Institutional investors: pension funds
17 important questions on Institutional investors: pension funds
What constitutes the principal assets in dutch household balance sheets? What makes it differ from other countries? What made house hold balance sheets come under pressure
- The principal assets in dutch household balance sheets exists of home ownership and pension wealth
- In most other countries pension wealth tends to be a lot smaller
- House holds balance sheets came under pressure by declining house prices and uncertain pension entitlements. (consumer confidence negatively affected and 1 million house owners under water)
Why do pension funds in a perfect world do not create value?
- There is a perfect labour market so any redistribution of financial claims will lead to wage claims (pension put is compensation for firm default risk) ???
- There is a perfect capital market so funding and asset allocation decisions do not create value ( risk management is a zero sum game)
Why do pension funds create value? What are the (dis)advantages pension funds have (against alternatives) (3 disadv. and 3 adv)
Intrinsic advantages of pension funds (against best alternatives):
- Savings on transaction costs, cost efficiency
- Better acces to capital market
- intergenerational risk sharing welfare enhancing
- Corrects behavioural biases (paternalistic motif, i.e. Helping people do something [the government thinks is right] they would not otherwise do – like building up pension savings)
Disadvantages
- Pension fund caters for representative participant, not the individual
- the "representative participant" may not be representative
- The pension contract is not complete (residual risk)
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- What are the cross-sectoral differences between a pension fund and a bank?
- What are the implications of the convergence of capital markets, banking products, and insurance market products?
- For a bank losses translated quickly into default, but for a pension fund (1) there is no immediate systematic risk or liquidity risk, (2) mark down pension liabilities is a measure of last resort (pension put), (3) pension put is not seen as a viable option. 2 an 3 ????
- The implications are that the price of risk is now a cross sectoral market (1) financial innovations facilities risk transfer ( 2) Pension funds mismatch risk is the reverse of banks?
Looking at the demographics and financial situation in the Netherlands, Is there a pension crisis?
- Lower ratio of workers per retiree ( old age support ratio declines)
- Life expectancy up
- Lower birth rates
Financial situation:
- fiscal sustainability of pensions paid by government
- shortfall between pension obligations and financial resources
What does the Dutch 3-pillar pension system look like?
- State pension ( general retirement benefits (AOW) --> Pay As You Go (PAYG)
- Collective pension scheme (Corporate or sectoral pension funds) --> Fully funded systems
- Individual pension savings ( tax-deductible savings or insurance schemes) --> fiscally supported private savings for old age.
Why is the fiscal sustainability of public pensions at risk?
- Public retirement schemes are largely pay-as-you-go systems (funded by payroll tax and intergenerational solidarity)
- Public liabilities for ageing exceed regular government debt
- Fiscal pressures as current sovereign debt crises makes pensions vulnerable
What are the remedies of the risk of the current pension system?
- Linke retirement age to life expectancy
- Raise old age support ratio (increase participation rate and more liberal immigration policy)
- Decrease benefits (decrease indexation)
- Increase taxes and premiums (also for retired?)
- Introduce means-tested benefits (eligibility based on financial means of individual, reduce or eliminate benefits for retirement above a threashold
What is needed in order to maintain full funding of pension funds?
- transparency, checks and balances
- balance between input (contributions) and output (pensions)
- adequate supervision
- contributions are invested, no affected by bankruptcy sponsor.
Name three characteristics of Dutch pension schemes: Why is participation mandatory (3 reasons):
Characteristics:
- Collective arrangement
- Mandatory participation for sector or profession
- Age independent average premium ('doorsneepremie')
Why mandatory:
- Economies of scale
- forces solidarity and avoids moral hazard that individuals expect the government to step in to ensure that elderly have sufficient means
- Avoids substantial risk of miss-selling
What is the difference between a Defined contribution and a defined benefit system? Name the risks of both and what system the current trend is.
- DB systems promises constant benefits. Risk of labour mobility, shrinking sector, or firm failure. current move from end wage to average wage.
- DC system based on constant contribution rates. Risks born by beneficiary, no liability or bonus for other beneficiaries.
Current trend is the DC system (world wide share of increased to 42%)
What does elements does Dutch pension regulation contain?
Assets and liabilities market-to-market valuation (liabilities discounted at actual market rates instead of fixed discount rate of 4%)
Funding ratio requirements (Assets / liabilities)
- Required ratio, including buffer 130%
- Minimum ratio > 105% (recovery period extended form 1 to 5 years)
- Stress test negative market scenarios
- maximum 15 years of recovery in exceptional circumstances
Why is a full funding of a pension important (in excess of 105%)?
- Underfunding has a price: 1.a High and volatile recovery costs: prevention cheaper than cure) 1.b uncertainty reduces consumption and increases savings
- Funding contributes to confidence in pensions (2.a confidence in the fact that pension funds will pay up, 2.b influences labour supply (facilitates retirement planning. 2.c encourages labour mobility (facilitates transfer of accrued rights)
- Funding is a hedge fro ageing society
Why are pension funds vulnerable to interest rate declines and why do net funding ratios decrease?
Interest rate declines
- GAP between duration assets (5 to 7 years ) and liabilities (15 years)
- Lowe interest rate implies liabilities > value assets
Funding ratio decrease:
- liabilities grow faster than assets (with hindsight contributions have been too low)
How to improve a funding ratio?
- No indexation
- contribution increases
- pension entitlement reductions if funding ratio substantially below 105%
- introduction of Ultimate Forward Rate(UFR) system. Maturities < 20 year market rate, maturities > 20 year market rates gradually decreasing role
Is the pension system in the Netherlands a solidarity system?
Yes,
- The principal of solidarity: now distinction between characteristics of participants (risks are shared, longevity risk, financial risk)
- Equal contribution for all employers (supports participation of older workers)
- Contribution of young participants has higher yield than of old. (arrangement between generations)
- Other solidarity (towards women and low educated)
According to a CPD study solidarity of the Dutch pension system is under pressure. For what groups in society?
- Freelances at mid-career (pensions to low 35%)
- Highly educated woman (pensions to high 23%)
- Low educated man quitting work half way (pension to low 54%)
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