Market Valuation, Pension Fund Policy and Contribution Volatility

Abstract

SummaryMarket valuation is becoming more and more popular, both in accounting and regulation, as well as in academic circles. For pension funds and their participants, the knowledge that marketvalued pension liabilities can indeed be transferred to a third party, if necessary, is a great virtue. Using a simulation model, this paper demonstrates the implicit costs and benefits of using market valuation for a typical Dutch pension fund, which offers a guaranteed average pay nominal pension with conditional indexation. The impact turns out to be fairly small, if fixed discount rates are still used for conditional rights. However, if market valuation is used for both unconditional and conditional rights, contribution volatility increases significantly. A remedy is to increase the duration of assets considerably. It is not clear, though, whether this option is available for large pension funds given the limited supply of long-term bonds.

Recovery measures of underfunded pension funds: higher contributions, no indexation or pension cuts?

“…The first strand consists of simulation studies. Van Rooij et al (2008), using a simulation model, show that market valuation for a typical Dutch pension fund (offering a guaranteed average pay nominal pension with conditional indexation) increases contribution volatility significantly if market valuation is used for both unconditional and conditional rights. Bikker and Vlaar (2007) present simulations showing that fully guaranteed indexation is virtually unaffordable, because the real discount rate is generally both very low and highly volatile.…”

Economic values of contribution cashflows for a sponsoring employer of a DB pension plan and measures to bring the economic costs under control within an affordable range

“…It should be noted here that market valuation of conditional benefits is problematic since the market-value of this conditional benefit increases along with the funded ratio of the plan [10]. Besides, if contribution rates are determined from the present value of the stream of expected benefit cashflows discounted by market risk-free rates, then the volatility of the contribution rates increases substantially and the economic cost of the contributions will become too much expensive for the sponsoring employer.…”

“…Besides, if contribution rates are determined from the present value of the stream of expected benefit cashflows discounted by market risk-free rates, then the volatility of the contribution rates increases substantially and the economic cost of the contributions will become too much expensive for the sponsoring employer. Thus one of the favourable points in introducing conditional benefits is that it enables a pension plan to set the contribution rates with relatively stable discount rates, taking into account the EER on the actual portfolio to some extent [10]. We will give further consideration to this point in Sect.…”

“…It is said that putting a fixed mark-up on the risk-free rate reduces volatility of contributions [10]. As shown in the previous sections, the maximum admissible markup can be determined by restrictions on the probabilities that the funded ratio hits the upper and lower boundaries defined by the targeted and minimum liability values, respectively.…”

Credit Crisis and Dutch Pension Funds: Who Bears the Shock?

“…In effect, by extending the recovery period from 3 to 5 years the Dutch government has postponed a decision on the option of directly cutting nominal pension entitlements. It should be noted that all projections in Table 1 are subject to considerable uncertainty (see Rooij et al 2008 for a stochastic analysis). In more optimistic scenario with a portfolio return of 8% rather than 5% (roughly one standard deviation higher) no rise in contribution rate would be needed at all.…”