An Actuarys Perspective on Pension Deficits

1
An Actuarys Perspective on Pension Deficits

• 10 March 2005

Bob Boeckner, F.S.A., F.C.I.A. Principal, Mercer
Human Resource Consulting
2
Extract from the Eighteenth Report of The Monitor
of Stelcos Restructuring February 4, 2005

• The solvency deficiency of the four pensions
  plans as at December 31, 2004 is estimated to be
  1.279 billion.
• The going-concern deficiency of the four pension
  plans as at December 31, 2004 is estimated to be
  409 million.

Huh?
3
Article about Stelco Inc. discussing the Report
of the Monitor, Toronto Star, February 5, 2005

• The company estimates the solvency deficiency
  from the four plans is 1.279 billion at the end
  of 2004, up from 1.059 billion in 2003.

4
Quotes from the Office of The Superintendent of
Financial Institutions

• At the end of 2002, 47 of the plans supervised
  by OSFI were in deficit.
• At the end of 2003, the percent had increased to
  53.

5
Certified General Accountants Addressing the
Pensions Dilemma in Canada

• At the end of 2003, the total deficit of
  Canadian defined benefit pension plans could be
  about 26 billion or could be about 240 billion.

How can there be such a large range?Which number
is correct?
6
Lets step back and consider how a pension plan
operates

• A typical pension plan starts with the basic
  assumption that a member will work until a
  specified retirement age, e.g., 65, and then
  receive an income for the rest of their life.
• Either the income to be provided is specified (a
  Defined Benefit plan like the Stelco ones
  mentioned in the newspaper) or how much money
  will be set aside to purchase the pension is
  specified (a Defined Contribution plan).

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Can have many variations

• A member can retire early or may postpone
  retirement.
• The Defined Benefit paid may depend on
• the members earnings at the end of their career,
  or
• their earnings over their total career, or
• it may be calculated as x per month times the
  number of years they have worked for that
  employer.

8
To pay the members pension, the plan must have
an accumulated amount of assets

• The assets may result from contributions from the
  employer only or they may be contributions from
  both the employer and plan members.

9
Fundamentally a pension plan is a mathematical
construct

• The actuarys job is to develop a model of the
  pension plan and determine whether, at a specific
  point in time, the accumulated assets are greater
  or less than the value of the amounts to be paid
  to the plan members.
• Then the actuary estimates what contributions are
  required to be paid into the plan.

Sounds simple.
10
How does the actuary do this? Many things to
consider ...

• Lets start with a factor we call mortality.
• This determines how many pension payments a
  retiree will receive.

11
You may have heard of a concept called life
expectancy

• The actuary analyzes statistics on rates of death
  involving thousands of pension plan members and
  concludes the average life expectancy for a male
  member of a pension plan, aged 65, is 17.9 years
  while for a female plan member, aged 65, the
  average life expectancy is 21.3 years.

What does this tell the actuary?
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Average life expectancy

• You could conclude that if the plan has 1,000
  male members who retire today at 65, they will
  get pension payments for 17.9 years until age
  82.9 and then all die on the same day.
• Or if the plan has 1,000 female members who
  retire today at 65, they will get pension
  payments for 21.3 years until age 86.3.

13
Average life expectancy

• This is a bit simple, but note that if each plan
  member gets the same dollar amount of annual
  pension, a plan with all female members would
  need more assets to provide pensions than one
  with all male members, because the females are,
  on average, expected to live longer.

14
Average life expectancy

• Not all 1,000 plan members will die on the same
  day.
• Some may die tomorrow at age 65 plus 1 day and
  some may live to age 105!
• What average life expectancy really means is that
  you take the number of years everyone in the
  statistical sample lives, add them up and divide
  by the number of people you started with.

15
What really happens is that you have a
distribution of ages at death

• One of the actuarys jobs is to estimate what the
  distribution will be for a particular pension
  plan so we can estimate how many total pension
  payments will be made.
• Distribution could look like...

or
16
Lets go back to the simple approach to discuss
some of the factors the actuary has to consider
in addition to mortality

• Lets assume our plan has 1,000 males, age 65,
  who will receive a pension of 30,000 a year for
  their life expectancy of 17.9 years.
• Thus, the plan will be paying out 30,000 x 1,000
  x 17.9 537,000,000.
• If the plan has 1,000 females, then the payout
  will be 30,000 x 1,000 x 21.3 639,000,000.

You can see why it is important to know how many
males and how many females are in the plan.
17
Some plans provide that the initial pension will
continue as long as the plan member lives and
when he or she dies, the plan will pay 60 of the
initial amount to a surviving spouse as long as
they live

• Now the actuary has to consider how many plan
  members have a spouse and what the relative ages
  of the partners are so he can estimate how long
  the spouse will live.

18
Again, for simplicity, lets assume none of the
plan members has a spouse

• We said 1,000 males age 65 will receive a total
  of 537,000,000 in payments.
• But since the payments are made over a number of
  years, the pension plan assets can be invested
  until a particular payment is to be made and earn
  investment income in the meantime.

So we dont need 537,000,000 in the bank on the
day our 1,000 males reach age 65 and retire.
19
Just to demonstrate that mathematically, lets
say we start the year with 537,000,000 in plan
assets, and we pay each pensioner 30,000, for a
total of 30,000,000

• We take the remaining 537,000,000 - 30,000,000
  507,000,000 and invest it at 5 to earn
  507,000,000 x 0.05 25,350,000.
• So we end the year with 532,350,000
  (507,000,000 plus 25,350,000) but only have to
  pay out 30,000 x 1,000 for 16.9 years or a
  remaining total of 507,000,000.

20
The actuary will calculate the amount required
when our 1,000 males turn 65 that, if invested at
5, will provide each pensioner with 30,000 a
year for 17.9 years and have zero left at the end

• In fact, this is a major part of the actuarys
  jobto determine at any point in time what amount
  is required to pay the promised benefits.

This amount represents the liabilities of the
pension plan.
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Assets and liabilities

• Pension plans have liabilities. They also have
  assets resulting from the contributions of the
  employer and, perhaps, the plan members, as well
  as the investment income earned by the fund of
  assets.

22
Where does a surplus or deficit come from?

• Lets say our 1,000 employees all start working
  for their employer at age 45.
• We could calculate how much needs to be set aside
  for each of the next 20 years so that at age 65
  the assets of the plan have accumulated to the
  amount required to pay the benefits.

23
Now lets consider the situation 10 years later,
i.e., all 1,000 members are now age 55...

• We could calculate the value of the liability at
  that point, i.e., how much will be needed 10
  years before retirement which will grow at 5 to
  produce the amount required at retirement.

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We can also look at the assets that have
accumulated from the contributions

• If the fund has earned 5 and all the required
  contributions have been made then the assets
  should equal the liability.
• If the assets have earned more than 5, the plan
  has a surplus.
• If the assets have earned less than 5, the plan
  will have a deficit.

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We can also look at the assets that have
accumulated from the contributions

• In fact, not all 1,000 members will have survived
  to age 55. The actuary will have made an
  assumption in that regard as well.
• If more people are still living than originally
  forecast, the plan will have a deficit.
• If more people have died than originally
  forecast, the plan will have a surplus.
• Its a bit morbid but, for a pension plan, more
  deaths than expected can be a good thing!

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Remember the Stelco quotation ...

• Solvency deficit is 1.279 billion.
• Going-concern deficit is 409 million.

What is the right number?It all depends ...
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One major difference would be the assumption
about investment income

• The solvency investment assumption is prescribed
  by regulators and assumes that todays low
  interest rates on bonds will continue forever.
• The going-concern calculation assumes the plan
  keeps going and total investment returns over
  time will increase back to historical levels.

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One major difference would be the assumption
about investment income

• In solvency calculations we may assume a rate of
  return of 5 whereas the going-concern assumption
  might be 6.5.
• A 1 change in the interest assumption could
  cause the liabilities to change by 12 to 15, or
  even more if there is a high ratio of retired
  employees to active employees.

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Rates of return

• Using historical averages for rates of return
  will smooth the volatility in a plans surplus
  determination.
• Can lead to results for a particular year that
  are hard to explain.
• For example, the OMERS plan just reported an
  excellent investment return for 2004 of 12.1,
  but a surplus of 509 million at the end of 2003
  became a deficit of 963 million at the end of
  2004.

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Rates of return

• Change reflects market losses suffered in 2001
  and 2002 that are being smoothed over five years.

31
Some other factors to consider ...

• How many of our 1,000 members at age 45 will
  stick with their employer to retire at age 65?
• Salary inflation if pension based on compensation
  in last 3 to 5 years before retirement.
• Inflation after retirement, if plan allows for
  post-retirement indexing of benefits (like CPP
  and OAS do).

32
Impact of indexing

• The indexing assumption was the critical factor
  in the numbers I quoted earlier from the CGA
  publication.
• If assume no benefit indexing between valuation
  and retirement and no indexing after retirement,
  then total defined benefit plan deficit would
  be26 billion.
• If assume full indexing pre- and post-retirement,
  then total defined benefit plan deficit would be
  240 billion.

33
Impact of indexing

• The report used full indexing before retirement
  for final salary plans, flat benefit plans and
  total career earnings plans and less than full
  indexing after retirement resulting in total
  defined benefit plan deficit of 160 billion.

34
Impact of early retirement

• We have assumed all retirements occur at age 65.
• However, most plans allow members to retire any
  time past age 55.
• Lets consider someone who retires at age 60
• Now instead of average life expectancy of 17.9
  years or 21.3 years (depending on the gender),
  the average life expectancy will be over 22 years
  for a male and around 26 years for a female.

35
Impact of early retirement

• If the pension to be paid at age 60 is the same
  30,000, the plan needs more assets to make the
  same payments over the longer period the member
  will be retired, and there are fewer years over
  which to accumulate the required assets.
• Alternatively, could reduce the payment to be
  made so the amount of assets required remains the
  same.

36
Adjust for actual retirement age

• Thus, part of the actuarys job is to
• estimate what the actual retirement age of the
  plan members will be,
• determine the appropriate adjustment to make to
  the pension to be paid, or
• if the benefit is not reduced by the full
  appropriate amount, determine the additional
  amount of assets that will be required, and the
  required additional contributions.

37
Ontario has a particular requirement when
calculating solvency liabilities

• Assume that if a plan winds up and a member has
  age plus service of at least 55, will get any
  enhanced early retirement benefits in the plan.
• In addition to the investment return assumption,
  this is another major factor in the difference
  between the two Stelco deficit numbers
  (going-concern and solvency).

38
Regular valuations

• Given all the factors that must be considered,
  the actuary needs to estimate the plan
  liabilities regularly to take account of any
  changes in
• benefits,
• mortality,
• investment returns, and
• average age at retirement, etc.
• Regulations require this to be done at least
  every 3 years many large plans calculate their
  liabilities annually (OMERS is an example).

39
Trend in investment returns

• For many years in the 1990s, investment returns
  were high and exceeded the actuarial assumptions.
• Plan surpluses resulted.
• More recently, investment returns have been low
  because stock values are down and interest rates
  at fairly low levels.

40
Example of investment returns
Median return Mercer pension database.
Interest rates decreasedfrom 6.75 (January
2000)to 5.5 (December 2004).
41
Two-edged sword

• As a result, asset values of pension plans are
  lower than anticipated.
• At the same time, low interest rates lead
  actuaries to conclude more money will be needed
  to pay benefits and therefore liability values
  increased.
• Two-edged sword has caused many plans to move
  from surplus position to deficit position.

42
Trend in the assets and liabilities of a typical
Canadian plan
Assets
Liabilities
Decline in interest rates
Poor returns
Source Mercer Pension Health Index
43
What to do about the deficits?

• Employers put in more money?
• Plan members put in more money?
• Reduce benefits?
• Hope economy changes?

44
Simple answer is for employer to put in more money

• What if business environment is difficult?
• Employer could put in more money now and when
  situation turns around, be unable to recover it.
• Legal requirements may apply.

45
For example ...

• Going-concern deficits must be funded over no
  more than 15 years.
• Solvency deficits must be funded over no more
  than 5 years.
• Under the Bob Rae government, 5 large pension
  plans including Stelco and Algoma Steel were not
  subject to 5-year requirements but had to pay
  increased premiums to the Pension Benefit
  Guarantee Fund.

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For example ...

• This was cancelled for Algoma Steel and is to be
  cancelled for Stelco.
• Federal authorities have allowed Air Canada to
  fund their solvency deficiency over 10 years,
  with conditions such as no benefit improvement
  without government permission.
• Note Canada Revenue Agency has limits on
  employer contributions to plans with a surplus.

47
Would members prefer to put in more money or have
benefits reduced?

• This often is an issue in negotiated
  multi-employer plans.
• Where to reduce benefits?
• older members - reduce early retirement
  subsidies.
• younger workers - delay eligibility.
• retirees - eliminate post-retirement indexing.

48
What improvements in economic factors would be
required?

• Mercer research has determined
• that if no special contributions, would need
  annual return of 10 (15 on equities) for 8
  years to reach 100 funding.
• to amortize current deficits over 5 years would
  require contributions in excess of 10 of payroll.

49
Actuary has duty to employer and plan members

• May develop several scenariossome aggressive
  some conservative.
• We are not fortune tellers!
• Compromise generally required.

50
Some interesting ways to deal with pension plan
deficits

• Employee and employer contributions vary
  depending on surplus/deficit.
• OMERS plan for example
• Employer/employee matching contributions.
• No contributions in 2002.
• Reduced contributions in 2003 (446 million,
  about one-third normal level).
• Full contributions in 2004 (1.4 million).

51
Some interesting ways to deal with pension plan
deficits

• OMERS plan for example
• Full contribution rates in 2004 (employee and
  employer).
• Normal retirement age 65 60
• Earnings up to 40,500 6.0 7.3
• Earnings above 40,500 8.8 9.8
• Defined benefit base with defined contribution
  addition.
• Benefit improvements depend on surplus status.

These affect liabilities.
52
Some interesting ways to deal with pension plan
deficits

• On the asset side, could change the asset mix to
  be less dependent on equities or use hedging
  techniques particularly if large portion of
  liabilities relates to retirees.

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To sum up how a pension plan works
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To sum up

• A pension plan surplus or deficit is determined
  based on an actuarys estimate of a number of
  factors.
• The law of large numbers allows an actuary to
  make an estimate of the total amount required to
  cover all reasonable eventualities and pay the
  benefits promised.
• As the actual experience regarding each of the
  factors emerges, surpluses can become deficits
  and vice versa.

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To sum up

• Part of the actuarys job is to suggest courses
  of action to deal with the variation of actual
  experience from expected.