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A Safari of DC SystemsDanger: 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%
01
23
4D
ensi
ty
0 .2 .4 .6 .8pension_liability__market_cap
Deficits
01
23
4D
ensi
ty
-.6 -.4 -.2 -5.55e-17 .2 .4pension_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
Vodaf one Group Plc
WPP Group
Amersham PLC
Compass Group
GKN
As traZeneca Plc
BG Group
P & O Princess Cruises
Northern Rock
Britis h American Tobacco
Dixons Group Plc
Scottish & Newcastle PlcCapita Group
Wolseley Plc
Centric a
Kingf isher Plc
Hil ton Group PlcHSBC Holdings Plc
Reckitt Benckiser Plc
J Sainsbury PlcBunzl
GlaxoSmithKline
Land Securi ties Plc
Smith & Nephew
TescoRolls -Roy ce Plc
Next Plc
Pearson Plc
Granada Group Plc
National Grid PlcMark s and Spenc er Plc
Reuters Group Plc
Alliance and Leicester
BAE Sy stemsBT PlcBradf ord & BingleyGus Plc
3I Group Plc
Imperial Chemical Industries Plc
Man Group Plc
Abbey National
Standard Chartered
Royal & Sun Alliance Insurance Plc
Cable and Wireless Plc
Anglo American PlcAllied Domecq PlcSix Continents
HBOS Plc
Inv ensy s Plc
Hay s Group
United Utilities PlcDaily Mail and General Trust PlcSc ottish Power Plc
Rentok il Init ial Plc
EMI Group Plc
Lattic e Group Plc
Barclay s PlcSevern Trent Plc
Roy al Bank of ScotlandBHP Bill iton Plc
Lloy ds TSB Group Plc
Bri tish Land Co Plc
WM Morrison Supermarkets Plc
Gallaher Group Plc
Scottish and Southern Energy Plc
Av iv a (f ormerly known as CGNU)
Safeway Plc
Cadbury Schweppes
Boots Company Plc
Bri tish Airways Plc
BOC Group Plc
Legal & General Group Plc
Unilev er Group
BP
Reed Elsev ier
Old Mutual PlcSmiths Group
Rio Tinto PlcHanson Plc
Prudential Plc
Imperial Tobacco Group PlcInternational Power Plc
Corus Group
Johnson Matthey
Diageo
Schroders Plc
Associated British Foods Plc
Exel
BAA PlcFriends Prov ident
0.2
.4.6
.81
equi
ty_s
hare
-.6 -.4 -.2 -5.55e-17 .2 .4pension_surplus__deficit___pensi
bandwidth = .8
Pension Risk
Pension Liabilities/Market Cap
Vodaf one Group Plc
British Land Co Plc
Reuters Group PlcLand Securities Plc
BG Group
International Power Plc
Compass Group
P & O Princess Cruises
Man Group Plc
WM Morrison Supermarkets Plc
WPP Group
Capita Group
3I Group PlcGlaxoSmithKline
Old Mutual PlcAs traZeneca Plc
Northern Rock
Next PlcHays Group
Smith & Nephew
BHP Bill iton Plc
Amersham PLC
Hilton Group Plc
Anglo American Plc
Standard Chartered
Legal & General Group Plc
TescoGus Plc
Dixons Group Plc
BunzlRentokil Initial PlcHBOS Plc
BPHSBC Holdings Plc
Reckitt Benckiser Plc
Rio Tinto Plc
Friends Prov ident
Wolseley Plc
Schroders PlcAbbey National
Bradf ord & Bingley
Diageo
Cadbury Schweppes
BAA Plc
Alliance and Leicester
Pearson PlcSix ContinentsJohnson Matthey
Prudential Plc
Kingf isher PlcLloyds TSB Group Plc
Reed Elsev ierGallaher Group Plc
Saf eway PlcScottish and Southern Energy Plc
Royal Bank of ScotlandAv iva (f ormerly known as CGNU)
CentricaCable and Wireless Plc
EMI Group PlcBarclays Plc
BOC Group Plc
National Grid Plc
Severn Trent Plc
British American Tobacco
Boots Company Plc
Associated British Foods PlcMarks and Spencer Plc
Granada Group Plc
Hanson Plc
J Sainsbury PlcScottish & Newcastle Plc
Imperial Tobacco Group Plc
Scottish Power PlcDaily Mail and General Trust PlcUnited Utilities PlcAllied Domecq Plc
Smiths Group
Unilever Group
Exel
Invensys Plc
Royal & Sun Alliance Insurance PlcGKNBAE Systems
BT Plc
Lattice Group Plc
Rolls-Royce Plc
Imperial Chemical Industries Plc
British Airways Plc
Corus Group
0.2
.4.6
.81
equi
ty_s
hare
0 1 2 3 4pension_liability__market_cap
bandwidth = .8
Pension Risk
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
0 20 40 60 80 100
Switzerland
Denmark
Australia
Canada
UK
Sweden
US
Hong Kong
Chile
Yes NoSource: Watson Wyatt GAS
Number of options typically offered
0
0
2
5
6
6
8
10
15
0 2 4 6 8 10 12 14 16
Denmark
Switzerland
Chile
UK
Hong Kong
Australia
Canada
US
Sweden
Number of choicesSource: 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
Nature of open plans
58%
4%1% 1% 1%
23%
5% 7%
0%
10%
20%
30%
40%
50%
60%
Finalsalary
Finalsalary
with DCunderpin
Final salary
with DC addition
Revaluedcareer ave
Cash balance
Occup’lDC
GPP Stakeholder
% o
f ope
n pl
ans
Current Occupational Pension Provision
Source: Watson Wyatt
Final salary plan becomes…
62%
15%
21%
3%
0%
10%
20%
30%
40%
50%
60%
70%
Occupational DC GPP Stakeholder Career ave
What type of plan, if any, was introduced after review
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.