The Belgian Pension Fund for Doctors, Dentists and Pharmacists (VKG) on 1 January 1995 changed from a pay-as-you-go-system to a system of individual capitalisation with defined contributions and a 4.75% interest guarantee. In mid-1997 the fund totalled Bfr15.7bn ($420m) with 10,750 active members.
The duration of the liabilities at VKG equals 15 years. This is because the average age of the active members is 42 and because members cannot dispose of their savings before age 60.
In view of the duration of the liabilities and a positive cash inflow it makes sense for the duration of the investments to equal the average duration of commitments. Equities have proved to generate a higher return over a long period than bonds. Equities account for 62% of assets.
Regulation plays an important role here. The fund must set up a legal solvency margin equal to 4% of commitments. It also requires that the market value of total assets at all times at least equals the total value of commitments. The accounting regulation is based on asset/liability management.
The VKG is obliged to increase its liabilities annually with a guaranteed interest rate of 4.75%. To cover years when the value of the assets (which are characterised by high volatility) don't increase by 4.75%, VKG has to have a buffer in place. The buffer is designed to maintain the accounting balance in years when the return on assets is insufficient. So the financial risk for VKG can be translated as a volatility risk. Although the original purpose of the solvency margin was to cover short-term fluctuations, in practice the use of the margin leads to the execution of a recovery procedure to restore financial stability. The solvency margin is based on an arbitrary calculation that doesn't correspond to VKG's real risk and investment profile.
VKG needs to have at its disposal an unallocated provision bigger than the legal solvency margin. That additional solvency provision can then cover short-term negative deviations from long-term stability, to avoid a recovery procedure.
We propose to calculate the solvency provision in a consistent statistically motivated way that takes into account VKG's real risk profile.
A first step is the reduction of the legal solvency margin by means of proportional reinsurance, as that margin is considered an arbitrarily defined, unusable provision. Secondly, total volatility is reduced through investment in uncorrelated markets. Hedging currency risk also has the effect of reducing risk.
The calculation of the required volatility buffer is based on the concepts of value-at-risk (VAR) and minimum acceptable return (MAR).
In normal market conditions, VAR quantifies the maximum amount the fund can lose over a particular time horizon with a given confidence level. VAR calculation is based on historical equity and bond prices. Calculations based on historical numbers until June 1997 give a VAR equal to 6.86% (with a 95% confidence level).
The MAR expresses the return on assets required to finance the guaranteed profit distribution, taxes of 9.25% on the profit distribution and general costs. Overfunding (the leverage) plays an important role. The MAR equals 7.5%.
The required volatility buffer must at least be able to cover the following damages"(decision rule):
q During the first year an internal rate of return (IRR) that equals the VAR and can nevertheless pay the MAR.
q During the following year it must be able to face an IRR equal to 0% and still pay the MAR.
Monte Carlo simulations demonstrate that there is about one chance in 2,000 of having two consecutive years with an IRR lower than the VAR.
The required volatility buffer is equal to 20.8% of the market value of the investments.
The aim is to constitute a level of solvency provision on the balance sheet equal to the required volatility buffer.
The volatility buffer is a function of the composition of the portfolio (VAR) and is fairly stable over time (unless there is a major change in investment policy). It has to be considered as an upper limit for the solvency provision mentioned in the balance sheet. In years when the financial markets perform well, the solvency provision is composed to the level of the required solvency margin. When the required volatility buffer is constituted, the profit distribution policy can be fully harmonised with risk management: in a year when the stock exchange performs very well, it should first be verified whether the legal solvency margin (following the above mentioned calculation rule) has to be raised. The resulting surplus can be fully paid out to the members (above the 3%, which is already calculated in the MAR).
In years when the financial markets underperform, the solvency provision is used to cover the deficit. The solvency provision decreases, but the volatility buffer stays at the same level.
Karel Stroobants is deputy managing director of VKG in Brussels"