A Safari of DC Systems Danger: wild guarantees
Mike Orszag May 2003 Safari Orientation
• DB not riskless for individuals. • Some forms of DB indeed may be riskier for individuals than traditional DC plans (change of job, job tenure) • DB not secure unless backed by government guarantees DB Guarantees in the UK
• Pensioners paid first • Others paid next
Example: pension scheme 75% funded, 50% of liabilities pensioner liabilities Pensioners are paid in full, others get 50% of benefits Level of Exposure to Risk
• FTSE100 returns for 2001 • Pension liabilities / market cap: – average = 40% in 2001 – 8 companies over 100% 4 3 2 Density 1 0
0 .2 .4 .6 .8 pension_liability__market_cap Deficits 4 3 2 Density 1 0
-.6 -.4 -.2 -5.55e-17 .2 .4 pension_surplus__deficit___pensi
2001 FTSE100: £11bn By end of 2002 much, much worse (£170bn in equities in 2001) Exposure
• Pension liabilities relative to market cap is one measure – Elasticity is -0.26 – statistically insignificant from 0 • Pension deficits relative to pension liability is another – Elasticity is -0.13 – again statistically insignificant Pension Surplus/Pension Liability
Pension Risk
1 Granada Group Plc
Dixons Group Plc WM Morrison Supermarkets Plc Vodaf one Group Plc HBOS Plc BG GroupGlaxoSmithKline3I Group Plc Diageo Friends Prov ident ScottishNext & NewcastlePlcHay s Group Plc BAA Plc .8 CentricaAbbeyR NationalBritish enSafeway t okBOC il LandI nit Group ialPlc Co Plc Plc CapitaHiltonBunzlJ Sainsbury Group GroupCable PlcPlc and WirelessPrudential PlcSchroders Plc Plc SmithAllianceBradf & Nephew ord and Sev& Scottish LeicesterBingley ernBP Trent and Plc Southern EnergyExel Plc Compass GroupHSBCBT HoldingsRoy Plc alSc &Lloy Plc ottishSun ds Alliance TSBPower Group PlcInsurance Plc Plc NorthernRolls-Royce RockGusAnglo PlcDaily BarclayAmerican PlcCadbury Mail s RioPlc andPlc SchweppesTinto GeneralJohnson PlcA ssociatedTrust Matthey Plc British Foods Plc KingfMarks isherBAE PlcSystemsand SpencerAv iv a (fPlcHanson ormerly Plc known as CGNU) AmershamGKN PLCTescoNationalAlliedSix UnitedGrid EMIContinents RoyDomecqGallaher Plc Group alUtilitiesUnilev Bank Plc PlcGroup er of Plc Group Scotland Plc ReckittPearson Benckiser Plc PlcReed Elsev ier .6 Land SecuritiesBHP Plc Bill iton Plc Reuters GroupLattice LegalPlc Group & ImperialInternationalGeneral Plc Tobacco Group Power Plc Group Plc Plc British Airway s Plc Britis h AmericanInv Tobacco ensy s Plc WPP Group Man Group Plc Sm ithsCorus Group Group AstraZenecaWolseley Plc Plc Old Mutual Plc .4 equity_share Standard Chartered Imperial Chemical Industries Plc P & O Princess Cruises .2
0 Boots Company Plc -.6 -.4 -.2 -5.55e-17 .2 .4 pension_surplus__deficit___pensi bandwidth = .8 Pension Liabilities/Market Cap
Pension Risk
1 Granada Group Plc
WMDixons Morrison Group Supermarkets Plc Plc VodafHBOS one Plc Group Plc BGGlaxoSmithKline3I Friends GroupDiageoGroup Plc Prov ident NextHaysBAA Plc Group PlcScottish & Newcastle Plc .8 BritishRentokilAbbeySafCentrica LandBOC eway NationalInitial CoGroup Plc Plc Plc Plc CapitaHiltonBunzlSchrodersPrudentialCable GroupJ Sainsbury and Plc PlcPlc Wireless Plc Plc SmithBPBradfAllianceScottish Sev& ord Nephew ern and&Ex and BingleyTrent elLeicester Southern Plc Energy Plc CompassHSBCLloy dsHoldingsScottish Group TSBRoyal Group PowerPlc & Plc BTSunPlc Plc Alliance Insurance Plc NAngloGus orthernRioCadburyJohnson BaPlcTinto AmericanAssociated rcl DailyRock ay PlcSchweppes Matthey s MailPlc Plc British and General Foods TrustPlc PlcRolls-Roy ce Plc KingfAvMarksHanson iv isher a (f ormerlyand Plc Plc Spencer knownBAE PlcSy as stems CGNU) AmershamTescoSiRoyalGallaher xEMINational C on UnitedAlliedGroup UnilevBank t inPLC Group en GridDomecq t Plc sUtilitiesof er GroupScotlandPlcGKN Plc ReckittPearsonReed Benckiser Elsevier Plc Plc .6 LandBHP Securities Billiton Plc Plc ReutersInLegal tern ati & onaGroup ImperialGeneral l Po Plc wer TobaccoGroup Plc Plc Group Plc Lattice Group Plc British Airway s Plc British InvAmerican ensy s PlcTobacco ManWPP Group Group Plc Smiths Group Corus Group OldAstraZenecaWolseley Mutual Plc Plc Plc .4 equity_share Standard Chartered Imperial Chemical Industries Plc P & O Princess Cruises .2
0 Boots Company Plc 0 1 2 3 4 pension_liability__market_cap bandwidth = .8 Public Awareness
• Watson Wyatt/YouGov survey of 2989 individuals (May 2 – May 6) of which 862 are members of DB pension • Do you know what would happen to your pension if your employer became bankrupt? • My pension is protected and I would keep all that I have saved (44%) • My pension is partly protected and I would keep some of what I have saved (3%) • I could lose all my pension unless I have already retired (5%) • My pension is not protected at all and I could lose all that I have saved (2%) • Don't know (46%) % of DC funds which offer a choice
Chile Hong Kong US Sweden UK Canada Australia Denmark Switzerland
020406080100 Source: Watson Wyatt GAS Yes No Number of options typically offered
Sweden 15
US 10
Canada 8
Australia 6 Hong Kong 6
UK 5
Chile 2
Switzerland 0
Denmark 0
0 2 4 6 8 10121416 Number of choices Source: Watson Wyatt GAS Overseas Bond Investments Asset Allocation DC Assets DC Plans
• Lots of talk about risk in DC and it is there… but DC plans are often guaranteed…. • … and there are many types of guarantees: – Guaranteed interest rates – Guaranteed annuity rates (Equitable Life) – Smoothing (implicit guarantees) – Guarantees offered by governments • … so a vast majority of DC assets in Europe are in funds which have guarantees DC Plans in the UK
• UK is complex • Flat pension (full pension currently about £80/week) • Minimum Income Guarantee + pension credit • Many types of DC – occupational, personal, contracted-in, contracted-out Current Occupational Pension Provision
Nature of open plans
60% 58%
50%
40%
30% % of open plans 23% 20%
10% 7% 4% 5% 1% 1% 1% 0% Final Final Final Revalued Cash Occup’l GPP Stakeholder salary salary salary career ave balance DC with DC with DC Source: underpin addition Watson Wyatt Final salary plan becomes…
What type of plan, if any, was introduced after review 70% 62% 60%
50%
40%
30% 21% 20% 15%
10% 3% 0% Occupational DC GPP Stakeholder Career ave
Source: Watson Wyatt, 2002 UK Personal Pensions
• Stakeholder pensions (max. charge 1%) • Tax relief (max( £3600/year, age-related percentage of income) • Mandatory annuitisation by age 75 • …. Up until recently with profits 50% or more of business With profits
• Reversionary bonuses • Terminal bonuses • Case of Equitable Life Switzerland
• 1985 BVG • Minimum contributions 7-18%, value increased at minimum interest rate (historically 4%) • Many employers historically chose DB provision for BVG Denmark
• 4-7% contribution rate • Little if any investment choice for individuals • Most products are minimum interest rate guarantee insured products Denmark
Grosen and Jorgensen, Journal of Pension Economics and Finance, 1(3), 2003 Germany
• Vehicles: book reserves (50%), Pensionskassen (20%), insurance contracts (15%), new pension funds • 0% guarantee on new funds, other guarantees on existing funds • Government guarantees on book reserve Guarantees are Expensive
• Guaranteed Interest Rate Problems: Denmark, Japan, Switzerland, UK • Guaranteed Annuity Rates: UK • Solvency Guarantee Problems: Finland
• How expensive? Lots of opinions. Smetters (JPEF), Haberman (2002), Mitchell et. Al. (2002) are indications of how expensive things might be. Cost of Interest Guarantees
• DB is just DC with interest rate equal to aggregate wage growth (career average) or individual wage growth (final salary) • DC with minimum guarantee might involve more risk to guarantor if interest rate is not much lower than wage growth Valuing Guarantees
• Haberman (2002) has done a variety of formal analyses – option pricing approach • Grosen and Jorgensen (2001, 2002) • Smetters (JPEF, 2002) – overfunding not effective in reducing the cost of the guarantees Lessons from the Safari
• Avoid guarantees • Poorly structured guarantees are interesting to look at … when visiting another country • If used need to be structured very carefully. Costs could be immense.