Application of Canadian Pension Plan Solvency Standards

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1 Application of Canadian Pension Plan Solvency Standards Introduction The Canadian Standards of Practice broadly apply to any arrangement that provides retirement income irrespective of whether it s funded or not, whether it s registered or non registered or whether it s a private sector or public sector plan 1. When giving advice on the funded status or funding of an ongoing Canadian Registered Pension Plan 2, Canadian actuaries typically prepare a going concern valuation and a solvency valuation 3. Solvency valuations are characterized by their recognition of benefits accrued to date and their use of discount rates based on current market conditions. While ongoing valuations are primarily designed to manage a funding program, solvency valuations are primarily informative 4. Solvency valuations help users understand how well funded a plan is in relation to benefits earned to date and in relation to funding levels of other plans. Solvency valuations can measure the value of benefits earned by employees in the current year, an important component of total compensation. Additionally, a comparison of ongoing and solvency valuations can provide insight into risks being taken in support of the ongoing funding program. Agents who manage pension plans on behalf of stakeholders, in Canada and elsewhere, can make better decisions about benefit design, risk taking, compensation, funding and investing when they are armed with the information delivered by solvency valuations. This article is broken into two major sections: Part One: Canadian Pension Plan Solvency Standards In part one, we outline the methodology behind the determination of the solvency discount rate. Although other assumptions (e.g. mortality) are important, this article focuses primarily on the economic assumptions as the magnitude of these assumptions outweigh all others significantly. Second, we explore the applicability of Canadian solvency standards to determine the usefulness to key stakeholders in that country. Part Two: Application of Solvency Standards outside Canada Solvency valuation concepts are not uniquely Canadian. The importance of the issues addressed by these valuations has led to similar plan measurements in other countries. In the U.S., solvency concepts have driven funding and accounting standards for private sector plans. One major U.S. public sector pension system has been reporting solvency type measures of assets and liabilities for almost a decade. Another major public system is in the process of measuring plan liabilities on a hypothetical termination basis for comparison with the market value of plan assets. 1 Standards of Practice ( ) do not apply to non-hybrid defined contribution plans, Registered Retirement Savings Plans (RRSP s), pension plan benefits guaranteed by a life insurer and social security programs (e.g., Canada/Quebec Pension Plan or Old Age Security). 2 In general, arrangements must be Registered under the Canadian Income Tax Act and regulations in order to receive preferential tax treatment. Analogous arrangements in the US are called Qualified plans. 3 A Solvency valuation is constructed as a hypothetical wind-up as required by law. Since the two terms are often used inter-changeably, for our purposes, we will collectively refer to them as a solvency valuation. 4 In selecting the discount rate for going-concern valuations, Actuaries may either use the expected investment return on pension plan assets or reflect the yields on fixed-income investments. Going concern valuation specifics are beyond the scope of this paper. Please see for more details.

2 Part One: Canadian Pension Plan Solvency Standards In part one, we outline the methodology behind the determination of the solvency discount rate; we then explore the applicability of Canadian solvency standards to determine the usefulness to key stakeholders in that country. Description of Canadian Solvency Calculation Methodology Earlier this year, the Canadian Institute of Actuaries (CIA) Committee on Pension Plan Financial Reporting (PPFRC) provided guidance on the assumptions to use in preparing solvency valuations in We provide an overview of the economic assumptions below; please refer to the May 2012 Educational Note for greater detail 5. The PPFRC collected non indexed pension data from eight Canadian life insurance companies who agreed to provide confidential quotes using pricing conditions at December 31, Here are the key highlights surrounding the data collection process and tabulation: The average of the three most competitive quotes using the UP94 generational mortality tables was used. Data was separated between retirees and deferred vested members. Quotes were separated into two blocks of business: large purchases (total premium greater than $15 million) and small purchases (total premium less than $15 million). After consideration, the guidance was simplified such that one rate would apply to both immediate and deferred annuities irrespective of the overall size. Solvency Discount Rate: Long Term GoC Bonds + 90 bps The data compiled on actual purchases of non indexed group annuities (during December 2011) resulted in an average spread of roughly 90 basis points (bps) over the unadjusted Government of Canada (GoC) marketable long term bond yield 6 (CANSIM series V39062): Long term GoC bond yield: 2.41% Spread 0.90% Discount Rate (prior to rounding) 3.31% The long term GoC yield decreased from 2.41% to 2.25% at June 30, If the solvency discount rate were to be updated, it would have decreased to 3.15% (2.25%+0.9%). Practitioners are allowed to round the resulting discount rate to the nearest multiple of 5, 10 or 25 bps as long as consistency is maintained. Informative Value to Canadian Pension Plan Shareholder or Stakeholders Before we investigate whether these solvency figures are useful to the key stakeholders of Canadian pension plans, we first distinguish between principals and agents. Agency theory defines the individuals with skin in the game as principals. It is their pocketbooks that will be impacted from the economic activity in question. Our principals often include the shareholders of insurance companies and corporations that sponsor pension plans, lenders and employees. The managers, who act on behalf of shareholders, are called agents; they make decisions that impact the principals pocketbooks. In the public pension arena, taxpayers, plan participants and municipal bond buyers are the principals or stakeholders. There are numerous agents in the public plan system first tier agents, who serve specific 5 Please see 6 This is the average yield over 10 years.

3 principals, include: elected officials on behalf of taxpayers, union officials on behalf of employees and bond rating agencies to serve municipal bond buyers; second tier agents, such as actuaries, accountants, money managers, asset consultants, and others with narrower duties, are not so clearly aligned with specific principals. In many jurisdictions around the world, the traditional actuarial process is designed to develop a budget to recognize cash inflows in order that benefit promises are met. This going concern valuation process typically projects benefits assuming future increases in salary and service. This valuation also uses a longterm investment horizon with periodic (e.g., annual) budget updates which smoothly adjust inflows with respect to emerging demographics and financial experience. Four Additional Desirable Measures Solvency calculations belong to a family of similar calculations (e.g., hypothetical wind up, lump sum commuted value, etc.) all characterized by discounting accrued liabilities at market rates of interest. That is, a solvency type valuation of liabilities looks at benefits already earned and typically does not include future increases for pay and service. In concert with the market value of plan assets (MVA), this solvency valuation, in theory, provides valuable transparency to the principals, agents, lenders and the rating agencies that serve them. In late 2006, the Society of Actuaries and the American Academy of Actuaries jointly issued the Pension Actuary s Guide to Financial Economics 7. The guide identified three liability measures, one of which, solvency liability, is "determined by reference to a portfolio of risk free securities that matches the benefit stream in amount and timing. Our analysis assumes a pension plan with 50 year cash flows and duration (treasury curve) of 18.4 years, valued at a (going concern) discount rate of 7.75% results in a June 30, 2012 actuarial liability or present value of $100. Solvency valuations provide at least four valuable additional data points generally not answered by long term actuarial values, including: 1) Inter generational Transfers of Wealth: An assessment of whether future taxpayers are paying for services provided to current generations of taxpayers. Valuing the same cash flows stated above at a Canadian solvency discount rate of 3.15% results in a present value of $197.07; this suggests a wealth transfer from future generations (to the current generation) of $ ) Assumption Spread: The magnitude of the spread between 3.15% and 7.75%; this 460 bps spread anticipates a return for risk not yet weathered. 3) Market Value of Benefits Earned: The market value of benefits earned (i.e., the normal cost or service cost) in the current year is very pertinent because it quantifies an important component of every employee s total compensation. Further, this figure also provides insight into intergenerational transfers of wealth. 4) Comparison across Jurisdictions: An apples to apples comparison of funding levels and benefit security across jurisdictions. One non arbitrary solvency valuation consistently applied to all plans permits transparent comparisons. 7 Principal authors of the Guide include this paper s author. The Guide is now part of the syllabus for future Pension Fellows of the Society of Actuaries.

4 Actual Transparency in Canada is not perfect In theory, measurement typically leads to good management. We now explore whether additional solvency reporting, in practice, has improved the health of Canadian pensions or in some way changed or improved behavior. Most would agree that with respect to private sector plans, solvency valuations have resulted in accelerated funding {NEED SOURCE: Speak with Malcolm or Keith??}. But what about public sector pension plans? Fortunately, the Canadian Institute of Actuaries'(CIA) professional standards require disclosure of wind up liabilities (irrespective of whether the plan is required to fund on a solvency basis). This disclosure is potentially more useful than the solvency liabilities since it ignores the regulatory exclusions and smoothing adjustments that find their way into the solvency liability calculation. In the case of the Ontario Teacher's Pension Plan, there is a history of recognizing actuarial liabilities at market interest rates. Unfortunately, solvency valuation results are not disclosed to the public; although these figures are available to the regulator, plan sponsor and typically members (upon request), taxpayer groups would not have access. Many public sector plans have exempted themselves from Solvency rules. Of the exempt plans, some are required to include the solvency balance sheet in their reports (for information purposes) while others are not required to calculate their solvency liabilities at all. Lack of uniformity across jurisdictions, exclusions and adjustments (inadvertent or deliberate) in solvency liability calculations and alterations to the wind up liability calculation make it is difficult to understand the real financial condition of a Canadian public sector pension plan. In the absence of strong regulatory oversight, it maybe that actual transparency really occurs only when the major players (e.g sub prime crisis) are financially motivated to take the other side of the trade. In the U.S., we find the average discount rate across all state plans is 8.0% and the average assumed inflation rate is 3.5%; as such, the average real return assumption is 4.5% (i.e. 8.0% less 3.5%) 8. The range of real investment return assumption was 3.5% 5.5%. Although similar research in Canada does not appear to exist, we ask ourselves, why have Canadian public sector plans lowered their estimated real investment return assumption in the range of 3.0% 4.25%? {NEED SOURCE: Speak with Malcolm or Keith??}. When we investigate this discrepancy, we find it is extremely difficult to find cause and effect. One could speculate that this difference is due to additional solvency reporting in Canada. Another explanation might be that a greater number of public sector plans in Canada have employee cost sharing provisions suggesting members are more financially motivated first to understand the true economics and second, to make more informed decisions. More research is needed. 8 Source: Merrill Lynch (Latter) April 26, Pensions & Endowments 18: Public Plans take center stage. Alternative calculation for real return: (1.08)/(1.035) -1 = 4.35%

5 Part Two: Application of Solvency Standards outside Canada We now look at pension systems outside of Canada for similarities and differences. Although examples can be found in several European countries, we limit our comparison to the United States. With respect to U.S. private sector pension plans, we find linkages to market interest rates in the funding and accounting rules. As a result of amendments to ERISA under the Pension Protection Act (2006), funding valuations use a modified fixed income yield curve to compute liability values that ultimately determine contributions. The key economic assumptions incorporate an AAA/A corporate spread over treasuries, a three segment interest rate and 24 month historical smoothing of rates 9. Similarly, accounting valuations incorporate a AA spread over treasuries. Given the above smoothing mechanisms, credit spreads and consistent funding relief, it is not entirely accurate to characterize these approaches as pure solvency standards. Nevertheless, given the valuations properly characterize pension promises as debt like, the table below allows for an interesting comparison: Data as of: Implied Present June 30, 2012 Yield (%) Value Flat 7.75% 7.75 $ Flat 12% ERISA Funding (PPA) FAS 87 Proxy CANSIM V bps Treasury Curve CANSIM V Four Additional Desirable Measures when Interest Rates are Relatively High (e.g. 12.0%) Back in the 1980's, we witnessed double digit interest rates. In the above table, we assume observed interest rates in the market produce a solvency valuation rate of 12%.A Solvency valuation would provide at least four valuable additional data points as identified earlier. Specifically, with respect to the first three points: 1) Inter generational Transfers of Wealth: A 12.0% solvency valuation rate produces a present value of $66.42; in this scenario, current taxpayers are paying $33.58 too much (i.e., a wealth transfer to future generations). 2) Assumption Spread: The magnitude of the spread between 12.0% and 7.75%; this 425 bps spread quantifies the amount of conservatism in assumptions. One has to wonder if this information had been available to all stakeholders back in the 1980's would investment bankers have terminated corporate pension plans and captured the surplus. Would another layer of Rube Goldberg like regulations contained in the Tax Reform Act of 1986 been necessary? 3) Market Value of Benefits Earned: The market value of benefits earned in the current year calculated at a 12.0% solvency valuation rate would show that the employee s total compensation is much less than the analysis using current solvency rates. 4) Comparison across Jurisdictions: Same principles apply irrespective of level of rates. 9 Add comment on MAP21-25 year smoothing. For an in-depth data on the IRS spot and three-segment yield curve please see: &

6 Voluntary Applications of Solvency Valuations to U.S. Public Sector Pension Plans When we turn our attention to the U.S. public sector, we find that with respect to the vast majority of pension plans, only the long term actuarial accrued liability figures are presented in the comprehensive annual financial report (CAFR). This information alone is not sufficient to provide the four desirable measures identified earlier. Although solvency type measures are largely missing from these CAFRs, we explore two case studies of voluntary disclosures on both coasts of the United States. New York City Retirement Systems (NYCRS) For close to a decade, Robert C. North, Jr. Chief Actuary of NYCRS has voluntarily provided supplementary information 10. For example, pages 160 and 161 of the 2011 New York City Employees Retirement System CAFR show several measures of plan assets and liabilities. The first column on page 161, based on the actuarial cost method used, shows the traditional actuarial funded ratio of the plan i.e., Actuarial Asset Value (AAV) divided by Actuarial Accrued Liability (AAL) every year from June 30, 1999 through June 30, 2010 at a constant 100%. However, the rightmost column displays the MVA over the Market Value of Accumulated Benefit Obligation (MVABO). We see this ratio has declined from 138% at June 30, 1999 to 48% as of June 30, The equivalent discount rate (page 160) declined from 6.0% to 3.6% over this same period. More recent figures will show this discount rate in the 2% range. This additional information is more useful in measuring the plan s financial status by providing additional transparency that helps to satisfy the four desirable measures identified earlier. California Public employees Retirement System (CalPERS) In August 2011, CalPERS board accepted the use of investments intended to match the cash flows and a market based discount rate for the calculation of liabilities on termination of contracts by contracting agencies. In general, the discount rate reflects a weighted average blend of 10 year and 30 year Treasuries at the time of contract termination; this discount rate at June 30, 2011 was 3.8% 11. If rates were to increase to a level of 7.75%, the termination liability would approach the ongoing funding liability. It is interesting to note that the choice of a US Treasury curve (in conjunction with accrued benefits and no increase for future pay and service) better satisfies the definition of a solvency liability defined earlier. Second, an additional significant development was the decision by the CalPERs Actuarial Office to include a hypothetical termination liability in their annual actuarial valuation reports. This will ensure that stakeholders have access to information about solvency liabilities with the attendant benefits mentioned previously. Third, CalPERS Chief Actuary Alan Milligan, anticipates providing information about the impact on the hypothetical termination liability when determining the impact of plan improvements. Conclusion In closing, we find that with respect to the application of solvency methodologies: These valuations provide valuable additional information such that agents and the principals (they serve) are better armed in making key financial decisions in managing their pension plans. Although U.S. private sector plans do not calculate an analogous Canadian solvency figure, there are linkages to market interest rates found in the funding and accounting rules. The vast majority of public sector pension plans do not compute solvency type figures; however, we explore two examples of voluntary disclosures that assist in providing the four desirable measures identified. 10 See 11 Details of the discount rate and methodology are outlined in Attachment 3 to the August 16, 2011 Agenda item 4b. See

7 Gordon Latter, FSA, FCIA Special thanks to Annette Serrao and Eva Zhou of Ryan Labs Asset Management for preparing the figures used in report. {Thank reviewers too?}

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