On 8th November 2010 The Society of Actuaries in Ireland issued a statement on the sovereign annuity concept which is aimed to alleviate many of the difficulties currently faced by defined benefit schemes in Ireland. The concept is intended as a short term tactical measure and not a substitute for long term reform. I have evaluated the proposal in this context below.
Firstly it is worth noting that 80% of Irish defined benefit schemes are underfunded and the intention of this proposal is to reduce some of the financial stress imposed on these schemes. This proposal argues that the interest rate used to comply with the minimum funding standard should be the interest rate on Irish Government Bonds. For the purpose of the minimum funding standard, the liability in respect of pensions in payment is determined by reference to the cost of buying annuities in the insurance market. This is because annuities are considered a matching asset to pension liabilities as they provide a regular series of fixed or variable income payments in a similar manner to pension benefits. Currently the discount rate used to value future pensions is the interest rate on German Government Bonds because of their availability, suitable duration and most importantly their excellent security rates. The funding deficits currently being experienced by most defined benefit schemes have been exacerbated by the current low yield on German sovereign bonds. At the time the proposal was issued the yield on German 10 Year Government Bonds was 2.5 % which was significantly lower than Irelands 8.062%. We can anticipate that the large spread between German and Irish Bonds will remain for the next couple of years.
The implications of valuing the minimum funding standard on a higher interest rate will of course lower the liabilities of trustees to their pension contributors as the higher rate discounts the future outgo streams in a more powerful manner. This would mean in the short term that the schemes would not in fact be underfunded. In addition this implies that pension schemes would need to invest in an asset that earns an interest rate equal (or greater) than that used in the discounting basis. In many cases this will mean direct investment in sovereign bonds themselves and would generate a significant new source of exchequer funding as it would encourage trustees to invest in Irish sovereign bonds as a matching asset for minimum funding standard and pensioner liabilities. It could then be argued that it is in this proposal is in the national interest and in the private pension holders interest as when Irish sovereign bond yields revert to norms, the capital value of the asset will rise. In addition because of the difference in spread ‘buying Irish’ instead of German bonds would mean that the annuities for retiring members can be bought more cheaply and this would free up funds for active and deferred members of the scheme. This would mitigate the effect of the “priority rule” under which pensioners have first call on the assets in the event of scheme wind-up. Another advantage is that it would align the interests of private pension holders who are under a prefunded scheme and state pension holders who operate under a ‘Pay as You Go’ System. Their interests are now aligned as they are now both depending on the state to look after them in their old age, the state pensioners under the PAYG system and the private pensioners through receiving the coupon form the government bonds.
Considering all of the above it is my humble view that the disadvantages of such a scheme significantly outweigh the advantages. The major flaw I see with the society’s proposal is that the argument assumes there is market distortion and that the market has overpriced the risks associated with Irish Government Bonds. I feel that the market acts on perfect information and it is extremely naïve to make such a radical assumption. Although a switch from German to Irish Sovereign Bonds does not involve currency risk, the main driver of the difference in spread is the counter party risk of default. The spread indicates that the market is demanding a premium for such a risk and it is unfair to assume that Irish pension holders would assess the risk differently. Any assumptions regarding the market should not stray too far from the notion of no arbitrage in my view and this scheme suggests a long term window of arbitrage as the default risk is consistently overpriced. In a practical sense it would of course be necessary for the National Treasury Management Agency to issue coupon only bonds of appropriate duration to match the liability to pension holders under this annuity scheme. However in my opinion there are other practical issues to be considered. One of the key arguments made in favour of this scheme is that it would align public state pensions with private pensions. In my view the private pension holders are at far greater risk of default. Consider if the ‘Pay As You Go’ state pension was to default or break down completely as its members are extremely well organised into unions and groups their power to lobby and strike is vast. I would anticipate riots on the streets, shut down of state services and essentially the fall of a nation unless the government made a U turn on its decision. As a result members of the state pension scheme have far greater bargaining power than individual private contributors who tend not to be as organised and receive such media attention. This is why I feel their interests are far from aligned as each group is facing different risks. Actuaries advising trustees of course are required to operate in accordance with society’s best interest and it may be deemed that the scheme would create a significant new source of exchequer funding. However it should not be to the detriment of the client which in the case is the private pension holders in the scheme. It is my view that these schemes increase the risk to an unacceptable level to pensioners concerned and for further reasons outlined above should not be introduced.
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