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Over the past few years, there has been a heightened awareness of the need for non-government-sponsored retirement alternatives. Pension beneficiaries, historically dependent on their governments for security in old age, must now put their trust in companies and, in many instances, depend on their own investment judgement for their retirement needs.
The interest in ratings on pension products differs significantly for defined benefit (DB) and defined contribution (DC) plans. This is to be expected, as their legal and structural natures differ considerably. The concept of ratings for both products is quite new, and still at the development stage. Worldwide, less than 10 DB plans are rated, and most of these are private ratings. Moody's has rating applications on two DC plans, but interest in this product appears to be very high.
DB plans in Europe are most highly concentrated in the UK, Netherlands and, to a lesser extent, Germany. Although each country's pension laws are different, in general, a company has a liability to meet a funding level for the plan to assure a target pay-out to pensioners. Ratings on DB plans are not usually used directly by the beneficiaries, but by third parties who need to assess the plan's financial strength. Plan sponsors may use ratings to promote confidence in the plan's quality. Plan trustees may use them as part of their due diligence review and contributing companies may use them to keep a handle on the investment manager. To an ever-increasing extent, however, a DB plan's financial strength rating is used by counterparties of the plan. Plans that trade in derivatives use ratings to satisfy the credit needs of trading counterparties.
DC plans are in various stages of development in many European countries. In Spain, there is likely to be interest following legislation on the external funding of pension funds. The French government is looking at a proposal which was dropped after the last elections. Most recently, DC plans have been approved in Italy and Germany. DC plans are gaining in popularity among employers since any liability to the plan is normally a fixed percentage of an employee's wage. The employer's contribution is therefore not affected by market conditions. Although each country has a slightly different scheme, they have one common thread. Individual investors are now responsible for making their own investment decisions.
Historically, European investors have been quite conservative. Accustomed to investing in high-credit-quality bond and money funds, the typical continental retail investor is unfamiliar with higher volatility products and with the relationship between objective and product selection. Therefore, it is the objective of many fund sponsors, as well as company sponsors of plans, to provide additional risk/reward information to the funds they are offering plan participants.
As DC and DB plans are fundamentally very different, the ratings on these products and the methodology used to reach them differ significantly.
DB plan ratings take the form of financial strength ratings. The ratings give Moody's opinion on the plan's overall ability to meet its financial obligations. Moody's employs a fundamental" approach to DB plan risk assessment, where a number of components are examined, including:
q regulatory environment and legal issues: The level of risk assumed by the creditors of a plan can vary, depending upon the regulations imposed under the relevant jurisdiction, the type of plan involved, and the specific transaction at hand. In particular, we are interested in knowing what the legal environment says about the employer's legal responsibility to contribute to the plan; who has control over the plan assets; and the priority of creditors' claims versus plan beneficiaries.
q funding status: The "funded ratio" is arguably the most comprehensive indicator of a DB plan's financial strength. Although a high ratio generally means a healthier plan, it is greatly influenced by the quality of assumptions used in the valuation process. For this reason, comparisons between funds can be misleading.
q sponsor/industry condition: The long-term viability of a pension plan is also dependent upon a steady flow of new contributions. Some of the key factors that can effect future funding include: financial condition of the sponsor and its industry; the surrounding political and economic climate (especially for public plans); the reasonableness of contribution rates in light of the sponsors economic condition; and factors which could lead to the termination of the plan.
q investment management: Clearly, investment management is a critical component of the overall asset-generation formula. Strong returns help plan managers meet actuarial liabilities, however, excessive risk may lead to disastrous performance under stressful economic conditions.
All DB plans share a common goal, which is to provide pensioners with the promised benefits upon retirement. Yet the strategies used to achieve this objective can differ significantly, resulting in a wide variety of risk profiles. This is where pension fund ratings can help.
DC plans generally take the form of mutual funds. Like most funds, they make no performance promise, other than to pay the market value per share to investors when they request redemption. Since funds, unlike debt issues, do not have a stated maturity or value, Moody's does not assign a traditional debt rating. Instead, mutual fund credit and market risk ratings are assigned.
A fund credit rating uses the traditional Moody's Aaa to C rating scale, although modifiers within rating categories are not used (ie. Aa1 or Aa3). The rating reflects Moody's opinion on the investment quality of the fund. The term investment quality covers four major concepts. First, it is an opinion on the credit quality of the fund's holdings. The credit quality of a fund is measured using expected loss theory - the lower a security is rated and the longer its maturity, the higher the probability of default. Portfolio managers invest their funds to maintain a certain expected loss level. For example, if it is a fund manager's ob-jective to have an Aa rated fund, the portfolio could invest in a mixture of securities, rated from Aaa to Baa, as long as the overall expected loss of that fund was equal to a Aa bond with a maturity similar to the fund's portfolio.
The second aspect of the fund rating looks at the management style of the fund in relationship to its objectives. It is important that the fund is managed in a style consistent with its stated objectives, whether those ob-jectives appear in a prospectus or in marketing materials. The third major rating point involves the quality of controls and oversight, in both the front and back office. Moody's re-views control procedures in the in-vestment company, the accounting area, settlements and at the custodian. The last major concept addressed by the rating is the liquidity of the fund - the ability of the fund to meet re-demption requests.
A fund market risk rating (MRR) expresses Moody's classification of the relative degree of downside volatility of a fund's total return. A rating scale of MR1 to MR5 is used, with MR5 having the highest downside volatility potential. MMRs are fund classifications, intended to complement the credit rating. Unlike performance rankings, MRRs are forward-looking rather than historical measures.
In very broad terms, most money market funds are MR1s, currency-pure intermediate government bond funds MR3s and speculative bond funds MR5s. In periods of market stress, an MR4 should display less downward volatility than an MR3 and an MR2 less volatility than an MR3. The rating process is fundamental in nature. Moody's looks at many different market factors including sector risk, duration risk, credit risk, and foreign exchange risk among others. All of these factors are analysed in relation to the objectives of the fund and a rating issued.
The rating of secondary pension products such as DB and DC plans is still relatively new. Interest, however, is very high. Companies with DB plans are looking at ratings for either fiduciary reasons or, in many cases, as a means for the plan to expand derivative trading or generate fee income through other structured means. DC plans are very new in Europe. As such, sponsors of these plans must be concerned that the risks of investment are transparent to the investors. Moody's expects extensive growth in DC plan ratings for money market, bond and equity portfolios in the next two to three years as more and more investors look towards alternative savings vehicles for their future.
David Vriesenga is representative director, global fund ratings at Moody's Investors Service in Frankfurt."