Defined Benefit Pension Management
ILLUSTRATION.
Source: Daily KONTAN | Editor: Ignatia Maria Sri Sayekti
KONTAN.CO.ID – For pension funds that implement a defined benefit program, there are challenges in itself compared to those implementing a defined contribution program. Because if it is in the defined contribution program (defined contribution) employees pay a defined pension contribution, the amount of the pension depends on the investment return.
In a defined benefit plan, the amount of pension contributions is based on actuarial calculations and the amount of pension promised based on certain formulas, such as variable years of service and basic pension income. If the pension fund is in deficit, the pension fund company must pay an additional contribution.
So, managers of employer pension funds (DPPK) with defined benefit programs, have their own challenges in managing pension funds. First, longevity risk due to an increase in life expectancy which makes pension fund liabilities higher than what has been estimated. Second, the downward trend in interest rates can raise liabilities and decrease investment returns. Third, expectations of an increase in the welfare of participants and inflation adjustment.
Fourth, most defined benefit employer pension funds have no new members and are entering the accumulation phase. Fifth, unavailability of assets that match the liabilities, both from the perspective timing cashflow and sensitivity to interest rates. Sixth, the implementation of the accounting standard statement (PSAK24) makes the recognition of obligations for post-employment benefits, which originally used the corridor and amortization mechanism, to be reflected directly in the equity statements of the companies founding pension funds.
Seventh, the relative decline in the ability of funding support from Pension Fund Founders due to increased competition and other factors.
In Indonesia, the number of Employer Pension Funds (established by the company for its employees) that manages defined benefit plans has continued to decline due to closures, namely from 194 Pension Funds in 2014 to 151 in 2020. The reduction occurred because the founders were liquidated, unable to pay pension benefits. to the participants, or the founders wanting to reduce the risk (de risking) by changing to a defined contribution plan or switching to insurance. Among them are 151 pension funds, there are 47 BUMN pension funds with funds under management of around Rp. 117 trillion.
These challenges make risk management even more important. However, it is also important to minimize risk in managing pension funds. According to various global researches, in the long term, the asset allocation factor (i.e. what portion of the portfolio is invested in which asset class) contributes around 90% to return investation. Meanwhile, about 10% is attributed to other factors such as industry selection, hedging exchange rates, selection of issuers and trading.
Importance asset liability management in pension funds is because both the asset and the estimated liability are uncertain: the asset is exposed to uncertainty over investment returns due to both systematic and non-systematic risk. Meanwhile, the realization of pension fund liabilities may differ from those previously assumed.
The high fund adequacy ratio in pension funds is also uncertain sustainable if there is a large mismatch of risk factors between assets and liabilities. Because assets and liabilities can move with and magnitude different. Likewise about the investment risk.
Investment strategy
Well, one of the suggestions for investing in pension funds is placement in bond instruments. The intended use of assets bond or bonds for a strategy dedication to pension fund obligations. Among other things, to pay pension benefit payments obligations that are due, manage fluctuations in the fund adequacy ratio, and cover the funding deficit
The dedication strategy for pension fund liabilities can be done with or without using derivative instruments. The strategy of using derivative instruments aims to minimize the duration gap (sensitivity to interest rates). Namely between assets and liabilities using instruments such as repos for purchases bond, total return swap, bond forward, interest rate swap and option or structured deposits.
There are strategies without derivative instruments in the form of cash flow matching, duration matching or combination matching.
Strategy cashflow matching aims to mitigate liquidity risk on pension benefit payment obligations by matching the coupon maturity and principal of the bond portfolio. So that the projected maturity of the pension benefit payment obligations can be relatively certain in terms of amount and time.
Strategy duration matching aims to equalize duration as a measure of the sensitivity of assets and liabilities to changes in interest rates. Namely by having a portfolio bond with NAV and duration equal to liability. So that with changes in interest rates, assets and liabilities will move in the direction of and magnitude the same so that the fund adequacy ratio will be immunized.
A strategy commonly used to compromise needs cashflow the short to medium term and the need for managing interest rate risk by reducing the gap in duration between assets and liabilities is a dedication strategy combination matching, which is a combination of the two strategies above.
This strategy will form a bond portfolio in the form of a barbell, which is partially concentrated in short and medium tenor bond assets with a strategy cashflow matching for certainty cashflow payment of obligations that are due. As well as some others are concentrated in long tenors with the hope that the movement of the entire portfolio will be in line with the movement of liabilities.
For pension funds that still have a relatively long investment horizon so that they still have enough room to accept volatility risk and enough time to do so recovery if there is a market decline, then invest in return portfolios such as public stocks (with good governance, of course) can optimize asset allocation.
However, the duration of shares is quite different from the duration of bonds. Since stocks have no maturity date, cashflow to shareholders is uncertain (because the payment is not as senior as to bondholder).
Given the increasingly challenging conditions, currently there is a global defined benefit pension fund de risking, switching to programs defined contribution or transferred to an insurance company (including General Motors, Verizone, Akzo Nobel, British Telcom Pension Scheme, etc.). For that reason, the risk management of the Pension Fund must be managed properly and optimally so that it does not have the potential to cause it bad surprises. Such as an additional obligation. This could be detrimental to defined benefit pensioners.
Author: Siti Rakhmawati
Telkom Pension Fund Financial Analyst