Pension Benefit Security: A Comparison of Solvency Requirements, a Pension Guarantee Fund, and Sponsor Support

• Author: Dirk Broeders,An Chen
• Published date: 01 June 2013
• Date: 01 June 2013
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01465.x

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The Journal of Risk and Insurance, 2013, Vol. 80, No. 2, 239-272

DOI: 10.1111/j.1539-6975.2012.01465.x

PENSION BENEFIT SECURITY:ACOMPARISON OF

SOLVENCY REQUIREMENTS,APENSION GUARANTEE

FUND,AND SPONSOR SUPPORT

Dirk Broeders

An Chen

ABSTRACT

Developed countries apply different security mechanisms in regulation to

protect pension benefits: solvency requirements, a pension guarantee fund

(PGF), and sponsor support. We compare these mechanisms for a general-

ized form of hybrid pension schemes. We calculate the expected log return

for the beneficiaries, the shortfall probability, that is, the likelihood of the

pension payment falling below the promised level and the expected loss

given shortfall. Comparing solvency requirements to a pension guarantee

system or sponsor support involves trading off risk and return. Additional

spending on default insurance reduces the shortfall probability and the ex-

pected loss given shortfall but also lowers the probability of high positive

returns as are feasible under solvency requirements.

INTRODUCTION

An occupational pension plan is a financial contract between an employer and its

(former) employees aimed at providing a supplementary retirement income. The

employer is often called the pension plan sponsor and the (former) employees the

beneficiaries. The accumulated pension assets and liabilities are in many cases admin-

istered by a pension fund.1Therefore, pension assets are typically placed bankruptcy

remote in a pension fund. Funding a pension plan boils down to accumulating suf-

ficient assets to pay future benefits. A pension plan is fully funded if the value of

pension assets is at least equal to that of pension liabilities.

Dirk Broeders is at De Nederlandsche Bank (DNB), Supervisory Policy Division, Strategy

Department, P.O.Box 98, 1000 AB Amsterdam, the Netherlands. An Chen is at the Department

of Economics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany. Broeders can

be contacted via e-mail: dirk.broeders@dnb.nl. The authors are grateful to two anonymous

referees, Anna Rita Bacinello, Paul Cavelaars, Marien de Haan, Birgit Koos, Jing Li, Marco

Navone, and David Rijsbergen. The views expressed in this article are personal and do not

necessarily reflect those of DNB or the University of Bonn.

1Sometimes, this role may also be performed by an insurance company or directly by the

sponsor. If pension assets and liabilities are “on balance sheet” items of the sponsor, the

beneficiaries are directly exposed to the sponsor’s default risk.

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240 THE JOURNAL OF RISK AND INSURANCE

The pension fund’s assets are invested in capital markets and as such exposed to

market risks. In addition, the pension fund is exposed to a variety of other risks,

including longevity risk, inflation risk, liquidity risk, and the sponsor’s default risk.

These risks relate to the mismatch of assets and liabilities. If all future cash out-

flows constituting the pension fund’s liabilities match the future cash inflows gen-

erated by its assets, then mismatch risk is negligible. However, if such a match

cannot be realized, then shortfalls or surpluses will occur in the future. The prin-

cipal duty of pension fund trustees is to keep these risks within acceptable limits so

that the beneficiaries’ entitlements are secured. In practice, the mismatch between

assets and liabilities is often large. This is typically true for defined benefit pen-

sion plans, where beneficiaries receive a minimum guaranteed income after retire-

ment. This amount is usually related to years of service and income.2The mismatch

risks or funding risks need to be absorbed by one or more of the pension fund’s

stakeholders.

This article, to the best of our knowledge, is the first to rigorously analyze secu-

rity mechanisms focusing on protecting pension benefits. We consider three security

mechanisms to allocate the risks across stakeholders: solvency requirements in which

case the pension fund does not share risks with external shareholders but holds addi-

tional assets over the liabilities as means of a buffer, a government-imposed pension

guarantee fund (PGF) in which the funding risks are borne by the pension guaran-

tee fund, and a sponsor guarantee in which the funding risks are absorbed by the

corporate shareholders.3This analysis is relevant to the current debate within the Eu-

ropean Union on equivalent regulatory regimes. Historically, the different European

countries developed divergent pension systems and consequently diverse regulatory

regimes. The European Commission (2010) recently issued a “green paper” on ade-

quate, sustainable, and safe pension systems. Part of this common goal is to bridge

the gap between different regulatory regimes. The current article is also relevant for

corporations dealing with the funding decisions of their pension plans. Finally, this

study provides a theoretical framework for PGF to set a fair price on their exposures.

However,it should be acknowledged that in practice implementing a fair price-setting

mechanism is often thwarted by political or practical considerations.

This article begins with describing the solvency requirements, the PGF, and sponsor

support in the “Different Security Mechanism” section. The “Problem Setup”outlines

the pension contract payoff and the economic environment, followed by the “Bench-

mark Model: Solvency Requirements” section where we analyze the solvency re-

quirements. The performance of the PGF and the sponsor support is addressed in

the “Protection by a Pension Guarantee Fund”and “Sponsor Support” sections, re-

spectively.The “A Further Discussion of Security Mechanisms” section compares the

three security mechanisms. The final section highlights the main conclusions. Techni-

cal derivations are available upon request or at: www.bwl3.uni-bonn.de/institut/dr-

chen.

2The alternative is a defined contribution plan in which the amount of the employer’s annual

contribution is specified. In this case the pension depends on the cumulative contributions

and investment returns.

3Other security mechanisms arecontribution adjustments and benefit adjustments. See CEIOPS

(2008). In these cases the beneficiaries are the key risk bearers.

PENSION BENEFIT SECURITY 241

DIFFERENT SECURITY MECHANISM

This section focuses on providing some background information on the three security

mechanisms: solvency requirements, a pension guarantee fund, and sponsor support.

Solvency Requirements

The objective of supervision of pension funds is to offer a high degree of security to

(future) retirees. As a first security mechanism pension funds in some jurisdictions are

required to hold a solvency margin of additional assets over the marked-to-market

value of pension benefits. This solvency margin is intended to absorb the risks inherent

in possible changes in the value of assets and liabilities. The additional assets are also

known as “regulatory capital” or “regulatory own funds” (see EuropeanCommission,

2003).

The additional assets over the liabilities can be used to absorb losses from adverse

events on the financial markets or in the development of the liabilities. Typicaladverse

events include a sharp decline in interest rates, a steep fall in stock prices, and an

increase in longevity estimations. The calculation of the amount of regulatory own

funds can, for instance, be based on a value-at-risk (VaR) risk measure for a specific

time horizon and confidence level.4This means that, theoretically, the required buffer

is at least sufficient to prevent a fund’s assets from falling below the level of its

liabilities within a certain probability margin. Examples of solvency regimesare found

in Denmark (Jørgensen, 2002) and in the Netherlands (Broeders and Pr¨

opper, 2010).5

Solvency requirements for pension funds raise the question whether or not Solvency

II for insurance companies (European Commission, 2009) should also be applied to

pension funds. Pension funds and life insurers are, after all, competing with each

other across Europe. Pension funds in several member states are offering similar

products as insurance companies but without the same regulatory capital require-

ments. The European insurance and reinsurance federation (CEA, 2008) argues that

there is no reason why beneficiaries of pension funds should have a lower security

level than beneficiaries of pensions provided by life insurance companies. The Eu-

ropean Federation for Retirement Provision, however, puts forward that applying

the proposed Solvency II directive to pension funds would result in many sponsors

withdrawing from defined benefit pensions and, hence, substantially reduced retire-

ment incomes (EFRP, 2008). It would also cause substantial shifts from equity to bond

investments, affecting financial markets. Solvency II advocates risk-based regulation,

which focuses on downside risk. It suggests using risk measures like default probabil-

ity and loss given default. In the “Risk-Based Capital Requirements Under Solvency

II” section we will discuss risk-based solvency requirements in detail.

Pension Guarantee Fund

A PGF may also operate as the guarantor of defined pension benefits. In this case

risks are effectively pooled with other pension funds and corporations. Such a system

4Alternatively, Butsic (1994) uses expected policyholder’s deficit as the solvency measure.

Olivieri and Pitacco (2003) specifically look at solvency requirements and longevity risk.

5In the Netherlands, for example, regulatory capital for pension funds is calibrated on a 1-year

default probability of 2.5 percent.