Solvency, equities, risk, affordability and the actuary Cameron McNeill

1. Solvency, equities, risk, affordability and the actuary Cameron McNeill

2. Agenda • Actuaries – inside and out • Solvency regulations and relaxations • What is a pension deficit and the implications • The role of equities • Risk, ERM and pension funds Note – all views expressed are personal and are not necessarily those of Buck Consultants

3. Actuaries – inside and out

4. How we see ourselves “Actuaries know risk like Ahab knew whales. And the profession is recognised, deservedly, not only for the rigour of its examination process but for the value it places on honest analysis.”

5. From our website Actuaries are professional business people who are skilled in the application of mathematics to financial problems. Actuaries employ their specialized knowledge of the mathematics of finance, statistics and risk theory on problems faced by ……pension plans Actuaries have practical business sense, the creativity to apply training and experience to new problems and provide innovative solutions, and the communication skills required to convince both colleagues and clients. They help people plan better for the future by controlling or reducing financial risks associated with …..retirement

6. The other view 17 Oct 2009 • “unreasonable assumptions” • “the unchecked optimism of actuaries” • valuations can be “subjective and sometimes very wrong” • it wasn’t my fault, it was down to “the fact that the company didn’t put enough money in the plan”

9. Solvency regulations and relaxations

10. Solvency regulations Note : solvency regs do apply in German Pension Funds

11. Solvency regulations relaxed

12. Why do we have solvency regs? • Politics • Protect central funds (Ontario, US, UK) • Secure members’ benefits • Force employers to fund None of that says anything about making pension plans more affordable for employers. So why do we abandon the solvency regulations when they are most useful, simply because they are difficult to comply with? Were they supposed to be easy?

13. …most useful…. • Does anyone suffer because of solvency relief measures? • Yes, where an employer goes out of business • Cash is temporarily diverted away from the Plan • Benefits are scaled down on wind up….. • ….. by more than they would previously have been • Offset by continued employment • Generational inequity and the FS problem • Short service gains • Long service losses • Not all plan members are employees • Solvency relief should and could easily deal with this

14. …most useful…. • Are market crashes and insolvencies linked? • Insolvency practitioners typically expect an upturn in insolvencies around 18 months after an economic downturn • KPMG report (Danger and Opportunity Ahead for Corporate Canada – 2008) • “..we are likely to see an increase in insolvencies in the next few years” • German corporate bankruptcies up 14.8% in 1st half of 2009 (Canadian Business Online)

15. UK experience

16. US experience US insolvency filings (RHS inverted) -v- Real GDP growth (LHS)

17. So why do we relax solvency regulations? • Politics • We believe the markets are wrong and will bounce back? • ….so we believe our assumptions were correct? • Because we don’t think companies should have to deal with equity volatility? • Bear in mind we already allow smoothing of asset values • We should do anything not to put a company out of business? • Because we want to support companies who have plans they can’t afford? • Because we don’t think security of benefits is important? • Because it’s ok to push unmanageable debt in to the future?

18. What is a pension deficit(& implications)

19. A reminder of what a deficit really is • A DB benefit is a “promise” to pay • The EU constitution defines DB benefits as deferred pay • A deficit is a temporary loan from the plan members to the company • Without their knowledge or consent • Without interest • With no collateral • With minimal bankruptcy protection • Order of priority on bankruptcy……..

20. Complex solvency relief • It all hinges on employer strength • Unencumbered balance sheet assets • Operating profits (excl exceptionals) • Cash generation • Order book • Risk management • Market position • Patents etc • Barriers to entry • Would you rather have a DB promise (not funded to wind-up levels) from a big 5 Canadian Bank or GM? • Someone (?) has to be making that sort of judgment when it comes to solvency funding and relief measures • We should be involved

22. Complex in practice • Will the company survive? YES • If YES, relief is allowed, provided • Accrual stops • No returns to shareholders • Explicit disclosures • If NO then no relief • If maybe? • Fit and healthy without pension costs? • Credit agencies look short term • 12 months • Recognise things move very fast pre insolvency

23. No solvency crisis • Solvency is linked to • Equity exposure • Risk • Affordability • Those are the problems • Solvency Relief is just a quick nip and tuck

24. The role of equities

25. Equity exposure in DB plans Equities outperform bonds over the long term Yes but they can be a bumpy ride Don’t worry, actuaries can smooth out the volatility I can’t afford my plan without equity exposure

26. Equities - the truth revealed • Equities do not “match” active member liabilities • So it’s about maximising return • Or maybe diversification? • What does the data say? • With a nod to Benjamin Disraeli

27. The data 1

28. The data 2

29. The data 3

30. The data 4

31. The data 5

32. The data 6

33. The data 7

34. Conclusions? • Out-performance not clear? • Very timing dependent • Major and frequent equity corrections lead to more risk • Disraeli was right • We still dismiss financial economics • Same old actuaries

35. Volatility is the enemy • We are not able to smooth out volatility in equity markets • We can not identify volatility from true value shifts • We should not try • We can smooth out the impact of volatility on cash flow • Should we? • Only if we are sure the company will survive to the end of the smoothing period • Or has free assets to cover the deficit • Very similar to the solvency arguments • But do it on cash flow not assets • It will only get worse • Electronic trading • Day traders • Endless media coverage and info • Plans will get more mis-matched • IAS19

36. What is an actuary to do? • Push for change and meantime…… • Reconsider our approach to funding • Market based valuation methodology • Assets at MV • Liabilities at MV • Smoothing must include evaluation of the risk of default • Need to involve the accountants? • Make Directors sign off on “credit-worthiness”? • Cover all the bases in working with clients • Drawbacks, employee interests etc

37. Risk, ERM and pension funds

38. ERM and DB plans • ERM almost always excludes pension plans • But DB presents business risks • To cash • To financial statements (shareholder distribution, shareholder value, bank covenants, access to capital and cost of capital) • To reputation (as does DC) • To employee engagement (as does DC) • To recruitment and retention (as does DC) • Often misaligned with sponsor risks

39. The key to DB plans in ERM • Establish what matters • Size it (using current asset mix) • Control it • Governance – is the company aware and in control? • Note this is not DB plan governance • Risk alignment • A well set Risk Budget • ie how much equity exposure can be afforded?

40. Stochastic risk budgeting • But first a word or two of caution John Meriwether Richard S Fuld

41. John Meriweather Huge bet on spreads closing They continued to widen Margin calls Leverage at 3bn on 100m Ran out of capital Inv bank cartel stepped in Partners out Market eventually corrected Spreads closed LTCM wound up Nb – Bear Sterns • Founder of LTCM • The professors • Merton and Scholes • Model-driven analysis • Huge bets on small play • The power of leverage • EG spread on bond yields • Across geographies • At and after issue • So what went wrong? Getting the model right can be little comfort

42. Richard S Fuld • CEO of Lehman Brothers • Insolvent • Why? • Arguably they were the most aggressive sub-prime lender • Moral hazard? • So they had no ERM model? Getting the model wrong can be truly disastrous WRONG Complex ERM Full statistical models as per all major lending institutions Severely understated covariance of default

43. Careful Stochastic risk budgeting • Focus on SD rather than VAR • Model fatigue at the extremes • Too much comfort in the 1 in 20 scenario • Keep it to one-year projections • Great care with small and new markets (exclude) • First cut is equity/ bond allocations • Second cut refines and uses IR (or Sharpe ratio) • Alternate asset classes have to fit in as a proxy • Use deterministic modeling too • Model error • Scenario testing

44. Might not be good news • The results will show that many companies really can’t afford their DB plan • Without an unrealistic dose of equity optimism

45. In summary • Solvency is not the problem • Mismanagement of equity risk is • We are complicit • Time for a new approach • Promoting change • Let it be complex • But keep it simple!! • How we consult • How we view equities • Supersizing won’t help • Compulsion is required • Corporate incentives