|
© Copyright 2000 Rogers Media. The following article first appeared in the April 2000 edition of
BENEFITS CANADA magazine.
Effective fiduciary communications
Pension fund trustees require long-term perspective and objective analysis from your reporting.
Communicating the right information is crucial.
BY ROBERT ADAMS
Communications to defined benefit pension fund fiduciaries should be sensitive to their principal concerns
and responsibilities. To do their jobs properly, they need clear, focused high-level information.
Unfortunately, fiduciaries (like the rest of us) are inundated with flavour-of-the-week mass media
investment commentary when long-term perspective and objective-related analysis are needed.
Trustees also face a broad array of statistics about the funds they oversee. For example, trustees must
deal with information about their fund's investment returns (by class and in aggregate), comparisons to
benchmarks, the asset allocation policy mix, the performance of individual managers, foreign content and
more. It's easy to see how one can lose sight of the trustee's principal objective--providing adequate
funds to pay pension benefits.
The problem with this seemingly endless menu of statistics is that it distracts attention from the fund's
overall financial health. Like any other business, a pension fund's financial health is measured by its
financial position and the effects of recent operations on that position. This focus can be achieved for
pension funds with two high-level measures.
The first of these measures defines the financial position as the fund's surplus (or deficit) as a
percentage of the liability. This single statistic goes to the heart of trustee responsibility, indicating
the size of either the funding cushion or shortfall (see "A measure of strength," above).
The second measure deals with the change in financial position since the last report. Essentially, this is
the result of operations--the net change in the financial position for the period. It is expressed as an
absolute percentage (positive or negative).
CHANGES IN LIABILITIES
Both these measures depend on up-to-date liability valuations. This is a bit tricky because formal
actuarial valuations are only prepared annually, or less often. Therefore, it is necessary to estimate
changes between the formal valuations.
Apart from new valuation assumptions, there are four main components to the annual change in valuation.
They are: the interest cost (determined by the discount rate) the current service cost; payments to plan
members since the last valuation; and employee contributions (if any). Information on the first three items
should be readily available in your most recent actuarial report.
Changes, or expected changes, in valuation assumptions present a bigger challenge. Still, they can be
estimated with acceptable accuracy. Just make sure that when estimating, you stick to consistent
proportionate relationships. For example, if a decrease in the discount rate of half a percentage point
produced a 6% increase in the liability in the last valuation, then you can estimate that a future 1%
increase in the discount rate will reduce the liability by 12%.
Changes in salary growth and inflation assumptions generally produce smaller effects. But they can be
estimated using the same approach. Changes in the underlying demographics of plan membership typically
occur slowly, and can be safely ignored between valuations, unless there is a significant corporate event
that would affect those demographics. Changes in the level of benefits provided by the fund are infrequent,
but they do require actuarial assistance to estimate.
THE FINANCIAL POSITION
The sidebar entitled "A measure of strength" demonstrates how a pension fund's financial position is
determined. If we assume that assets have grown to $4,358 million during the following quarter (without any
contribution), and the liability is now $2,740 million (see "The quarterly valuation estimation process,"
page 71), the surplus is now $1,618 million ($4,358 million - $2,740 million). That produces a financial
position of 59% ($1,618/$2,740).
This 11% increase in the financial position is the result of operations for the quarter. Obviously,
revenues exceeded costs. Or in pension parlance, the investment return was higher than the liability growth
rate. (Including the current service cost as an element of the liability growth rate provides a single
statistic for comparison with a fund's investment return.)
The rate of investment return during the quarter should be calculated in accordance with Association for
Investment Management and Research standards. For the purposes of this article, assume an even pattern of
cash flows during the quarter, and calculate the return as follows:
The rate of growth in the liability can be determined in essentially the same manner used to calculate
investment returns. Again, assuming that the payments were evenly distributed over the quarter, this rate
of growth is:
The sign (positive or negative) of the difference between the investment return and this liability growth
rate indicates the direction of change in the financial position percentage. If the two rates are equal,
the financial position statistic will remain unchanged.
But if the two rates differ, the financial position statistic will change by more or less than the
return/liability growth difference. This is because of the gearing in the financial structure.
In our example, the funding position increased from 25% to 28%, due to a 2% positive difference in
operating results, levered up by the gearing in the financial structure (see "The quarter's operating
results," page 71).
PUTTING IT ALL TOGETHER
The process used to estimate the liability valuation for the current quarter can be applied to the past to
develop a multi-year history of quarterly valuations. It can then be compared with the quarterly asset
values to calculate historical quarterly financial positions. This data can be presented graphically to
illustrate trends, and show the effect of major economic events (see "Putting it all together," page 69).
Funds may have target financial positions. If so, these can be incorporated into the graph to provide a
sense of progress or achievement. Trustees might also welcome knowing how much of the financial position
was at risk if the capital markets had collapsed. This can be done with an appropriately labeled single
point on the graph.
CRUCIAL POINT
Locating this point is simple. Calculate how much of the financial position would be eroded if the assets
lost twice the historical standard deviation of the portfolio mix. An alternative approach is to show a
financial position range based on two standard deviations above and below the actual return (see "Financial
position," page 69).
It is useful to follow this graph with the measure of operating results for the same period, as it provides
an explanation of the change in financial position.
It is also useful to include quarterly statistics on the policy return, and to identify the benefit of
leverage. If contributions improved the funding position during the quarter, their effect should be shown
separately.
Effective fiduciary communications are important to your pension fund. These measures are not intended to
displace other information provided to trustees, but to provide the starting point for the discussion of
each quarter's position and performance.
Robert Adams is senior manager of the Pension Fund Society at the Bank of Montreal in Toronto.
*** ***
What does it all mean?
"Could we have just one measure that tells the whole story?" That trustee complaint is an expression of
justifiable frustration at the variety of statistics presented in performance reports. Pension funds and
businesses generally need concise, focused information--not mounds of data.
Thinking of a pension fund as a business helps improve the value of trustee communications. The financial
position of a business is the result of its accumulated operating results. This familiar concept can be
easily applied and understood in the pension fund context.
*** ***
Financial position
The surplus or deficit of a pension fund's assets in relation to its liabilities is a useful high-level
measure of the fund's financial strength.
*** ***
A measure of strength
A defined benefit pension fund, with assets of $4 billion and liabilities of $2.7 billion, has a surplus of
$1.3 billion. This would be reported to trustees as a financial position of +48%. A deficit would be
calculated in the same way.
*** ***
Putting it all together
Operating results
Summarized operating results enable trustees to quickly assess the implementation and effectiveness of
their policy, and compare performance with other pension funds. An examination of operating results over
the three-year period ending Dec. 31, 1999, illustrates that policy and implementation have strengthened
the fund's financial position as the rate of investment returns exceeds the growth rate of its liabilities.
The overall change in financial position has two components: operating results (returns vs. liability
growth) and the effect of leverage on the rate of growth in surplus relative to liabilities.
|
Change in Liability + Payments - Contributions
|
=
|
40 + 40 - 0
|
|
=
|
80
|
=
|
3%
|
|
|
|
|
|
Initial Liability - 1/2 Payments + 1/2 Contributions
|
2,700 - 20 + 0
|
2,680
|
The quarterly valuation estimation process
Facts
-
Last valuation: $2.7 billion
-
Discount rate: 8%
-
Annual current service cost: $104 million
-
Employee contributions: nil
-
Payments to pensioners during quarter: $40 million
Estimated Valuation
-
Last valuation: $2.7 billion
-
Interest cost (@ 2%): $54 million
-
Current service: $26 million
-
Payments: $40 million
-
Estimated liability: $2.74 billion
The quarter's operating result
-
Investment return: 10%
-
Liability growth: 3%
-
Operating results: 7%
-
Leverage benefit: 4%
-
Improvement in financial position: 11%
|
News
News
