Ponds, E.H.M.

English

Research Papers in Economics

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THE  POLICY LADDER:  A  FAIR TaaL  Ta  MANAGE  PENSION
FUND  RISK
E.H.N.  PONDS
ABP  recently  U uly 2003)  has introduced a new  system  employees being  100%  certain  to  receive the  pre-
of  management  of  pension  fund  risk, the so-called  ~olicy  defined  pension income  at  retirement  that  is  fully
ladder'  (in Dutch beleidsstaffel).  indexed over the remaining life of the participant.  The
Tbe ladder  leads to two important  adjustments in the  participant  experiences no exposure to standard-of-
pension  plan.  living  risk.2 In a pure DC plan (defined contribution),
.The  first  adjustment is the introduction  of a set of  a part  of wage income is allocated  ready  to the DC
explicit rules regarding the  allocation of funding risks  account of the individual  participant.  The individual
to the  plan  members:  the ladder  establishes  a direct  bears all  the  risks  in  the  funding  by bis own.  The
relationshiP between  the  funding ratio on the  one  hand  exposure  to standard-of-living  risk is maximal.
and  on the  other hand  the  indexation  rate  and
contribution rate.  In the Netherlands, pension  plans designed as  pure DB
.A  second  adjustment is the move  from  a final-pay  plans are absent. Employees and retirees are usually
scheme  to an average-wage  scheme  with  conditional  risk-bearers toa as they take part in contribution  rate
indexationapplied toallparticiPants,  retirees  as weil  risk and accept indexation  risk. Moreover, gains and
as  active  workers.  T he  ladder implies  a  firm  move  from  losses  in the funding process can  be shifted forward  in
an implicit  to an explicit pension  deal.  time  by  accepting  -temporarily  -a  situation  of
overfunding  or  underfunding.  This  implies  risk-
This contribution  presents  a descriPtion  of  the background  sharing  with  fut ure  participants,  hence
and the working of the  policy ladder.  intergenerational  risk-sharing.  Unfortunately,  the
multi-stakeholder  base  in risk-hearing is seldom made
explicit.  What is lacking is a transparent and explicit
1  PERSPECTIVES ON PENSION PLAN  DESIGN  pension  deal.
1.1  Standard-of-living  risk
The  most  important  risk  in  providing  retirement  1.2  Towards  an explicit  pension  deal
income  is  standard-of-living  risk.1 A wage-indexed  With  the term pension deal  we mean  the contract
defined-benefit  (DB) scheme  pI;imarily aims to protect  between  employees  and the employer that sets  out:
the individual  worker tor standard-of-living  risk. The  .the  nature of the pension  promise (final paf or
pension income of the DB plan is rel.ated  to the wage-  average  wage, indexation policy),
path during the career  (average  wage)  or to final-pay, so  .the  funding of this promise and,
workers  have the prospect of a standard-of-living  at  .how  the risks in the funding process  is allocated
retirement  comparable to the pre-retirement  period.  (implicit  or explicit) amongst the stakeholders.
The  pension income  will  be received as long as the  Many plans in the Netherlands traditionally  have been
retiree  lives.  Moreover,  during  retirement  pension  mor~ or less  implicit  as  to the kef aspect  of risk-hearing.
income usually is indexed tor wage-inflation  or price-  Usually there are no rul.es  regarding how, by whom and
inflation.  Defined  benefit pensions have to be geen  as  to what extent the funding  risks of the plan have to be
deferred  wage  income  (at  least  theoretically)  and  borne. This maf easily  lead to asymmetry in the pension
contributions  paid to the pension plan are to be geen  as  fund policy in relation to the funding  position.  In the
retirement savings Erom  grogs  wage income.  90's, pension funds experienced huge surpluses that
have  been  used  tor  cuts  in  contributions  and
Crucial  question in the process of funding  is: Who  is  improvements  of the  pension benefits  of the  active
hearing the risk? The answer  to this question is decisive  employees.  Mter the dramatic fall in stock prices in the
tor the characterization of the plan. In a pure DB plan,  last three years, Dutch  pension funds struggle  with
it  is  the  employer  who  is the  risk-bearer  with  the  funding  deficits.  The supervisor insists on a recovery
TIJDSCHRIFr  VOOR  CoRPORATE  FINANCB  41111.  JAARGANG  8, 2003,  NUMMER  3/4
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.."  ." "THE POUCY LADDER:  A  FAIR  TOOL TO MANAGE PENSION  FUND RISK  E.  PONDS
:
on the  short term,  however stakeholders disagree on  contribution  ra  te  as the  main  tooI  to  control  the
who bas to par. Actually  the situation  during  the last  funding  ratio  risks.  However,  an  important
three years  can  be characterized  as  one of'policy  inertia'.  characteristic  of  a  mature  pension  fund,  is  the
The  introduction  of  an explicit  pension  deal  will  ineffectiveness  of  the  contribution  ra  te  to  abs  orb
overcome  the prevailing state of apathy, because  the set  funding ratio risks.3  A mature pension fund, therefore,
of explicit  rules prescribes  who bas  to par, when and to  bas  to look forward to new tools of risk management.
what extent in a deficit  situation.  These tules also set
down who wiil  benefit, when, and to what extent in a
surplus situation.  2  POLICY  LADDER
Furthermore  the case  of an explicit  pension deal is also  ABP  bas  recognized  the  need  to  improve  the
stt:engthened because  of the switch  in valuation  and  governance  of pension fund risks in order to safe  guard
accounting  methods  towards  fair  value  principles.  the  sustainability  of  the  pension  fund.  Fair  value
There  is  growing  awareness  principles  have  been  in  use
that  traditional  pension fund  since  the  end  of  the  90's
governance suffers from severe  improving  transparency  in
shortcomings  in  the  accounting  issues  and  the
measurement  and  manage-  measurement of pension fund
ment of pension  fund risks.  risks. The  policy  ladder  was
introduced recently, aiming to
Byand  large the governance  of  improve  the  management  of
pension funds bas been  rooted  pension  fund risks.
on the actuarial approach  based
on hook value principles  and  The basic idea of the ladder is
tules  of  thumb,  like  fot  quite  simple.  We explain the
example a fixed  4%  actuarial  basic  idea with help offigure  1.
discount  rate. Risk is ignored  The horizont al axis shows the
or  disguised.  Actually,  the  value of assets.  Two points  are
actuarial  approach leads to  a  of  crucial  importance.  This
self-constructed  portrayal  of  concerns  fitst of all the value of
the  financial  solidity  of  the  nominal  liabilities  (with
pension  fund  without  a  clear  insight  into  the  valuation  based on  the  nominal  field  curve)  and
magnitUde of actual risk exposure.  The situation is now  secondly the value of indexed liabilities4 (based on the
changing rapidly,  with  the increasing use of financial  real field  curve). Contribution  rate and the indexation
economics and  fair  value principles.  The  economic  are set along the vertical axis. When the value of the
approach implies market-based valuation of assets  and  aSsets  matches the value of the indexed liabilities,  the
liabilities,  so the balance sheet  reflects true economic  contribution  rate is set equal to the cast price of new
values. Information of financial markets is used  to assess  accrued  liabilities  and the indexation matches  the wage
the risk position of the pension fund. As the use  of fair  inflation.  There wiil  be cuts and charges  regarding the
value  principles  leads to  an  improvement  of  risk  base  contribution  rate and indexation  when the value
measurement, it also  reveals  the weakness  of the current  of the assets  deviates from  the value of the indexed
funding  position  and the urgent need to develop the  liabilities.
risk management process that is suited fot a fair value
framework.  lndexation policy:  The  size  of  the  indexation  is
proportionally  related  to  the  size of  the  available
Most Dutch pension funds stem from the 50's and 60's,  indexation reserve,  this is the difference between  assets
so  they  now  have  a  high  degree  of  maturity.  and  nominal  liabilities.  There  is  room  for  fuil
Traditionaily  pension  funds  make  use  of  the  indexation, when the value of the assets  equals  the value
TIJfs::HRJFf  VOOR  CORPORA  TB  FINANCB  41111.  JAARGANG  8, 2003,  NUMMER  3/4
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'.  ..-'-  ;.  .-,'..
.,THE  POUCY lADDER:  A FAIR TOOi TO MANAGE FENSION  FUND lUSK  E.  Po~
of the indexed liabilities.  The actual indexation reserve  (de  Pensioen-  en Verzekeringskamer)  bas  lead to a number
matches  the  required  indexation  reserve.  The  of modifications.  Compare for the details the official
indexation rare will  be zero when the assers  are  equalto  press  release  in the appendix, in which onJuly  lst  ABP
or even below the nominalliabilities.  The indexation  informs  on the ladder. AII  these changes have had no
reserve  is actually zero. BetWeen  these  points there will  'impact on the core  principles behind the policy ladder.
be a cut in the indexation where the cut depends  on the
actualdeficit  in indexation reserve.  Whenever the assers  The introduction  of the 'policy ladder' bas  a number of
exceed  the value of indexed liabilities,  th~re is room to  advantages that allwill  contribute  to a fair and more
provide extra indexation until  there is a full  catching-  sustainable pension  plan:
up of previously missed  indexation.
1.  Indexation  policy  and  contribution  are related
Contribution rate: The contribution  rare is set equal to  explicit  and unequivocal to the actual indexation
the cost price of the new accrued liabilities  of one year  reserve  position; this will  prevent the re-occurrence
of service  when the assers  are equal  to or exceed  the value  of the recent situation  of poiicy-apathy.  U sing the
of indexed liabilities.  A contribution  charge is levied  ladder  it  is always clear who,  when and to  what
when assers  fall short of the indexed liabilities.  To the  extent takes part in the funding risks;
analogy  with  the  indexation  cut,  the  charge  will
increase when the deficit is increasing. The maximum  2.  The ladder maintains the DB character of the plan:
charge is determined  by the annual funding  costsin  It is still  aimed to realize a target pension income
order to build  up the required indexation reserve  within  according to the preferred level related to final-pay
T years.  or average-wage, however this  target income now
bas  to be seen  as  an expected  income surrounded by
The preceding bas set out the basic idea of the ladder.  uncertainties  as  implied  by risk-allocation  rules of
The discussion  with the stakeholders  and the supervisor  the ladder;5
Policy Ladder
Cost price  + maximum  charge
1  price
1  t.  cuts
Contribution  rare  1 :  -- :  -- .-- I  --
:  --
Indexation  I  :  ~  ~ 100%  indexation
..1  ~ + eVt. catch-up 0%  lndexatlon  ~  ~ indexation
~  Required  ~
: .-.i
~  indexation  reserve  i
N ominal  Indexed  Assets
liabilities  liabilities
i
TIJJH;HRIFT  VOOR CORPORA  TE FJNANCE  -JAARGANG  8,  2003,  NUMMER 3/4
.:..  "
...;THB POUCY LADDER:  A  FAIR  TOOL TO MANAGE PENSION  PUND RISK  E.  PONDS
3.  The  ladder  leads to a broadening  of the  risk-sharing  pension income  according  to the preferred  level related
capacity  of the fund  as retirees,  workers  and future  to final-pay  or average-wage.
participants  are involved  in the risk-sharing  process;
The  ladder  is  a collective  scheme  because  the  risks
4.  The  ladder  guarantees  that  the interests  are treated  regarding  future  înflation  and ratesof  return  are borne
in symmetry  of those who  paf contributions  and the  by  the  collectivity  of  active,  retired  and  future
participants  receiving  indexation.  participants.
5.  The  ladder  checks  for  fairness  as the  participants
take  part  in  the  risk  by accepting  indexation  risk  Eduard Ponds works  for ABP  Pensioenfonds,  stafrisicobeheet;
proportionally  to  their  accrued rights;  e.ponds@abp.nt
6.  The  ladder  mayalso  be  seen as a solution  to  the  NOTES
question  of ownership  of the pension fund  by stating
that  in case of discontinuity,  the assers of the fund  1  Compare  the following citation:  'Most economists  using a
are  distributed  amongst  the  participants  standard  life-cycle analysis  would probably agree  that the
proportionally  to  their  accrued  rights.  With  this  primary objective of a pension system  is to provide a stan-
rule,  it  is  always  obvious  to  who  the  funding  dard of living  in retirement comparabie  with  that enjoyed
shortage  or surplus  belongs.  during the working years',  in: Merton R.C. (1983): 'On
consumption  indexed public  pension  plans', in: Bodie Z.
& Shoven  J. eds.:  'Financial aspects  of the US pension  sys-
3  FROM  'PURE  DB'  TO  'HYBRID  DB/DC'  tem', Chicago University Press.
SCHEME
2  There maf be some risk in reality due to default risk of
By  introducing  the ladder,  the pension  plan  is moving  the sponsor.
away from  a 'pure  DB'  plan  towards  a 'hybrid  DB/DC'
scheme.  In a pure  DB  plan,  indexation  is always  giveri  3  The ratio of pension  liabilities  to total wages  is projected
whereas the contribution  rare absorbs the funding  risks.  to go up from the current 2.6 to 4.5 twenty years  from
By  introducing  the  ladder,  the  scheme  bas  ncw. A decrease  in the funding ratio of 1  % then would
characteristics  of a DC  plan  because funding  risks  are  require an additional contribution of 4.5% of salary in the
primarily  absorbed  by adjusting  the  indexation  rare.  future instead  of the current 2.6%.
Hence,  the  value  of accrued  rights  and  benefits  of all
panicipants  are volatile  as in a DC  scheme. At  the same  4  ABP regeling, ABP omvang,  ABO liabilities
time,  the  ladder  still  maintains  the  DB  character
because the  risks  regarding  future  inflation  and rates of  5  The volatility  in the yearly indexation rate maf give
return  are borne  by thecollectivity  of active, retired  and  ground to characterize  the scheme  as  a DC plan (see  para-
future  participants.  Also  ,it still  aims to realize  a target  graph 4).
I
TI~  VOOR  CORPORATE  FINANCE  4111.  JAARGANG  8, 2003,  NUMMER  3/4

The policy ladder as a fair tool to manage pension fund risk.

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Research Papers in Economics