NZZ on life tables

Influential Swiss daily Neue Zürcher Zeitung has quoted me on the subject of the appropriate choice of mortality tables for Swiss pension funds (here and here, both in German). Most Swiss pension funds still use period life tables rather than the more realistic cohort life tables (for a distinction see here - nothing useful on Wikipedia, but a nice Wolfram demo here). Cohort tables are preferable because they better reflect increased longevity, whereas period tables have to be adjusted manually. Given that longevity continues to improve, the use of period tables will give systematic advantage to the present pensioner cohort at the disadvantage of future cohorts.

The recently published "technical basis" BVG2010 makes available a set of cohort life tables for the first time. It would make sense for pension funds to adopt that new basis as soon as possible, despite the consequential nominal increase of their liabilities.

Swiss Pensions Conference

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The Future of the Occupational Retirement Act

The book Zukunft BVG (The Future of the Swiss Occupational Retirement Act) has just been published. I have contributed an article about the Prudent Investor Standard and its alleged implementation in Switzerland. The article will also appear in an abridged, English version in the forthcoming December issue of IPE, to which we will link as soon as it becomes available. Comments are very welcome!

Hedge accounting does not account for longevity hedges

Tuesday's ARG meeting was extraordinarily interesting, for it held a good and a bad surprise: Meeting the incoming IASB Chairman Hans Hoogervorst was a pleasant surprise, while discovering that the hedge accounting project underway will actually discourage longevity hedging if the standard were to stand as it currently does. This is a consequence of the proposed architecture of pensions accounting. Hence there appears to be no easy way out.

However, this outcome is deeply unsatisfactory and should be addressed. While there are not very many cases to account for at present, it would be unfortunate indeed if effective management techniques for the second most important risk facing pension funds were developed, only to be thwarted by accounting artefacts. Watch this space!

Save the dates!

I've been invited to moderate the closing panel at this year's Asset Management Forum on To beat or not to beat - The active vs passive investing debate on 1 September in Zürich. It would be great to see you at that event. You can register following the link above.

The next date to save is a little bit further out: 9 March 2011. This is the date of the Swiss Pensions Conference, the preparation of which I am heavily involved with. You can watch the progress of those preparations under that link.

EU Green Paper

The Commission has published its impatiently expected Green Paper towards adequate, sustainable and safe European pension systems today. The scope of the paper is very broad indeed, questioning the basics of the current EU pension legislation except - ostensibly - member states' responsibility for pensions. While initial reactions focus on incumbent battlefields such as solvency regimes for pension funds and retirement age, I would not be surprised at all if the intended discussion were soon to turn towards more comprehensive harmonisation, especially given the objective of adequate and sustainable pensions in the light of most member states' evident inability so far to reform their pensions systems sufficiently to rise to the double challenge of demographic shifts and inevitable fiscal austerity.

EFRP has started its own EU Pensions Debate website. It will be interesting to monitor the yield of the four month consultation period.

Pooling

This nice illustration of the consolidation continuum that stretches from informational to comprehensively organisational is taken from the Aegon white paper on asset pooling. The paper is as good an overview of the issues involved as white papers go.

Cross-border IORP growth slowing

In its third Report on Market Developments, CEIOPS provides an update of recent developments in cross-border pension funds. Net growth has dwindled to a mere 9% in the reporting period. Notably, there were 4 discontinuations of cross-border activities of IORPs. The report includes little conclusive evidence of the reasons for the slow growth. In particular, the discontinuations were not attributed to the regulatory framework, but anecdotally to reasons specific to the institution in question. Nevertheless, our assumption would be that the uncertainty surrounding the pending revisions of the pensions directive are certainly not encouraging strong growth at this juncture.

Linking pensions to longevity

The OECD has issued an interesting working paper Life-Expectancy Risk and Pensions: Who Bears the Burden?, which looks into a number of OECD countries' relatively recent policy changes to share part of the longevity risk with pensioners. Given the proportions of the risk and the massive inter-generational skew in cost/benefit, this is perfectly reasonable and should be adopted universally.

For some undisclosed reason, Switzerland is virtually omitted from the scope of the analysis, even though there clearly is no linkage between longevity risk and pensions whatsoever. In the Swiss three pillar system, longevity risk is borne in the first pillar by the tax payer, by employers in the second, and by individuals in the third pillar.

Farewell America

Bank Wegelin's most recent investment commentary by the same title is remarkable. It provides an extensive explanation of the US taxation risks involved when investing in US securities as a non-US person. The fact that the status of US-person is left (intentionally?) unclear is of particular concern to Qualified Intermediaries (i.e. foreign banks) because they assume liability for their clients' putative tax liability. This is the reason why Wegelin is actively advising its clients to exit all US securities and may not sign the more rigorous QI Agreement. Wegelin's move receives particular attention in Switzerland because its Managing Director is also Chairman of the Swiss Private Bankers Association.

Non-US pension funds (and listed entities) may be eligible to an exemption from a new 30% compulsory withholding tax on US securities held by non-US companies, as explained by the Green Book.

Discounting pensions

The IASB proposes to modify the discount rate applicable to the valuation of pension liabilities in IAS19. The proposal would eliminate the requirement to apply government bond yields instead of high quality corporate bond yields where there is no deep and liquid market for such securities. The proposed modification is triggered of course by the massive expansion of the spread between corporate and government bonds in the wake of the crisis, which serves as an excuse for yet another instance of accelerated due process...

While I agree that applying government bond yields to discount pension liabilities makes sense in only a very limited set of circumstances, and definitely not as a generic fall-back position in the absence of a deep corporate bond market, the proposed discount rate suffers one important flaw. The Board argues (BC4) that comparability is served by reducing the range of rates used. Yet, the motive for not just fixing a single rate (maximum comparability in that sense) is probably that this would not reflect economic reality in any sense. But this purpose is not served by choosing high quality corporate bonds, either. What if the reporting entity is not of high quality (which is the rule rather than the exception nowadays)? The liability is overstated.

The economically correct discount rate to apply to the valuation of pension liabilities in my opinion is WACC. Cost of capital is calculated for each entity separately and thus cannot be compared uniformly, but it reflects the economic reality of financing decision making. As an analyst knowing about the many arcane ways in which pension liabilities are valued, I don't take the nominal amount of pension liabilities at face value anyway, so that comparison is of little interest.

No return on closing DB plans

The July/August issue of FAJ has an intriguing article looking at empirical evidence of whether freezing DB pension plans would increase company value. Since cost and volatility impact on earnings are the justifications most often referred to for closing DB plans, the default expectation should be that it would. Yet, the authors cannot find any significant evidence of that.

They have been looking at the price reaction in four different event windows of 82 US announcements of frozen / closed DB plans between 2003 to 2007 in various industries. Interestingly, there seems to be a correlation between closure events and the generic business cyclicality of the firm's industry sector. Event firms exhibited stock market underperformance compared to their peers in the years leading up to the event.

Results indicate no systematic empirical evidence for positive abnormal returns associated with DB plan freezes / closes. Separating freezes and plan closures exhibits a small, yet unexpected diversion: Plan freezes generated a negative abnormal return, whereas the (small) sample of closures (for new employees) produced a more pronounced positive return.

In sum, it seems that DB pension plan closures / freezes tend to be short-term, ineffective measure adopted by managements to counter performance pressure.

Victims IV: The real crisis

The Economist deserves praise for having featured a special report on the impact of ageing populations in this time of crisis, which overrides longer term requirements with its fiscal profligacy. The majority of industrialised countries were already on an unsustainable fiscal path before the crisis struck. It is difficult to see how government finances will ever be able to return to a trajectory that is stable longer-term.

It goes without saying that the foreseeable instability of public finances has a dramatic impact on capital funded retirement systems. At this juncture, the jury is still out on the prefix of instability, i.e. whether we will see inflation or deflation. Either way, the contradictory demands on the investment strategy of individual funds are anything but trivial and may need to be implemented consistently in very short order once the dust settles. Scenario analysis and preparation is the name of the game. I look forward to a workshop producing a Shell/Oxford-method scenario analysis on Switzerland 2030, to which I have been invited by the federal crisis management education unit.

Impact of accounting and prudential regulation on pensions

"A long-term view involves short-term risk, whereas a short-sighted strategy involves increased risk over the long term."

EDHEC just released its impressive report Impact of Regulation on the ALM of European Pension Funds. Even though we disagree in some instances, we think this is mandatory reading for anyone in the pensions investment space because it highlights those areas of regulation which will be of increasing consequence for pension funds' investment strategies in the near future, as we have continued to stress over the recent past.

At the core of the report is the development of an asset allocation model in the presence of liability constraints. The solution involves the components cash, risky assets and the liability hedging portfolio. The state of the art model takes inflation and longevity risk management into account as well.

There is not enough space nor time for an in-depth review of this valuable piece. Nevertheless, I would like to mention two issues that have slightly moderated my enthusiasm for the report:

• There seem to be a few at least implicit factual inaccuracies in the parts describing the regulatory environment. The most glaring of which may be the assumption that the EU pensions directive is applicable in Switzerland - it is not.
• Accounting standards seem to be understood to effectively determine investment action. While it is not unheard of that managements structure transactions in such ways as to optimise their reporting, this clearly goes one step too far. We are well aware of the interdependence between perception (qua accounting standards) and (economic) reality, but at least in an academic report, the latter needs to retain some vestige of predominance over the former. Remember: pension funds' long-term time horizon, as accounting standards can and do change.

The tyranny of the present

In a recent issue of its flagship publication Sigma, SwissRe described Scenario analysis in insurance, identifying scenario analysis as a key tool to analyse fat-tail risks and their impact on profitability and competitive position of insurers. One of the pioneering sources of scenario analysis is the approach developed by Shell. Whereas scenario analysis is referred to as a key tool for both strategic planning as well as enterprise risk management of insurance, Sigma reports with some degree of astonishment that banks do not use it to assess their total enterprise risk exposure.

Applying the concept of scenario analysis to pension funds should be self-evident, not least if you think of a pension fund as the insurance subsidiary of your firm. It faces a set of opportunities, threats and parameters quite similar to those of an insurance, yet scenario analysis is not common in the pensions industry. Nevertheless, a number of pensions-specific scenarios easily come to mind: a jump in longevity due to unexpected medical progress, prolonged negative real interest rates, a pandemic (as explained in Sigma), regulatory changes to the competitive landscape ...

The Economist Intelligence Unit has just come up with its own bleak exercise in scenario analysis (hat tip Global Guerrillas). Its central forecast of stabilisation is assigned a probability of just 60%, whereas the more disruptive instability scenarios are assigned 30% (de-globalisation) and 10% (collapse in USD) respectively. Scenario analysis has been posted as a means to escape the tyranny of the present, but being where we are today, we are not so sure this is a good thing.

CEIOPS State of Pensions Report

CEIOPS' Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors has a good section (starting p. 22) about recent developments in the European pension funds market, giving insights into last year's changes in a number of countries and a statistical overview, based on Eurostat.

CFA Institute Code for Pensions

The CFA Institute has published a Code of Conduct for Members of a Pension Scheme Governing Body. The Code is intended to guide the behaviour of individuals sitting on governing bodies of pension schemes worldwide (ASIP has contributed, among others), which is why its principles are worded rather generically (see IPE story). Go to the comments section for more detailed explanation.

I find Fi360's Periodic Table of Standards of Excellence to provide a great complementary overview of best practice.

Pensions webcast

In yet another effort to increase its accessibility, the IASB makes its first ever recorded webcast about its recent pensions DP available to the public on its pensions project site. The webcast had about 120 participants and the included Q&A session was rather good.

I think that the IASB ought to add public webcasts to its ongoing projects due process. The ease of (global) participation and dialogue would enhance the reach of the IASB's due process to a new group of users (of financial statements) which was hitherto unreachable due to lack of time and attention.

Multilocal pensions?

While not at all intended for that particular function, the McKinsey Quarterly Managing Cross-border Functions is a useful stimulus to consider the different organisational options in setting up a pan-European pensions operation. Clearly, the regulatory context may play a more prominent role than in many other industries, but this is not a qualitative differentiator.

Don't miss!

On Thursday, 27 March the IASB is going to release its long expected discussion paper on post employment benefits. Don't miss IASB member Steven Cooper's live web presentation introducing the discussion paper from 1200h to 1230h (UTC). You can register for the event here.

It may be interesting to compare the IASB's position to the previously released paper of the UK ASB on the same topic. My guess is that the ASB's position will prove to be more aggressive, especially with regards to the highly controversial use of risk free interest rates to discount pension plan liabilities.