Modelling long term interest rates for pension funds Michel - PowerPoint PPT Presentation

Modelling long term interest rates for pension funds Michel Vellekoop Netspar and the University of Amsterdam Actuarial and Risk Measures Workshop on Pension Plans and Related Topics University of Piraeus, October 2014 Joint work with Jan de Kort Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 1 / 22

Overview Provisions for funded pension system Inter- and extrapolation problems for long term discounting Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 2 / 22

Overview Provisions for funded pension system Inter- and extrapolation problems for long term discounting Extrapolation using an ultimate forward rate assumption Alternative formulations Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 2 / 22

Overview Provisions for funded pension system Inter- and extrapolation problems for long term discounting Extrapolation using an ultimate forward rate assumption Alternative formulations Conclusions & Future Research Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 2 / 22

Motivation In collective funded pension schemes which provide annuities at retirement, the participants share Interest rate Risk, since price of funding long-term liabilities depends on current term structure in market-consistent approach Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 3 / 22

Motivation In collective funded pension schemes which provide annuities at retirement, the participants share Interest rate Risk, since price of funding long-term liabilities depends on current term structure in market-consistent approach Equity Risk, when proceeds are partially invested in stocks in an attempt to compensate for inflation in pension payments Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 3 / 22

Motivation In collective funded pension schemes which provide annuities at retirement, the participants share Interest rate Risk, since price of funding long-term liabilities depends on current term structure in market-consistent approach Equity Risk, when proceeds are partially invested in stocks in an attempt to compensate for inflation in pension payments Longevity Risk, since expected remaining lifetime at pension age is currently increasing over time. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 3 / 22

Motivation Risk sharing over different generations makes sense for the first two risks, if we believe that economic cycles may generate lucky and unlucky generations in investments: Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 4 / 22

Motivation Risk sharing over different generations makes sense for the first two risks, if we believe that economic cycles may generate lucky and unlucky generations in investments: Pension of older generations is not reduced immediately in bad economic times (dampening of effects of underfunding) Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 4 / 22

Motivation Risk sharing over different generations makes sense for the first two risks, if we believe that economic cycles may generate lucky and unlucky generations in investments: Pension of older generations is not reduced immediately in bad economic times (dampening of effects of underfunding) Buffers above what is needed for indexation of existing pensions are kept for younger generations (dampening of effects of overfunding) Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 4 / 22

Motivation Risk sharing over different generations makes sense for the first two risks, if we believe that economic cycles may generate lucky and unlucky generations in investments: Pension of older generations is not reduced immediately in bad economic times (dampening of effects of underfunding) Buffers above what is needed for indexation of existing pensions are kept for younger generations (dampening of effects of overfunding) Longevity risk is currently unidirectional and highly correlated across ages so diversifying risk over generations seems less effective. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 4 / 22

Motivation Pension fund may thus provide a collective risk-sharing contract over generations which cannot be found in the marketplace. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 5 / 22

Motivation Pension fund may thus provide a collective risk-sharing contract over generations which cannot be found in the marketplace. Agreement on valuation principles essential for fairness of collective schemes: Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 5 / 22

Motivation Pension fund may thus provide a collective risk-sharing contract over generations which cannot be found in the marketplace. Agreement on valuation principles essential for fairness of collective schemes: Being overly optimistic in valuation is beneficial for older participants (and for pension fund managers ?) Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 5 / 22

Motivation Pension fund may thus provide a collective risk-sharing contract over generations which cannot be found in the marketplace. Agreement on valuation principles essential for fairness of collective schemes: Being overly optimistic in valuation is beneficial for older participants (and for pension fund managers ?) Being overly pessimistic in valuation is beneficial for younger participants (and for regulators ?) Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 5 / 22

Motivation Incorporating market information whenever possible is useful in the search for objective criteria. But bond prices and swap rates are not available beyond a certain maximal maturity. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 6 / 22

Motivation Incorporating market information whenever possible is useful in the search for objective criteria. But bond prices and swap rates are not available beyond a certain maximal maturity. Even before that maturity, illiquidity in long-term fixed income products may make informatio on higher maturities considerably less reliable. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 6 / 22

Motivation Incorporating market information whenever possible is useful in the search for objective criteria. But bond prices and swap rates are not available beyond a certain maximal maturity. Even before that maturity, illiquidity in long-term fixed income products may make informatio on higher maturities considerably less reliable. In times of severe market distress, even shorter maturities may not give consistent information. Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 6 / 22

Motivation Incorporating market information whenever possible is useful in the search for objective criteria. But bond prices and swap rates are not available beyond a certain maximal maturity. Even before that maturity, illiquidity in long-term fixed income products may make informatio on higher maturities considerably less reliable. In times of severe market distress, even shorter maturities may not give consistent information. Concrete subproblem in this talk: how can we use market prices for fixed income products to generate discount curves that extrapolate beyond maturities for which reliable information is available? Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 6 / 22

Approach of European Insurers To generate official discount curves European insurance regulator EIOPA uses information from coupon bonds or swap quotes for maturities up until 20 yrs Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 7 / 22

Approach of European Insurers To generate official discount curves European insurance regulator EIOPA uses information from coupon bonds or swap quotes for maturities up until 20 yrs a given constant asymptotic value (UFR) for forward rates after 60 yrs Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 7 / 22

Approach of European Insurers To generate official discount curves European insurance regulator EIOPA uses information from coupon bonds or swap quotes for maturities up until 20 yrs a given constant asymptotic value (UFR) for forward rates after 60 yrs interpolation (up until maturity 20 yrs) and extrapolation (from 20 to 60 yrs) Michel Vellekoop (University of Amsterdam) Long term rates for Pension Funds Piraeus, October 2014 7 / 22