"The Very Hungry Caterpillar,” Eric Carle's classic picture book, is one of the best-selling books in history. It tells the story of a tiny, yet voracious caterpillar that eats his way through all sorts of food, before eventually turning into a colorful butterfly. Besides teaching children basic skills like counting, the book also inspires them to think about the concept of transformation. While many pension professionals might have read the book as a child, they seem to have collectively forgotten about this important concept.
The life of a pension fund has two distinct phases: accumulation and decumulation, or payout.
A pension fund is extremely fragile in the decumulation phase. In it, the fund is much less likely to survive any shock that puts it into deficit.
Once a pension fund enters the decumulation phase, market volatility is dangerous even with long-term positive returns. Unexpected as this may sound, even when the fund is fully funded and it makes an average of 8% on its risky assets, it still faces a serious risk of not surviving the next 20 years.
Regarding the investment horizon, a mature pension fund — one close to or in the decumulation phrase — cannot be seen as a long-term investor. Even when a fund is fully funded and experiences good geometric returns over a longer period, things can still go wrong. Decumulation dynamics matter.
In a decumulation phase, applying higher discount rates or smoothing funding ratio figures obfuscates the risks, misinforms beneficiaries about the financial health of the plan and delays necessary actions.
Defined benefit pension promises with beneficiaries need serious redesign in a mature phase. If a fund has a considerable deficit, there should at least be no ambiguity about how the remaining assets are to be allocated over the various generations of stakeholders in the pension fund. This avoids an all-or-nothing situation eventually leaving whole generations without pension benefits.
The accumulation phase for most pension funds started after World War II with a relatively young population with a low average age of participants and few retirees. The second half of the 20th century was generally characterized by wealth accumulation. Positive returns on pension investments contributed to the strong growth in assets under management. The net inflow of contributions far in excess of benefits payouts made wealth accumulation almost natural.
The accumulation phase has two important features.
First, the fund is likely to expand rapidly, like the caterpillar during its feeding frenzy. In recent decades, growth actually has been so strong that the assets of many pension funds completely overshadow the value of their sponsor company.
A second feature is stability. Even if the returns on investment in any given year are disappointing, the net inflow of new money will ease the pain. In the accumulation phase, a pension fund is a robust, long-term investment vehicle with resilience and recovery potential, thanks to its human capital.
After decades of growing, our defined benefit pension system is moving into a decumulation phase. Demographics have accelerated this process, with the ratio of retired people to active people in a pension fund rising fast. Some mature funds already have entered the decumulation phase, many others will follow between now and 2020. Although the transformation might not be as sudden or spectacular as that of the caterpillar turning into a butterfly, the effects will certainly need to be reckoned with and will not be beautiful.
For example, a pension plan we stylized as a “sinking giant” has a funding ratio at 80% (using a risk-free discount rate to value liabilities) and requires a steady return of 3% above bonds in order not to fail. If the funding ratio falls to 60%, the necessary return would have to rise to 7% above bonds. Many pension funds in Western countries find themselves in such a position. Even a moderate shock — inevitable over a longer time — would then be capable of transforming enormous pension savings vehicles into uncontrollable sinking giants. But even when the fund is not underfunded, the situation might prove to be more fragile than expected.
To illustrate the thin line between survival and exhaustion, we consider a mature pension fund that is currently fully funded. The fund has decided to take investment risk as it wants to benefit from a positive expected risk premium. Half the assets are therefore allocated to risky investment categories, such as equity. The other half is invested in relatively risk-free categories, proxied by bonds. In our setup, we use the past 20 years of history of the MSCI World Total Return index, starting in 1990, for the future development of the risky assets. Bonds are assumed to grow at the same pace as the value of the liabilities.
Working with actual observed returns means we introduce volatility. It is often said that volatility of returns is not a problem, as long as the long-term returns are good. While this might be true for relatively young funds in the accumulation phase, it turns out to be false for mature pension funds close to or in the decumulation phase. Although perhaps counterintuitive at first glance, even with very good realized long-term returns, a pension fund that is fully funded today can be ruined.
The mature fund has completely different dynamics from a young fund. Such a mature pension plan could appear rock solid. But bad returns within a few years push the fund into a deficit. When the funding ratio falls below 100%, benefit payments have a further detrimental effect than when it is overfunded since positive returns impact a lower asset volume. Being in the decumulation phase, the net outflow of money further deteriorates the deficit.
With a funding ratio falling to 50%, an annual return of about 10% is required just not to slide any further. The fund is already in such a dire state that even seven years of excellent returns are not sufficient to bring about recovery. The fund remains very fragile. Then two or three years of negative returns completely destabilize the funding ratio. The fund is depleted.
Given the seriousness of the situation, one might think that the topics of decumulation and risk management of the funding ratio are on top of everybody's list. Unfortunately, they're not. Some practitioners deny the problem or believe that risks are overstated. In its Economic Survey of the Netherlands, June 2010, the Organization for Economic Cooperation and Development is in favor of using less volatile and higher interest rates (proposing AA-rated corporate bond curves) that reduce the present value of the future pension obligations, rather than the risk-free swap curve used by the Dutch. Changes in the swap curve were largely responsible for the drop in funding levels in recent years. The OECD report claims the higher rate would make pension funds look better if their funding ratio does not fluctuate too much.
The OECD report reads like a plea to conceal, rather than face the problem. Unfortunately, the OECD stance on volatility means that risk management strategies are discarded that might otherwise strongly reduce the effect of fluctuations.
Using higher discount rates does not make much sense in the decumulation phase. When a sinking giant is depleted, it eventually loses all of its assets. When that happens, the funding ratio is zero, regardless of any discounting method. The accounting method merely delays the message that the younger generations need to save for their own pension rather than rely on the existing system and that redesign of the current pension system is required.
Decumulation dynamics require more risk management and appropriate pension redesign than accumulation dynamics.
Theo Kocken is CEO and Joeri Potters a consultant at Cardano Group, Rotterdam, Netherlands.