White Paper Planning Your Way Out Of The Financial Crisis

Planning your way out of the ­financial ­crisis A roadmap to derisking

Jeroen J.J. Bogers

Table of contents 1 Introduction  2 The ‘derisking dilemma’ – why the time is never quite right 3 The rising cost of risk  4 The impact of the credit crunch on sponsoring corporations 5 The roadmap to derisking  Conclusion  Acknowledgements Appendix 1 Pension funding ratio assumptions  Appendix 2 References and notes 

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3 4 6 7 11 16 17 18 19

1 Introduction Planning your pensions out of the crisis Few people could have foreseen the severity and impact of the present financial crisis. Back in 2007, the headlines were full of company pension plans moving into the black or reporting healthy reserves. One and a half years later, these same company pension plans are in the news again – this time with dire warnings of underfunding and the freezing of indexation. Pension fund trustees and regulators are pressing sponsoring corporations to increase pension contributions or to make large cash injections, and all the time the rising pension fund deficits are weighing down corporate balance sheets. Some pension fund managers will have seen the storm coming and reduced their risks, but many didn’t. The reasons for this are various, but the consequences have been painful. Why didn’t more corporations and their pension funds take the ­opportunity to derisk – and what can they do now?

This time, things are different This white paper looks at why pension funds have become such an important issue for CFOs and why companies – and pension fund trustees – should be planning to derisk their pensions. We show why the effect of the current crisis on pensions internationally differs from previous crises. Using a standardised multi-country pension model, we will explain how the changed corporate reporting regulations, combined with different national and international regulations, make it increasingly difficult for the CFOs of internationally operating companies to forecast and ­manage the impact of their pension funds on the corporate balance sheet.

Regaining control of the corporate balance sheet Paying particular attention to the UK, the USA and the Netherlands (some of the largest, most mature second pillar pension markets), this paper explores the effect of the financial crisis on the pension funds of multinational corporations, and the subsequent impact on the sponsoring ­corporations. In conclusion, we reveal how derisking can help corporations to regain control of their balance sheets and their pension funds, offer some useful guidelines on how to draw up an effective roadmap to derisking (making derisking more affordable in the process) and show which actions can – and should – be taken now.

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2 The ‘derisking dilemma’ – why the time is never quite right Pensions have not usually made for exciting reading material. Recently, however, pension funds have been hitting the news more than ever. For most CFOs ­concerned, this has not been a welcome development.

2008 headlines • USA – Retirement Blues: Financial crisis pulls billions from pension plans, ­crimping consumers’ dreams and corporate profits.1 • NETHERLANDS – The solvency crisis among Dutch funds is the most severe in the industry’s history. 2 • UK – UK funds drop 11% in October. 3 It is hard to believe how different things were in 2007 – with talk of increasing assets and shrinking deficits.

2007 headlines • USA – Improvement in U.S. chemical sector’s pension funding shortfall bodes well for credit quality.4 • NL – Shell gives itself pension contribution holiday.5 • UK – Pension deficits shrink by more than 90% in a year.6 • GLOBAL – Equity strength sees deficits cut to GBP 21bn.7 While some pension fund managers saw the gathering storm, planned ahead, and hedged8 their risks, many others didn’t. It is easy now to speak with the benefit of hindsight but a brief historical survey shows that many pension funds could have derisked more fully. So why didn’t more pension funds and their sponsoring ­companies take advantage of the opportunity while it was there?

Pension investment management – balancing short term volatility against long term returns Pension funding ratios improved dramatically in 2007, so why didn’t pension funds hedge their risks when they were able to do so? In addition to the fact that not all pension funds had success­ fully increased their funding ratios by the time the financial crisis hit, there is an important additional reason why pension funds were unwilling to hedge their risks – the derisking dilemma. This means that when ­derisking was affordable, it was not generally perceived as being desirable. In the current climate, however, derisking is seen as desirable but is also less affordable. Figure 1 illustrates this issue. The graph shows the funding ratio of a model pension fund over the last ten years, as affected by equity markets and interest rates over time.9

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Desirable

Funding ratio

Desirable

Affordable

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1999

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2001

Affordable

2002 Funding ratio

2003

2004

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2008

100%

Figure 1. The derisking dilemma Source: AEGON Global Pensions

If the funding ratio of a pension fund is high, derisking becomes more affordable. At such a time, however, it is very hard to persuade all the stakeholders to derisk, as equity markets are rising, interest rates are low and derisking seems expensive and unnecessary. Once equity markets start to fall, the desire to hedge risk rapidly increases, but the ability to fund derisking measures decreases.10 This dilemma highlights an issue of judgement and incentives – how should sponsoring companies and their pension funds approach risk? And how should they weigh up short-term gains against both short-term and long-term risks? What level of risk should sponsoring companies and their pension funds be willing to take with their pension schemes, and on what principles can these decisions be based?

Governance and commitment are essential Commitment is essential when hedging risks: if the moment is right but decision-makers cannot reach agreement, the window of opportunity will pass. Navigating between the different interests of the sponsoring company, the pension fund trustees and the pension fund members makes it even more difficult to hedge risks at the right time. In addition, it is not always easy to decide – or to explain – which risks are acceptable in order to generate returns, and which risks are no longer acceptable. For multinational companies, getting commitment is even more difficult, since pension fund governance is arranged differently in different countries, thus ­introducing extra complexity into the decision making process. It is therefore understandable that many sponsoring corporations have not derisked their pension funds, even if they had plans (or intentions) to do so.

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This paper is intended to help sponsoring companies to align all stakeholders in order to be able to derisk their pension fund at the right moment, and also to make derisking more affordable. It offers guidelines for determining the appropriate moment and appropriate level to derisk their pensions, and provides clear ­arguments for why derisking is essential in some cases but unnecessary in others.

3 The rising cost of risk Prior to the financial crisis, credit markets were liquid, risk was inexpensive and ­routine refinancing arrangements were common. This meant that large positions could be disposed of quickly. Investor focus shifted to short-term risk, and debt was seen as a residual of balance books. Companies that hoarded cash were seen as inefficient and viewed with suspicion. After the start of the financial crisis, the freezing of inter-bank liquidity forced the banks, quickly followed by the more highly leveraged companies, to scramble for cash. In doing so, they had to get rid of their debt holdings in illiquid markets, increasing the risk of default and lowering share prices in the process. In retrospect, corporate debt was traded at unrealistically low spread levels, while lending standards declined and excess leverage built up across the system. ­Essentially, Greenspan’s conundrum turned nasty.11

The bursting of another bubble: the risk premium of corporate bonds The effect of the newly acquired risk awareness shows itself in the exploding risk spreads above the risk-free rate, as shown in Figure 2.12 As the market price of the default risk of once highly rated companies increased sharply overnight, corporate borrowing became more expensive. At the same time, due to a flight to quality and the reduction of short-term central bank interest rates, the yield of long-term government bonds is now decreasing. As the spread between corporate bonds and government bonds has increased, it has become harder and more expensive for companies to borrow money, and revenues have been hit by higher interest payments. One can argue that the ­increase of this spread and the decrease of company equity values go hand-in-hand, as shown in Figure 3.13 The effects of the current market turmoil are clear: investors are demanding a higher risk premium for their investments and for debt from corporations, while the interest rate of government bonds is decreasing. The sudden changes in three core elements – equity returns, corporate bond yields and government bond yields – has had a dramatic effect on pension funds and their sponsoring companies on a global scale.

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8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 1998

1999

2000

2001

2002

2003

2004

Risk-free rate

2005

2006

2007

2008

AA corporate yield curve

Figure 2. Exploding risk spreads Source: MLX®

4.5%

4500

4.0%

4000

3.5%

3500

3.0%

3000

2.5%

2500

2.0%

2000

1.5%

1500

1.0%

1000

0.5%

500

0.0%

0 1998

1999

2000

2001

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2003

AA corporate yield spread

2004

2005

2006

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2008

MSCI World

Figure 3. Falling equity markets Source: Datastream

4 The impact of the credit crunch on sponsoring ­corporations 2008 headlines: • US – Companies will need to inject more than USD 100bn into their pension funds to cover market losses, putting them in a cash squeeze at a time when it is difficult to raise money.14 • GERMANY – Siemens AG, Europe’s largest engineering company, might have to make a cash injection into its EUR 2.5bn underfunded pension scheme if stock markets fall further, analysts said.15 • BELGIUM – Belgian pension funds achieve a negative return of – 15.5% over first nine months of 2008, forcing corporate sponsors to inject cash into their plans, according to consultant Mercer.16

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• NETHERLANDS – Listed companies with defined benefit pension arrangements may have to fork out millions of euros to make up for the present shortfall of their company schemes.17 • GLOBAL – Australian airline Qantas today identified problems connected to British Airways’ pension fund as one of the ‘significant matters’ that still need to be resolved before a merger with British Airways can be achieved. IPE understands concern about pension fund liabilities has also delayed progress on British Airways’ proposed tie up with Spain’s Iberia carrier.18

This time, it’s different Following the stock market crash of 2001, corporate CFOs did not yet have to disclose to analysts what was happening with their pension funds. Both FAS and IFRS accounting rules did not require reporting the funded status of a pension fund on the balance sheet. Pension funds were little more than a footnote in the annual report. Even if analysts checked this footnote, the funded status of a pension fund was buried under assumptions that could increase reported asset returns and decrease liabilities more or less at will.19 In addition, credit rates were relatively high and stable at the time of the stock market crash, effectively keeping liabilities low, and funding ratios more or less intact. The relatively stable spreads between government and corporate credits meant that the reporting and forecasting of pension funding ratios over multiple countries did not introduce many ambiguities for the CFO of a sponsoring company. Those days are over. Not only are local regulators demanding more stringent measures to decrease pension fund risk, but international accounting rules have also changed so that pension funding volatility is much more visible both on the balance sheet and in a company’s profit and loss statement. In 2009, pensions are a major concern for CFOs, since the funding shortfall of pensions is posted on the balance sheet as debt. 20 Even though many companies have tried to reduce their exposure to pension funds by closing Defined Benefit schemes, pension legacies (benefit rights that have been built up in the past) usually still represent a large part of the balance sheet of a pension fund. Sponsoring companies are therefore still continuously confronted with the volatility of their unhedged risks. On top of other issues, CFOs are now facing an additional problem: while their company’s stock value and revenues have been hit by a dramatic downturn in the economic cycle, the pension fund they sponsor has also been hit by the crisis and its funding ratio has dropped. As a result, many pension fund trustees are now demanding higher contributions from their sponsor, or even worse, immediate cash injections. Therefore, while the funding shortfall itself is (only) an accounting issue, the need for additional funding creates extra cash flow demand at a time when cash is already scarce.

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In a global world, pension fund regulation is still local The requests from pension fund trustees might come as an unwelcome surprise to some CFOs. The reason for this is that the sponsoring company may well value its liabilities differently from its local pension funds. This range of ways to account for pension liabilities combined with the unprecedented corporate bond spread impairs the CFO’s view of the actual pension funding ratio. Under FAS and IFRS, sponsoring corporations discount their liabilities against a high quality rate or AA rate bond curve. Since the AA bond curve has increased tremendously, as shown in Chapter 3, this has led to a decrease in pension fund liabilities. Funding ratios have therefore been mainly resilient or even increased, despite the downturn in the stock markets. Figure 4 shows this effect on the funding ratio of our pension fund model from Chapter 2 , now fully discounted at the increased discount rate of AA bonds. This funding scenario provides an example of how corporate

Funding ratio

entities view the funding ratio of pension funds.

1998

1999

2000

2001

2002

2003

2004

Funding ratio

2005

2006

2007

2008

100%

Figure 4. Funding Ratio under FAS/IFRS Source: AEGON Global Pensions

However, unlike accounting rules for corporations, pension scheme funding ­regulations are still a national matter. This makes it difficult to create a uniform account of the effects of the financial crisis on the combined pension funds of a multinational corporation. In Figure 5 the funding ratios of three similar national model pension funds (US, UK, NL), have been plotted. The funding ratios of these pension funds are valued using the reporting requirements of the national pension regulators. Depending on their regulator, these pension funds might either report that they are underfunded (NL), almost funded (UK), or fully funded (US). 21 This difference between national pension fund reporting and corporate accounting creates misalignment between perceived funding at corporate level and the actual call for funding at a national level. The unprecedented events on the credit markets and the subsequent consequences on pricing have effectively distorted the valuations of pension liabilities, highlighting the misalignment, especially for multinational companies.

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Funding ratio

\

1998

1999

2000

2001

USA Pension Fund

2002

2003

2004

UK Pension Fund

2005

2006

2007

2008

NL Pension Fund

100%

Figure 5. Funding ratio according to US, UK and Dutch local pension regulator Source: AEGON Global Pensions

Things will get worse before they get better Unfortunately, the mismatch between corporate balance sheets and local pension fund reporting is not the end of the story. It is useful to understand what will happen when markets return to ‘normal’ again. Using the model pension fund, we can make a simulation of the impact of such ‘normalisation’ on IFRS/FAS funding ratios, reported on the balance sheet of ­sponsoring corporations. Given a spread tightening to ten year averages over the next two years, as shown in Figure 6, and an average increase of the MSCI World of 10% annually, the IFRS/FAS funding status of the pension fund would still dramatically decrease from approximately 130% to 90% in two years, as shown in Figure 7. Because sponsoring corporations discount their pension liabilities against a high quality bond rate curve, the decreasing AA bond rate has a dramatic effect on the pension liabilities they

8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2000

2001

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2004

Risk-free rate scenario

Figure 6. Interest rate scenarios Source: AEGON Global Pensions

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AA corporate yield curve scenario

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Funding ratio 2000

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Funding ratio

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100%

Figure 7. IFRS/FAS funding ratio scenario Source: AEGON Global Pensions

report. Due to a mismatch in the liability duration, which works as a lever, this decrease more than offsets the increase in stock markets and government bonds. Given these differences between pension funding calculations and the increased influence of international accounting standards, sponsoring a pension fund has made balance sheet forecasting and control more difficult than ever.

5 The roadmap to derisking The financial crisis and the subsequent deterioration of pension funding levels have increased the importance of a core question: ‘Which risks should a pension fund take?’ In order to answer this question, pension fund stakeholders should first be aware of two things: 1. Know your limits 2. It is never too late to derisk

Know your limits Not all risk is bad risk. In the longer term, equity has more upward potential than risk-free bonds, and diversification can lower risk while retaining return. If a ­sponsoring company is willing and able to bear the risk of a sudden decrease in the plan funding ratio, then the long term risk premium on risky assets can structurally decrease pension contributions. However, if a company is not willing or able to bear this shortfall risk, it is better off to increase yearly contributions and lower pension fund risk, improving pension cost forecasting and balance sheet control in the process. For the sponsoring company, a large, unhedged pension fund represents a balance sheet liability and a potential cash flow risk that is very difficult to manage. In order to regain some balance sheet control, it is important to limit the maximum possible shortfall and to remove

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­unrewarded risks from the pension fund, while retaining its ability to provide ­pension benefits, once employees are retired.

It’s never too late to derisk Although most pension funds may not be able to afford derisking at this time, it is nevertheless the perfect moment to draw up plans and to reach agreement on how and when to derisk. In other words, now that pension funds and their sponsoring companies have the desire to derisk, they should make plans to do so for when it becomes affordable. In order not to become trapped by the affordable/desirable dilemma, it is essential to separate decision making from the execution of the decisions. Instead of having to go through the decision making process with a diverse group of stakeholders every time an opportunity presents itself or a crisis hits, the most important decisions should be made now. Execution can then be made dependent on predetermined factors that allow for long term planning and continuous ­commitment. The following guidelines are designed to support the sponsoring company in implementing such a forward-looking decision making process.

Decide Funding ratio

E xe

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e cut

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Figure 8. Separate decision and execution Source: AEGON Global Pensions

Guideline 1: Perfect timing is impossible. Plan for good timing instead In most circumstances, derisking instruments will cost money, and impact the funding ratio. However, history tells us that price has not always been the most important factor with derisking, but rather the commitment to derisk at the right moment. If all decision-makers are fully informed and in agreement, when a window of opportunity opens, the appropriate actions can be taken immediately, before the window closes. One way to achieve this is to plan a roadmap towards the desired risk level. This roadmap might consist of different elements for each country, since derisking options, prices and the determination of funding levels differ per country (as shown in

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Chapter 4). Pension funds are, in essence, long-term vehicles, and history also tells us that there will be times when a pension fund will once again have sufficient funding to derisk to the desired level. It is also important not to focus completely on perfect timing. There are so many different factors involved that perfect timing is impossible to achieve. Instead, companies should aim to establish which cost is affordable and reasonable, and plan to derisk at the point at which derisking is both reasonable and affordable.

Guideline 2: Agree on the targeted risk level now Both the sponsoring corporation and the pension trustees should be comfortable with the risk level that is retained. It is therefore important to agree on which risks should be hedged, the maximum allowed shortfall and its effect on both the pension fund and the key performance indicators of the sponsoring corporation. It should be noted that hedging risks at pension fund level does not always mean that this risk is also hedged at a corporate level, since reporting requirements might differ, as shown in Chapter 4. The most straightforward example of this is the fact that even if a Dutch pension fund has fully hedged its interest rate risk against the risk-free rate, it still represents an interest rate risk on the corporate balance sheet, as, in the Netherlands, pension liabilities are discounted against the AA bond curve. Volatility in spreads between the two will therefore also need to be hedged at a corporate balance sheet level in order to remove all interest rate risks.

Guideline 3: Derisk segments Especially now, not all pension funds and their sponsoring corporations can afford to derisk in a single transaction. However, it may be both possible and more ­efficient to derisk in stages, segmenting liabilities according to affordability over time while retaining solidarity between pension scheme members. In this way, derisking is carried out in manageable – and affordable – phases, according to a derisking roadmap. Risks in a pension fund can be split up into several major elements: • Market risk • Interest risk • Inflation risk • Longevity risk. The price of hedging risks changes over time and differs per member group (active members, deferred members, pensioners), or, on a more detailed scale, per age group (or cohort). By splitting the scheme’s liabilities into individual cohorts, and, for each cohort, reviewing which elements to derisk, risk can be identified and prioritised for removal, where it is most needed. As each layer

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Hedge deferred risk Hedge pensioners risk

Hedge inflation risk

Hedge market risk

Lower contribution

Hedge interest rate risk

Funding ratio

Increase contribution

Decide

Execute and communicate

Figure 9. Segmenting risks; an example Source: AEGON Global Pensions

of benefit is secured, investment gains can be ‘locked in’ and future funding volatility reduced. Figure 9 shows a non-exhaustive example of a possible derisking scenario. Different risks can be hedged at different stages from those shown in this example, depending upon circumstances and the characteristics of the pension fund.

Guideline 4: Set ambition levels In order to strengthen the commitment to the derisking roadmap, derisking levels should be agreed on beforehand. By using preset ambition levels, the decision ­making process is clear to all parties beforehand and ensures that derisking can occur quickly once a window of opportunity arises. Figure 10 shows an example of how ambition levels can be used to bring this into practice. Over the last ten years, the average interest rate has hovered around 4.75%. The pension fund stakeholders can decide to set the interest rate ambition level at that average: once the interest

Average interest rate 7,0% 6.5% Do not hedge 6.0% 5.5% 5.0% 4.5% 4.0% 3.5%

Hedge interest rate risk

3.0% 1998

1999

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EU Risk-free rate

2004

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Average interest rate

Figure 10. An example of using ambition levels Source: AEGON Global Pensions

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2006

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2008

rate mean reverts and is above 4.75% the trustees can start to hedge the interest risk to the desired risk level. The same approach can be used to determine the level of inflation risk or the level of market risk by setting an ambition level at – for instance – the cost of an inflation hedge and the price of put options on equity markets.

Guideline 5: Select providers early From the start, a consultant can expedite the decision making process, functioning as a knowledgeable mediator between the sponsoring corporation and the pension fund. In addition to consultants, providers like banks, insurance companies and asset managers should also be included early in the process. Providers can give you an overview of all opportunities, and help you determine the best pricing of the hedge at any given time. Some risk hedges, like longevity, are particularly difficult to price, and a good consultant or provider will be able to give you a price indication on a frequent basis. It is also important to involve a legal advisor from the start. Different derisking solutions might have different legal impacts, which should be fully understood before any decisions are made. A legal advisor can help you understand the ­possible limitations and timelines that a derisking construction might involve.

Guideline 6: Communication is key Once the roadmap is determined and there is agreement between all stakeholders, this should be communicated to all pension scheme members. This communication is an ongoing effort until the aspired risk level has been reached. It is essential to ensure that, once derisking is affordable, all stakeholders are still aware of why it was desirable in the first place. Continuous communication ensures commitment to this common goal.

The world changes, change with it While these guidelines will help in building a roadmap towards derisking, they should not be implemented rigidly. The world will change in ways we will not be able to foresee. This means that the roadmap will have to be reviewed on a frequent basis in order to keep pace with change. This can be done without impairing the effectiveness of this roadmap as long as the principles on which it is based are solid and are being followed. 

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Conclusion The guidelines in Chapter 5 do not offer an instant cure to the instabilities of today’s market, and the future will probably not work out as smooth as the example implementation in Figure 9. However, the guidelines do give insight into structuring a more risk/return efficient pension fund design and the way to attain it. Good governance is an essential element for making this work. Knowing the maximum risk a sponsoring company is willing and able to bear is fundamental. The segmentation of risks and the use of the long-term characteristics of a pension fund can help to make strategic decisions that benefit all stakeholders. So, what can you do now already? In sequential order, these are the first steps to take: • Talk to your consultant and preferred suppliers • Make an overview of your most important local pension funds and its stakeholders • Invite all important decision makers to the table • Decide on the corporate budget and redesign pension benefits within that budget • Agree on an aspired derisking level and ambition levels • Set a timeframe for derisking the schemes, with clear decision points • Implement a communications programme to support the employer and employees. And, over time: • Derisk according to pre-established ambition levels • Manage investment and longevity risks of retained risks • Manage the pensions budget in order to reduce expenses and maximise funding.

As markets recover, balance sheet control can be restored Markets will rise again and they will also experience further highs and lows. ­The pendulum of affordability and desirability has swung towards desirability – but the pendulum may finally have stopped. This time, the pension fund environment has changed in such a way that its ups and downs are visible to everybody. By using knowledge available now, it is possible for companies to use the swing towards affordability to their advantage, and to regain control over their corporate balance sheet.

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Acknowledgements I would like to thank the following people for contributing and sharing their ­much valued insight. Jeroen J.J. Bogers

Name

Organisation

Office Location

F. Randall

AEGON Global Pensions

United Kingdom

F. van der Horst

AEGON Global Pensions

The Netherlands

G.A. Moerman

AEGON Asset Management

The Netherlands

H.E. Waszink

Waszink Actuarial Advisory Ltd.

The Netherlands

I. van der Veen

AEGON Corporate & Institutional Clients

The Netherlands

J. Rico

Transamerica Retirement Services

United States

M. Haddad

Transamerica Retirement Services

United States

M. Leeijen

AEGON Asset Management

The Netherlands

M. Tans

AEGON Global Pensions

The Netherlands

P. Westland

AEGON Asset Management

The Netherlands

R. Baird

AEGON Actuarial Services

United Kingdom

R. Pater

TKP Investments

The Netherlands

T. Read

AEGON Trustee Solutions

United Kingdom

W. van Ettinger

IPENCO BV International Pension Consulting

The Netherlands

Y. Vermaes

AEGON Asset Management

The Netherlands

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Appendix 1 Pension funding ratio assumptions

Pension model assumptions

Initial liabilities

100

Initial assets

110

Asset allocation World equity

70%

Fixed income

30%

Duration fixed income assets

8

Duration liabilities

12

Duration portfolio

2.4 NL

Indexation

UK 1.50%

US 2.50%

IFRS/FAS 0%

1.50%

Fixed income indices Credits 10 year: Euro aggregate corporate AA spread 10 year Risk free 5 year: Euro government Spot-conv 5 year Risk free 15 year: Euro government Spot-conv 15 year Equity index MSCI world € total return index

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Appendix 2 References and notes 1

Money Morning, 29 January 2009.

2

Global Pensions, 7 January 2009.

3

Wealth Bulletin, 28 November 2008.

4

SandP credit research, 6 August 2007.

5

De Telegraaf, 2 October 2007.

6

Personal Finance Editor, 3 December 2007.

7

EPN, 13 August 2007.

8

In this paper, “hedging” refers to the explicit removal of risks by using market or insurance instruments.

9

The pension funding ratio assumptions of the model pension fund can be found in Appendix 1.

10

In more technical terms, during good (low volatility) times, existing risk models underestimate tail risk and imply that underfunding is extremely unlikely. Unsurprisingly, this underestimation of risk increases the risk ­appetite of pension fund investors. However, as the models are not able to take account of unknown risks and as the correlation between different asset classes in down markets is much higher than is assumed in the models, it has become clear that diversification alone is not a sufficient tool for managing risk. Some risks have to be mitigated even at the cost of forgoing an amount of (uncertain) returns.

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‘For the moment, the broadly unanticipated behaviour of world bond markets remains a conundrum, bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.’ Alan Greenspan, before Congress, 16 February 2005.

12

Euro aggregate corporate AA spread 10 year, Euro government Spot-conv 15 year.

13

MSCI world € total return index.

14

FT.com, 29 October 2008.

15

IPE.com, 13 November 2008.

16

Mercer, 14 November 2008.

17

SNS Securities, 9 December 2008.

18

IPE.com, 8 December 2008.

19

‘The Gerstner Effect: Managerial Motivations and Earnings Manipulation’, Daniel Bergstresser, Mihir A. Desai, Joshua Rauh, December 2003.

20

CFO Europe, ‘Top Ten Concerns of CFOs’, February 2009.

21

The model used is intended to show the effect of different accounting regulations and does not necessarily reflect the actual funding ratios of real pension funds in the UK, USA or The Netherlands.

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Contact details AEGON Global Pensions Lochside Crescent Edinburgh EH12 9SE United Kingdom Telephone: +44 (0) 131 549 5375 E-mail: [email protected] Website: www.aegonglobalpensions.com

Disclaimer This white paper contains general information only and does not constitute a solicitation or offer. No rights can be derived from this white paper. AEGON Global Pensions, its partners and any of their affiliates or employees do not guarantee, warrant or represent the accuracy or completeness of the information contained in this white paper. AEGON, March 2009