Pension Scheme Asset Allocation with Taxation Arbitrage, Risk Sharing and Default Insurance

Sutcliffe, Charles

doi:10.1017/s135732170000297x

Cited by 5 publications

(10 citation statements)

References 44 publications

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“…These significant increases in investment risk taken on are due to the reduced weighting to the risk of being in deficit under SG and LG, allowing the employer-sponsor to attempt to reduce contributions by taking on this investment risk. This is consistent with the theoretical results of previous papers such as Sutcliffe (2004) relating to the PBGC in the U.S., even though the objective function in this paper does not provide any benefit for surplus. However, the increase is much higher than that observed by Crossley & Jametti (2011), with equity allocations for schemes in Canada under the effect of default insurance being consistent with an attempt to reduce levy payments rather than trying to game the default insurer.…”

Section: Resultssupporting

confidence: 92%

“…Early PBGC-based studies focused on the incentives of the employer-sponsor to reduce funding levels and increase investment risk due to the put option offered by the PBGC protection (see for example Sharpe (1976), Treynor (1977) and Niehaus (1990). A similar argument is made by Sutcliffe, 2004). These incentives were exacerbated by the flat premium structure that was unrelated to the risks of the scheme 5 and hence did not penalise employers in terms of higher premiums for lower funding levels.…”

Section: Introductionsupporting

confidence: 75%

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Effects of scheme default insurance on decisions and financial outcomes in defined benefit pension schemes

Butt

2013

Ann. actuar. sci.

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A simulation investigation of the effect of default insurance on the optimal equity allocation and deficit spread period of a model defined benefit pension scheme is performed, using the old and new frameworks of the Pension Protection Fund in the U.K. as a starting point. The old default insurance levy framework encourages an increase in the allocation to equities, creating an indirect effect of increased deficits. The new framework reverses the effect to a reduction in the allocation to equities, thus reducing deficits. In addition the gaming element of default insurance is investigated and found to significantly increase optimal equity allocation and deficit spread period, leading to a significant increase in deficits.

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Section: Resultssupporting

confidence: 92%

Section: Introductionsupporting

confidence: 75%

Effects of scheme default insurance on decisions and financial outcomes in defined benefit pension schemes

Butt

2013

Ann. actuar. sci.

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“…Three factors are excluded from this analysis, but are considered at length in Sutcliffe (2004) -taxation, risk sharing and default insurance 2 . Analysis of the reasons advanced for the cult which attitudes towards the cult of the equity, with the asset allocation decision depending on which group prevails.…”

mentioning

confidence: 99%

“…If the shares of capital and labour in national income remain constant, then equities and salaries are expected to increase at the same long run rate. Therefore, equities provide a good hedge for salaries over the long run, and so, as well as reducing the cost of 16 The risk sharing aspects of the problem are considered in Sutcliffe (2004).…”

mentioning

confidence: 99%

“…The issue of risk sharing is considered in Sutcliffe (2004 The increasing maturity of pension schemes means that the magnitude of pension liabilities has increased at a faster rate than the value of many employers. If the scheme is large relative to the employer, the risk of employer default is higher than otherwise, and the ability of employers to guarantee the solvency of the scheme is diminished.…”

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confidence: 99%

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The cult of the equity for pension funds: should it get the boot?

Sutcliffe¹

2005

Journal of Pension Economics and Finance

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Over the last half century UK defined benefit pension schemes have followed the cult of the equity by investing a large proportion of their assets in equities. However, since the turn of the millennium this cult has faced two serious challenges -the halving of equity prices, and the complete rejection of equity investment by the Boots pension scheme. This paper summarises the history of the cult in the UK and the arguments advanced at the time to support its adoption. It then presents the case for the cult (excluding taxation, risk sharing and default insurance). This is followed by a detailed consideration of the validity of this case, including an examination of the relevant empirical evidence. It is concluded that, in the absence of taxation, risk sharing and default insurance, the asset allocation is indeterminate; and depends on the risk-return preferences of the trustees and employer.Key words: pension funds, asset allocation, cult of the equity, time diversification, mean reversion, liability matching, equity risk premium. Throughout this paper, except where specified otherwise, equities is taken to mean a well diversified portfolio of shares, e.g. the market portfolio. 2Taxation is irrelevant for public sector pension schemes, while default insurance has not applied in the UK. Risk sharing may mean that the employees and the employer have different 1The allocation of a pension fund between equities and other asset classes is a key decision for trustees (Blake, Lehmann and Timmermann, 1999;Brinson, Hood and Beebower, 1986;Brinson, Singer and Beebower, 1991;and Ibbotson and Kaplan, 2000). The Boots Pension Scheme announced in July 2001 that they had liquidated the 75% of their assets invested in equities, and moved to a 100% bond portfolio, Ralfe (2001Ralfe ( , 2002, Ralfe, Speed and Palin (2003). This constitutes a clear rejection by Boots of the cult of the equity 1 ; which may be defined as investing a large proportion of the assets of a long term investor (e.g. a pension fund or a life assurance company) in equities. This paper shows how the cult has become established in the UK, and examines the arguments for its continuation.The total deficit of private sector UK defined benefit pension schemes was estimated in July 2003 by the Confederation of British Industry (2003) at £160 billion (although they note it might have been as high as £300 billion). The CBI also estimated that company profits would be depressed by about £16 billion per year over the next decade because of the need to increase employer pension contributions to fill this pensions deficit. A major cause of this deficit is the cult of the equity. Over the period January 2000 to March 2003, the FTSE All Share index fell to less than half its initial value. The UK cult of the equity meant that pension scheme losses from this stock market fall were much larger than would otherwise have been the case. These equity losses were an important factor in pension schemes reporting large deficits, closing to new members and increasing their co...

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Meeting defined benefit pension obligations: measurement, risk and flight paths

Hatchett¹,

Hurd²,

Clacher³

2012

Br. Actuar. J.

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The UK defined benefit pension scheme landscape has changed dramatically over the last few decades. During this period of change, conflicting views regarding the measurement of both assets and liabilities has made communication challenging. This has led to an under appreciation of risk and often suboptimal decision making. This paper seeks to draw together a variety of contrasting views to provide a coherent framework for stakeholders to meet pension scheme obligations over time.The proposed framework encourages agreement between both scheme sponsors and trustees towards a common target through a well articulated plan, or "flight path". In addition, the proposed flight path structure provides a common basis underpinning the measurement of both pension obligations and the risks inherent in any plan to meet those obligations.In an alternative recent framework, the recent paper by the Discount Rate Steering Committee (2011) proposed that discount rate calculations could be broadly split between matching calculations and budgeting calculations, although in their final update (2011) they noted that "in limited circumstances, a blend of matching and budgeting can be relevant." In their final update (2011), the Discount Rate Steering Committee also published in appendix 2 a table setting out how their recommendations, including the budgeting/matching framework, corresponded to the Technical Actuarial Standards published by the Board for Actuarial Standards. This paper develops the existing research beyond discount rates. Flight pathsAs defined benefit pension schemes close to new members and to future accrual (The Pension Regulator's Purple Book 2010), the focus of sponsors and trustees tends to change.Many traditional valuation methods focused on the ongoing nature of schemes, whereas the recent trend has been towards an end game. The change in employer debt regulations on 11June 2003 together with the mass extinction of discretionary increases have also hardened the obligations reinforcing this trend. This focus on an end game is likely to give greater commonality of objectives.Once a common goal is agreed, then stakeholders can focus on the critical stage of the process, which is how they intend to get to their target, also known as a flight path. Any measurement information should support this decision making, rather than being an end in itself.One particular area of debate, which this paper addresses, is how to reconcile the views held by financial economists and those of other market analysts. This paper proposes a robust framework for allowing for investment returns above "risk free" rates.The authors note that the recent crisis has highlighted, once again, that nothing in life is risk free. However, "risk free" rates form a common building block and useful short-hand for much actuarial and financial economic analysis. We have chosen to side-step this debate in this paper. The reader may choose to interpret "risk free" in a UK context as a low credit risk instrument such as a gilt or a suitably well collateralise...

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Pension Scheme Asset Allocation with Taxation Arbitrage, Risk Sharing and Default Insurance

Cited by 5 publications

References 44 publications

Effects of scheme default insurance on decisions and financial outcomes in defined benefit pension schemes

Effects of scheme default insurance on decisions and financial outcomes in defined benefit pension schemes

The cult of the equity for pension funds: should it get the boot?

Meeting defined benefit pension obligations: measurement, risk and flight paths

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