................56 2.3. Market Trends: Reaction to Tightening Regulations .............................................................................68 3. Asset-Liability Management for Pension Funds .......................................................73 Introduction ................................................................................................................................................................74 3.1. A Brief History of ALM Techniques .............................................................................................................75 3.2. A Formal ALM Model .......................................................................................................................................79 3.3. The Implementation of the Liability-Hedging Portfolio for Hedgeable Risks: Cash Contracts and Derivatives ................................................................................................................................................86 3.4. The Implementation of the LHP for Imperfectly Hedgeable Risks: Inflation, Wage-Indexed Liabilities and Longevity Risk .......................................................................................................................94 Conclusion on Risk Management Techniques ................................................................................................114 4. Prudential and Accounting Constraints on Pension Fund ALM .........................115 Introduction ..............................................................................................................................................................116 4.1. Biases in the Regulatory Measure of the Liabilities .............................................................................116 4.2. The Impact of Short-Term Regulatory and Accounting Constraints on Long-Term Investors ..............................................................................................................................139 Conclusion ................................................................................................................................................................150 5. Appendices ..........................................................................................................................153 5.1. Country Background and Prudential Regulations ...............................................................................154 5.2. OECD Pension Glossary.................................................................................................................................174 5.3. References ........................................................................................................................................................183 About the EDHEC Risk and Asset Management Research Centre ..........................188 EDHEC Position Papers and Publications .........................................................................192 About AXA Investment Managers ......................................................................................197 Printed in France, January 2009. Copyright EDHEC 2009. The opinions expressed in this survey are those of the authors and do not necessarily reflect those of EDHEC Business School and AXA Investment Managers. Impact of Regulations on the ALM of European Pension Funds - January 2009 Foreword The publication that we are pleased to It is our conviction that the two main present here is the sum of the first year conclusions of the study—that the of work done as part of the EDHEC/AXA retirement system would be more stable Investment Managers (AXA IM) research if regulators were more willing to tolerate chair “Regulation and Institutional short-term risk and that pension funds Investment.” should build internal models for their investment strategies—will have far- After an in-depth EDHEC study of reaching consequences on institutional the impact of international financial investment in Europe. reporting standards and the Solvency II on the financial management of European AXA IM’s support of this ambitious project insurance companies (The Impact of has been essential. I would like to thank IFRS and Solvency II on Asset-Liability AXA IM both for the business partnership Management and Asset Management that enabled production of this in Insurance Companies, Noël Amenc, publication and for the firm’s dedication Philippe Foulquier, Lionel Martellini and to the project. We look forward to Samuel Sender, November 2006), a study developing the analyses and conclusions done with the support of AXA IM, it of this publication in the coming years of became clear to us that the interaction of the research chair. institutional investment management and regulation was a key issue for European We wish you an informative read. institutional investors. As a consequence, our subsequent aim was to examine the influence of the institutional and regulatory frameworks on the financial management of Noël Amenc pension funds and thus to highlight the Professor of Finance challenges posed to institutional Director of the EDHEC Risk and Asset Management Research Centre investment management by European regulatory developments. The work involved in covering the impact of prudential and accounting constraints in four major European countries was considerable. I would like to thank my co-authors, Samuel Sender and Lionel Martellini, for the quality of their research and the scope of their efforts. An EDHEC Risk and Asset Management Research Centre Publication 3 Impact of Regulations on the ALM of European Pension Funds - January 2009 About the authors Noël Amenc is professor of finance and director of research and development at EDHEC Business School, where he heads the EDHEC Risk and Asset Management Research Centre. He has a masters degree in economics and a PhD in finance and has conducted active research in the fields of quantitative equity management, portfolio performance analysis, and active asset allocation, resulting in numerous academic and practitioner articles and books. He is a member of the editorial board of the Journal of Portfolio Management, associate editor of the Journal of Alternative Investments and a member of the scientific advisory council of the AMF (French financial regulatory authority). Lionel Martellini is professor of finance at EDHEC Business School and scientific director of the EDHEC Risk and Asset Management Research Centre. He holds graduate degrees in economics, statistics, and mathematics, as well as a PhD in finance from the University of California at Berkeley. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. An expert in quantitative asset management and derivatives valuation, Lionel has published widely in academic and practitioner journals and has co-authored textbooks on alternative investment strategies and fixed-income securities. Samuel Sender has participated in the activities of the EDHEC Risk and Asset Management Research Centre since 2006, first as a research associate—at the same time he was a consultant to financial institutions on ALM, capital and solvency management, hedging strategies, and the design of associated tools and methods. He is now a full-time applied research manager at the EDHEC Risk and Asset Management Research Centre. He has a degree in Statistics and Economics from ENSAE (Ecole Nationale de la Statistique et de l'Administration Economique) in Paris. 4 An EDHEC Risk and Asset Management Research Centre Publication Executive Summary An EDHEC Risk and Asset Management Research Centre Publication 5 Impact of Regulations on the ALM of European Pension Funds - January 2009 Executive Summary This study analyses the impact of of the accounting volatility from pension prudential and accounting constraints funds, with particular attention paid to on the asset-liability management the accounting discount rate. (ALM) of European pension funds in • Higher prudential funding requirements the Netherlands, the UK, Germany, and cannot be avoided. Stricter minimum Switzerland. funding constraints, i.e., limited allowances for underfunding, can be managed with European pension funds are the funded modern ALM techniques. These techniques vehicles that support the retirement of also help meet the regulatory requirement an ageing population. Defined-benefit for better risk management. (DB) plans, in which sponsors provide • Pension funds are long-term investors guarantees to employees, are under subject to short-term regulatory intense scrutiny from regulators and the constraints. Because short-sighted financial community, which are seeking to strategies are counterproductive, the ensure the payment of promised benefits challenge for both pension funds and and to measure their true costs. their regulator is to take a long-term approach to investing pension fund assets As illustrated below, pension funds and and to regulating pension funds. their sponsors face two main bodies of regulation: accounting standards, which require charging the impact of surpluses The impact of stricter accounting and deficits to the P&L of the sponsor, regulations and prudential regulations, which set Accounting regulations stipulate that the minimum funding requirements and lay cost of providing DB pensions be reported down the conditions for the correction of in the balance sheet of the sponsor and underfunding. that shortfalls be amortised in the P&L Figure 1: Accounting and prudential regulations Accounting regulation Prudential regulation Prescriptions Valuation (defined-benefit obligation Valuation (basis for minimum funding requirements is reported in the balance sheet of the at the pension fund) sponsor). Specifics: basis for calculation Specifics: basis for calculation and discount rate and discount rate. Cost: measurement of the cost of providing Cost: recovery plans involve contributions pensions in sponsor’s P&L account. (from sponsor and employees). Risk-based regulations regulate the capacity to invest in risky assets. Main impact P&L volatility of the sponsor. Minimum funding requirements. In what follows, we highlight three main of the sponsor. In Europe, international challenges for pension funds, as well as accounting standards (IAS 19) require the means by which these challenges may that the fraction of the deficit or surplus be met: that is higher than 10% be divided by • The trend toward stricter accounting the average remaining working life of regulations implies careful management participants. The British equivalent, FRS 6 An EDHEC Risk and Asset Management Research Centre Publication Impact of Regulations on the ALM of European Pension Funds - January 2009 Executive Summary 17, does not allow smoothing surpluses to game regulation. In most cases, then, and deficits. creating multi-employer pension funds is simply not an option. IAS 19 requires reporting the projected benefits, a best estimate of liabilities, Interestingly, because the IAS 19 constraint including any prospective increase in the is mainly a volatility constraint, it can be guarantees (as a result of future wage managed with modern financial tools. increases, for instance, or, for hybrid DB plans, of conditional indexation). In • First, prescriptions in the calculation of addition, projected benefits are discounted the liability must be taken into account in at a rate that assumes a credit spread the design of the investment strategy. For (an AA corporate yield is usually used to instance, we show that as IAS 19 requires discount liabilities). spreading, i.e., discounting liabilities at a rate that assumes a credit spread, fixed Worries are that tightening accounting liability cash flows require a portfolio standards will have a great impact on of forward credit rate agreements as a the financial information communicated match. by sponsors. For instance, were IAS 19 to • Next, modern ALM, also known as be aligned with FRS 17, smoothing would dynamic liability-driven investment no longer be allowed, and under current (LDI), involves three building blocks—the strategies the cost of providing pensions performance-seeking portfolio (PSP), the as reported in P&L accounts would become liability-hedging portfolio (LHP), and the very volatile. cash account—and requires in particular diminishing the allocation to risk when One of the trends observed in the UK the funding constraint becomes binding. market after the implementation of FRS The LHP—the projection of liabilities over 17 (the restrictive version of IAS 19) is the tradable assets—is the risk-free portfolio closing of DB plans and the opening of for the ALM investor. In other words, it defined-contribution (DC) plans. However, is the portfolio of assets that generates this rather extreme solution involves the least risk for the pension fund, given possible dissatisfaction for employees, its liabilities. Modern ALM permits the as they often make poor investment management of funding constraints; decisions and may also miss the benefits for instance, it is possible to reduce the of risk-pooling (protection from longevity likelihood that the funding ratio will and investment risks). Moreover, after breach the 90-110% range beyond which closing a DB plan, solutions for existing surpluses and deficits impact the P&L of liabilities must still be found. the sponsor. • Because of the costs associated with The multi-employer exception to IAS 19 developing models that allow the means that the balance sheets of the implementation and monitoring of sponsors of industry-wide pension funds these modern ALM approaches, fiduciary are shielded from the impact of surplus management is an advantageous option volatility. Industry-wide funds, however, for small and medium-sized pension are the result of a culture, not of a desire funds. An EDHEC Risk and Asset Management Research Centre Publication 7 Impact of Regulations on the ALM of European Pension Funds - January 2009 Executive Summary • Finally, actuarial risks cannot be on a variety of discount rates. In the UK efficiently managed, as effective means of and Switzerland, discount rates may be set transferring longevity risk to the capital according to the expected rate of return markets have yet to be found. on the assets. In the Netherlands, the swap rate is used; UK protected rights are discounted at a government bond yield. The impact of stricter prudential In Germany, the discount rate is below the regulations long-term government bond yield, and is Prudential regulations set the funding almost fixed. (capital) requirements for pension • The required duration of recovery plans funds. They apply to all pension funds varies greatly. The minimum duration in and their sponsors, regardless of their the Netherlands is three years and the status and organisation. Multi-employer average in the UK is 7.5 years. pension plans as well as state-driven funded pension plans must comply with A shift toward Solvency II? prudential regulations. One of the initial goals of the directive was to facilitate the creation of cross-border The European directive for pensions pension plans. As domestic prudential European regulations are bound by regulations are very diverse, revisions to the 2003 IORP framework directive the IORP directive are being discussed. (Directive 2003/41/EC on the activities and supervision of institutions for One of the main outside references is occupational retirement provision), which the coming prudential regulation for lays down the following four principles. insurance companies, Solvency II. • Technical provisions are a prudent Solvency II is the most accomplished valuation of accrued benefits, i.e., the example of risk-based regulation, as value of the benefits available for a capital requirements—defined as the participant in the event his employer value of assets over that of liabilities— declares bankruptcy and the pension plan are set according to a 99.5% one-year is closed. Value-at-Risk target and approximation. • Some flexibility in funding requirements Applying Solvency II to pension funds is provided as underfunding is allowed for would initially raise funding requirements: “a limited period of time”. • Solvency II requires financial buffers on • Underfunding requires a realisable top of fully funded liabilities. recovery plan. • The great variety of protection • The “prudent person” rule, not mechanisms enjoyed by pension funds quantitative restrictions, applies to reduces their need for capital. However, investments. the standard formula will not be able to capture these mechanisms and will The translation of the framework directive demand an exaggerated funding ratio. into domestic regulations varies greatly from one country to another, in particular Solvency II, however, may provide great for the first two principles: incentives to build internal models, a • Valuation of accrued liabilities is based feature we view as favourable to the 8 An EDHEC Risk and Asset Management Research Centre Publication Impact of Regulations on the ALM of European Pension Funds - January 2009 Executive Summary development of sound risk-management requirements can thus generally be practices. managed (just as accounting volatility can be) with modern ALM. The impact of higher funding requirements The regulatory discount rate must Higher requirements involve an immediate be highlighted in the design of the increase in funding ratios and thus investment strategy. When the regulatory require additional contributions. The risk constraint is binding—perhaps because is that these contributions will be the funding ratio is low and neither perceived as a direct and unwelcome cost sponsor nor employees are willing to and result in knee-jerk closures of DB make additional contributions—pension schemes. funds may be forced into prudent or even risk-free investment strategies, risk-free, Higher funding requirements would that is, from the prudential regulator’s thus be hard to avoid. As mentioned for point of view. In this case, asset allocation accounting constraints, creating DC plans will not merely need to take into account does not mean that the DB plan no longer the presence of this constraint; instead, it has to comply with regulation, even when will be governed entirely by the regulatory 1 - The German discount rate is not totally fixed. the plan is closed to new members. LHP. It represents 60% of the ten-year average of the long-term German Fully avoiding prudential regulations The current trend is to use the swap yield government bond yields. requires getting out of defined benefits curve for discounting. For very long-term altogether: in the buy-outs, the maturities, the swap market is more liquid pension sponsor transfers the pension than the market for government debt. fund’s balance sheet, together with its As such, swaps are the preferred hedging commitments, to a third party, generally instrument for very long-term liabilities an insurance company. Sponsors thus and the swap curve is becoming the reduce the threat of unwanted future standard for discounting. Two historical regulatory ramifications—accounting or standards, still used today, are worth prudential. The wave of buy-outs in the considering as well. UK is revelatory of sponsor attitudes toward regulation. The fixed discount rate: Historically, most countries have used The impact of stricter minimum fixed rates to discount liabilities. The funding constraints and the importance Netherlands used a fixed 4% discount of the prudential discount rate rate, Germany a 6% rate for book- Higher funding requirements, of reserved pensions, and now the 2.25% course, involve immediate additional for Pensionsfonds (and Pensionskassen) is contributions to all pension funds and almost fixed.1 cannot be avoided. By contrast, stricter funding requirements involve improved In this case, the value of liabilities is monitoring of minimum funding totally independent of market interest constraints rather than immediate rates. When the bond portfolio is marked additional contributions. Stricter funding to market, the portfolio that immunises An EDHEC Risk and Asset Management Research Centre Publication 9 Impact of Regulations on the ALM of European Pension Funds - January 2009 Executive Summary the funding ratio against movements in market rather than on historical excess financial markets (mainly interest rate returns. Because the forward-looking ERP movements) is . . . the cash account or, increases when past performance falters, when regulatory reporting takes place it follows that the forward-looking every year, the one-year zero-coupon measure is counter-cyclical. bond. The role of internal models in Discounting at an equity risk premium: risk-based regulations Discounting liabilities at an equity risk Risk-based regulations are meant to premium (ERP) means under-estimating foster the development of good risk these liabilities. From a regulatory management practices. In the Basel perspective, discounting at an equity accords, risk management is simply a return is an unsophisticated way to allow qualitative obligation. In Solvency II, pension funds to take risks. incentives for good risk management are such that capital requirements can be The traditional practice of discounting measured with internal models, so that at an ERP is pro-cyclical, i.e., it amplifies the risk of insolvency or underfunding the impact of the business cycle on the is limited to 0.5% per year for insurance 2 - Implementation measures differ from those for financial health of the pension fund. companies. Internal models must be used insurance companies. Assets Many financial institutions have been to manage and control risks and are thus must be high enough to cover the liabilities over a one-year using a historical estimate of the risk best defined not as risk measurement horizon with a probability set premium, computed over a period of say software but as a full risk management at 97.5%. fifteen years (between ten and thirty years, system. sometimes depending on the maturity of the liabilities). This practice, without any The Solvency II framework has been further analysis, may lead to the “equity applied to pension funds in the risk premium trap”, i.e., the risk of being Netherlands.2 Other countries may trapped in permanent underfunding after follow. Pension funds facing risk-based market downturns. prudential regulations will greatly benefit from building internal models and having After all, when the value of assets falls, them approved for the purpose of setting so do historical estimates of the risk funding requirements. Doing so will enable premium. Falls in expected returns trigger them to have funding requirements more a further rise in the reported value of the closely aligned with the nature of their liability, and therefore further lower the risks and to enjoy reduced quantitative funding ratio, involving a second round requirements when they have risk- of adverse consequences on the reported mitigation techniques and instruments health of the pension fund. unrecognised in the standard formula. (For instance, when risk management relies on In regulations that tolerate or encourage these models to reduce the likelihood of discounting liabilities at a risk premium, underfunding, a smaller capital buffer is we strongly recommend practitioners to required. Pension funds would do well use forward-looking equity risk premiums, then to develop internal models that rely based on the valuation of the stock on modern ALM principles.) In addition, 10 An EDHEC Risk and Asset Management Research Centre Publication

Description:
The “Three-Pillar Structure” of the European Retirement System .. a research associate—at the same time he was a consultant to financial institutions on ALM, capital .. bodies that they have mastered a long- . Une des tendances observées sur le marché .. le développement des bonnes pratiqu
See more

The list of books you might like

Most books are stored in the elastic cloud where traffic is expensive. For this reason, we have a limit on daily download.