If policyholders are transferred from guaranteed products to market rate products, L&P companies will remove large liabilities from their balance sheet and are no longer obligated to give
policyholders a promised return on their contributions, thereby reducing their capital requirements. This will immediately improve the solvency of the L&P sector, instead of postponing the problems to the future.
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10.2.1 Intergenerational Transfer of Solvency Risk
When the discount curve was lifted by the SW method, a short-term effect was an improved solvency of the entire sector. However the capital that previously was held to make sure that L&P companies were able to meet their obligations, was reduced. As a consequence, there will be enough money for pension payments to current retirees, but if the market interest rate does not converge to the UFR within 30 years, too little capital have been held for benefits to future generations. Hence the new imposed discount curve did not solve any problems; it just postponed the issues to younger generations. This is an intergenerational transfer of solvency risk, coming from the SW discount curve, and the risk is borne by young pension savers.
If the L&P sector manages to transfer policyholders to market rate products, the postponed underfunding problem may never be an actual cost to the companies since they will no longer be obligated to the guarantees. In a market rate product, the future pension benefits rely entirely on the performance of the market and the problem of an intergenerational transfer of solvency risk will be eliminated. Hence with market rate products the risk of cuts in pension benefits will be reduced. By this, young policyholders are better off by leaving their guaranteed contracts since then they will receive the value of their depot as well as additional compensation. If they stay in their contracts, they are faced with a risk of cuts in their pension benefits at retirement.
10.2.2 Transfer of Investment Risk
Historically, most of the contracts issued by Danish L&P companies have been DC schemes with embedded interest rate guarantees. Because of this guarantee and the low interest rate environment, all of the investment risk is borne by L&P companies.
If these guarantees are removed, the pension contracts will have the characteristics of pure DC schemes where the return entirely depends on the performance of the financial market and how well the portfolios are managed. As a consequence, a long-lasting downturn in the market, as
experienced in the Global Financial Crisis of 2007-2008, will have large impacts on policyholders’ pension savings since the floor imposed by the interest rate guarantee is removed. This results in a transfer of all investment risk from L&P companies to policyholders.
10.2.3 Increased Flexibility in Investment Options
When L&P companies have issued products with guaranteed interest rates, they are tied to invest in portfolios with a high fraction of bonds backing the guaranteed returns. For example, AP Pension in Denmark has to hold 90% of their reserves in bonds to cover their guarantees and requirements (Nielsen 2013).
In a low interest rate environment, this is obviously not an optimal way to invest policyholders’ contributions if a high return wants to be achieved. In connection to the ongoing debt crisis in Europe, there are few indications that the interest rates will climb noteworthy the next years in
70 Europe and Denmark (Pension 2012), hence bonds will not be able to offer the same return as equity investments.
The removal of the interest rate guarantees leads to reduced liability values; hence a decreased requirement to the amount of capital placed in safe investments. A higher degree of flexibility in investment options will be possible and more investments can be placed in shorter maturities and stocks and create a possibility of higher returns compared to bond investments covering the guarantees. However, according to the risk-return framework, higher returns will also increase the risk of negative investment returns. Since the investment risk in a pure DC scheme is borne entirely by policyholders, they are left with the increased equity risk when the interest rate guarantees are removed.
10.2.4 Concluding Remarks of Removed Guarantees
We have now investigated some of the effects a removal of the interest rate guarantees will have on L&P companies and policyholders. Based on this, should policyholders move away from their guaranteed contracts to pure DC products?
Seen from L&P companies’ point of view, moving policyholders away from guaranteed products towards pure DC schemes, will reduce pension liabilities significantly and thereby the capital requirements. In addition, the change will transfer all investment risk to policyholders. If the guarantees are not removed, L&P companies will continue to delay the problem of high issued guarantees and low interest rates, and the government may need to increase the discount curve once more. The longer the problems are postponed in the sector, the more drastic solutions are needed to permanently improve the solvency of the L&P sector.
Seen from policyholders’ point of view, they are faced with risk in both scenarios, especially the youngest generation of pension savers. If the guarantees are not eliminated, they bear the risk of major cuts in future pension benefits if L&P companies have held to little in capital to cover promised benefits. If the interest rate guarantees are removed on the other hand, policyholders’ carries all the investment risk. But the higher expected return in market rate products, due to more flexible investment options, may compensate policyholders for the increased risk.
Since both scenarios are connected to high risk to policyholders, the best case according to our evaluation would be to remove the interest rate guarantees from the balance sheet since this reduces the chance of insolvency of L&P companies in the future. But as we have seen throughout analysis, policyholders receive less for their guaranteed contracts than they are entitled to. Even though the removal of the guarantees leads to lower values than fair value for policyholders, the transfer would still benefit policyholders: If policyholders stay in their guaranteed contract they may experience unknown cuts in their pension benefits at retirement, while a market rate product could provide policyholders with a higher market return, reducing the loss of fair value stemming from the transfer to the DC scheme.
71 Based on the discussion above, we conclude that the removal of the interest rate guarantees is the best solution for both policyholders and L&P companies.
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