**Target rate of return as an alternative for the funding ratio**

*By: Agnes Joseph and Arno van Mullekom (Achmea)*

The funding ratio is often seen as the key indicator of financial health of pension funds. In the period 2008 till 2010 the funding ratios of Dutch pension funds dropped spectacularly, raising questions on the adequacy of current regulation and the overall sustainability of the second pillar pension contracts in the Netherlands. All elements of contracts and regulation are currently under reconsideration, but the funding ratio seems to remain the key indicator in every discussion. Nonetheless we think the funding ratio as leading indicator for regulation should also be reconsidered. As an alternative for the funding ratio we mention the target rate of return.

**Introduction**

Due to low interest rates and rising life expectancies the market value of the liabilities of the Dutch pension funds increased spectacularly in the last few years. This increase in the value of the liabilities resulted in a drop of the funding ratios, which is the key indicator of financial health of a pension fund in the current supervisory regime in the Netherlands. Once the funding ratio is below the

(minimum) required level, pension funds need to draw up a recovery plan. The recovery plan shows how the funding ratio is expected to recover above the required level within the maximum recovery period, by means of for example cuts on conditional indexation, additional contributions and expected excess investment returns. If, at the end of the recovery period, the funding ratio is still not above the required level, a pension fund has no other options but to cut also the unconditional (nominal) benefits and to de-risk the investment portfolio as to lower the required funding ratio. The result is that future nominal benefits are well protected, but the chances to compensate for future inflation are reduced to a minimum, leaving all purchasing power risk to the participants.

There now is a strong debate on the sustainability of current second pillar pension contracts and also on the current supervisory regime. One of the disadvantages of the current supervisory regime is that the regime is based on protection of the nominal pension benefits, while it

is argued that it would be better to focus on protection of the purchasing power of the retirement income of the participants. This is one of the reasons why the current supervisory regime will be changed. Every element of the current supervisory regime is reconsidered, e.g. the discount rate and the risk based capital requirements, except for the funding ratio that is and stays the key indicator of financial health of a pension fund. This is strange because there could be better alternatives than the funding ratio. As an example we mention the ‘target rate of return’. Similar to the funding ratio, this risk measure depends on the current value of the assets and future benefits of the pension fund. But one of the main advantages of the ‘target rate of return’ is that it is independent of the discount rate that is used to value the liabilities to obtain the funding ratio. Therefore it is more stable over time and it is easy to interpret this number.

**Target rate of return**

The ‘target rate of return’ is defined as the minimum yearly investment return on the assets that is needed to pay all future benefits. As an example, we take a pension fund with a funding ratio which is currently 100%. In theory, this pension fund has exactly enough assets to cover the liabilities. But due to the capital requirements the pension fund should have a funding ratio of 120%.

Therefore this pension fund is subject to a recovery plan, until the funding ratio is on or above 120%. The capital requirements are chosen such that the pension fund should be able to meet all future benefits with 97.5% certainty. Now we look at the ‘target rate of return’ of this pension fund, it is 2.2%. In other words, as long as the pension fund manages to get a yearly investment return of exactly 2.2% on its asset portfolio it will be able to pay all future benefits. The expected rate of return of the pension fund is, given its asset mix, 4.6%. So if the pension fund manages to realize exactly this expected return on assets, there is even (4.6%-2.2%) = 2.4% left for inflation compensation every year.

**97,5% certainty level**

But investment returns are not constant every year, there is also volatility in the asset returns. Given the volatility of the asset returns we can calculate a ‘97.5% certainty target rate of return’ or ‘required rate of return’. This is the target rate of return that should be made on the investment portfolio to be able to pay all future benefits with 97.5% certainty. This required rate of return depends on the investment portfolio of the pension fund. The riskier the investment portfolio, the higher the required rate of return, equivalent to the current risk based capital requirements and required funding ratio. For our example pension fund the required rate of return is 4.1%.

*Figure 1. Target rate of return as a function of the volatility of the pensions assets given a required certainty level to be able to pay all future benefits*

*Different certainty levels for the required rate of return are also possible, see also figure 1 where the required rate of return and its dependence on the certainty level and the volatility of the investment portfolio of the pension fund is given. As can be seen, the higher the certainty level and/or volatility of the investment portfolio is, the higher the required rate of return.*

**Conclusion**

We think the target rate of return and the risk based required rate of return can replace the funding ratio and risk based capital requirements in the new supervisory regime. As long as the expected returns on the investment portfolio are above the required rate of return at a given required certainty level and at the chosen volatility of the pension funds’s asset-mix, the pension fund has adequate coverage of the liabilities. To prevent the pension fund of using unrealistic high expected investment returns, the supervisor could set maxima on the used return parameters, comparable with the current set of maximum parameters as used for the continuity analysis. In the example here we focused on nominal benefits, but the

target rate of return and a required rate of return can also be calculated for benefits that include a compensation for inflation.

The target rate of return has many possibilities, and there will be more risk measures that could easily replace the funding ratio. When setting up the new supervisory regime these measures should also be taken into account.

** Dekkingsgraad of rendement?**Op 2 oktober 2013, tijdens de verdiepingssessies van Het Pensioen Forum, verzorgt

**Agnes Joseph**(Actuaris Synturs Achmea Asset Management) een lezing getiteld ‘

*De dekkingsgraad is niet de juiste thermometer, kijk naar het benodigde rendement!*‘. Meer informatie over deze lezing, het 2-daagse programma en de 55+ sprekers vindt u op de website van het Pensioen Forum.