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Fair Value Implications for the Asset Mix of a Pension Fund

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  1. Introduction: A pension fund in relation with akzo nobel
    1. Akzo Nobel
    2. Pension Plans
    3. Akzo Nobel Pension Fund
  2. Changing the valuation of pension plans
    1. The Pensions and Insurance Supervisory Authority
    2. Driving factors for reform in pension supervision
    3. New Financial Assessment Framework (FTK)
  3. Estimating the liabilities of the akzo nobel pension fund
    1. Considerations in estimating the present value of pension fund liabilities
    2. Estimating liabilities in practice
    3. The market value of pension liabilities
  4. Implications of market valuation on the asset mix
    1. Development of the funding ratio
    2. Simulation results
    3. Fair value compared to actuarial valuation
  5. Approaches to a stable funding ratio
    1. Increasing the level of fixed income securities in asset allocation
    2. Increasing the duration of the fixed income portfolio
    3. Cash flow matching
    4. Conditional indexation
    5. Portfolio composition
  6. Bibliography
  7. Appendices

Pension funds serve to collect and manage an amount of capital, sufficient to make all payments to which participants of the fund are entitled based on the pension plan. The Akzo Nobel Pension Fund
(APF) is responsible for the provision of pensions for all employees of Akzo Nobel in the
Netherlands. It is the task of the Pensions and Insurance Supervisory Authority (PVK) to provide
rules and regulations which guarantee that pension funds are able to fulfill their pension promises. In response to economic and demographic changes in the environment in which pension funds operate,
the PVK drafted a new Financial Assessment Framework (FTK) that is meant to become effective as
of January 1st 2006.

Essential in the new FTK is the fact that the pension liability resulting from a defined benefit pension plan has to be calculated using market value interest yields as discount rates as opposed to the
current practice which uses a fixed rate for discounting pension liabilities. The new FTK increases
the risk exposure of pension funds, since the value of the liabilities will depend on volatile interest rates. As a result, the volatility of the funding ratio of the pension fund will also increase compared
to the current situation in which the liability value is not influenced by changes in market interest rates. This thesis aims to analyze the impact of the new valuation method of liabilities on the asset allocation of the APF.

[...] Based on a term structure the present value of the liabilities of a pension fund can be calculated Implications of market valuation on the asset mix 5 Implications of market valuation on the asset mix 5.1 Introduction Chapter 4 shows that pension funds have to manage additional variance in the funding ratio as a result of the market valuation of the liabilities. Section 5.2 introduces a model for the analysis of the development of the asset portfolio. Given the development of the assets and liabilities over time, it is possible to analyze the funding ratio of a pension fund. [...]

[...] Figure illustrates that the addition of inflation linked securities does reduce the downside risk for the pension fund Probability density function of simulated funding ratio Funding Ratio Figure 6.5 .4: Comparison of the distribution of the funding ratio of the current asset mix to a mix containing inflation linked securities. Under the actuarial valuation method for liabilities investing in inflation linked securities is less attractive. Considering the fixed discount rate, the asset portfolio must generate a real return of to finance indexation. [...]

[...] The fluctuations in the funding ratio can be significantly decreased if the duration of the portfolio consisting of fixed income securities is increased (See figure 5.3 .4) Development of assets and liabilities after 1 year fixed income portfolio with duration 15 fixed income portfolio with duration 5 liability value Simulations Figure 5.3 .4: Simulations of asset developments for a portfolio existing completely of fixed income securities under different durations and liability development when inflation effects are ignored Implications of the market valuation on the asset mix Figure shows that in a situation where the duration of the fixed income security portfolio increases from 5 to 15, the effect of shifts in the term structure will affect liabilities and assets of a pension fund in a similar way. [...]

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