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					 Canadian                 L’Institut
  Institute               canadien
         of               des
 Actuaries                actuaires

 2006 General Meeting
Assemblée générale 2006
    Chicago, Illinois
                          PD-3 Assumption Setting For
                                 Pension Plans


                          What is a Reasonable Going
Assemblée générale 2006




                           Concern Discount Rate?
 2006 General Meeting




                                    Bill Watson
                          Mercer Human Resource Consulting
                              Assumption Setting For Pension
                                Plans: What is Reasonable?
                          •   Current challenges
                          •   Mercer’s process for setting reasonable
                              assumptions
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 2006 General Meeting




                              –   Going-concern
                              –   Expected Return on Assets under CICA
                          •   Wrap-up




                                                     3
                                           Current Challenges
                          •   Pension costs matter
                              •   Plans have matured
                                   •   Aging workforce and an increase in retiree
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                                       liabilities
 2006 General Meeting




                              •   Now a significant part of a corporation’s
                                  financial statements/cashflow requirements
                                   •   Relative to the size of the active operations
                              •   Sharp rise in costs in recent years due to
                                  decreasing interest rates
                              •   Increased volatility

                                                             4
                                          Current Challenges
                          •   Heightened Scrutiny
                              •   Plan sponsor
                                   •   Pension and corporate governance
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 2006 General Meeting




                                   •   Finance area
                              •   Auditors
                              •   Regulators
                              •   Business community




                                                           5
                                        Current Challenges
                          •   Increased litigation
                              •   Class actions
                              •   Court decisions
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                              •   Fiduciary concerns
                              •   What is the role of the actuary?




                                                        6
                                       Current Challenges
                                       Lower Bond Yields

                          7%           6.84%
                                                6.78%
                                                            6.65%   6.51%
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 2006 General Meeting




                          6%   1.1%=

                                                                            = 1.8%
                                        5.72%
                          5%                    5.45%
                                                            5.15%
                                                                    4.69%
                          4%
                                                                              4.22%
                                Going Concern Discount Rate (FSCO Stats)
                          3%     Long Canada Benchmark Bonds
                                       2002     2003        2004    2005     2006
                                                                       January 1st

                                                        7
                          Current Challenges

                            Financial Pressure
                          + Heightened Scrutiny
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                          + Increased Litigation
 2006 General Meeting




                          + Lower bond yields
                          = Challenging Environment
                            for Pension Actuaries

                          Actuaries must be able to
                          justify their assumptions

                                       8
                            Setting Reasonable Assumptions
                             Going Concern Discount Rate
                          What rate of return can we reasonably
                           expect the pension fund to earn over the
                           long-term?
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 2006 General Meeting




                            –   Not a prediction
                            –   But as much as possible, a reading of the
                                market




                                                     9
                                  Setting Reasonable Assumptions
                                   Going Concern Discount Rate
                          Historically, the typical approach for a
                            Mercer actuary was:
                          • Stable long term economic views
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 2006 General Meeting




                              –   Based largely on empirical evidence
                          •   Little emphasis placed on market rates




                                                      10
                            Setting Reasonable Assumptions
                             Going Concern Discount Rate
                          Mercer’s current approach
                          • Provide actuaries with a market based

                            model to assist in determining the going
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                            concern discount rate
                          • The actuary must assess the

                            appropriateness of the assumptions for
                            each valuation in the context of the
                            particular case and the prevailing
                            economic environment

                                                11
                            Setting Reasonable Assumptions
                             Going Concern Discount Rate
                          First Step: Establish long-term expected
                            return for each asset class
                          • Bonds
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 2006 General Meeting




                            –   Based on current market yields in effect on
                                valuation date
                            –   Split by Universe, Long and Real Return
                                Bonds




                                                    12
                              Setting Reasonable Assumptions
                               Going Concern Discount Rate
                          •   Equities
                              –   Long bond yields plus equity risk premium
                              –   Equity risk premium considers expected
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 2006 General Meeting




                                  GDP, dividend yield, growth in corporate
                                  earnings
                                   •   Model provides 3 equity risk premium scenarios


                          Combine expected returns based on target
                           policy mix

                                                           13
                              Setting Reasonable Assumptions
                               Going Concern Discount Rate
                          Adjustments to expected return
                          •  Provision for active management
                              –     Based on portion of fund that is actively
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 2006 General Meeting




                                    managed
                          •       Provision for expenses
                              –     Expenses charged to the fund not already
                                    explicitly included in the current service
                                    cost



                                                       14
                            Setting Reasonable Assumptions
                             Going Concern Discount Rate
                          Adjustments to expected return
                          •  Margin for adverse deviations
                            –   Based on portion of fund that is invested in
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 2006 General Meeting




                                equities and underlying equity risk
                                premium
                            –   Consider any margins (positive or
                                negative) inherent in other actuarial
                                assumptions



                                                   15
                            Setting Reasonable Assumptions
                             Going Concern Discount Rate
                          An example,
                            Expected Return                 6.98%
                            Active Management               0.30%
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 2006 General Meeting




                            Expenses                       (0.50%)
                            Margin for adverse deviation   (0.68%)
                          Going Concern Discount Rate       6.10%




                                               16
                               Setting Reasonable Assumptions
                              Other Going Concern Assumptions
                          Other assumptions
                          •  Economic assumptions (inflation,
                             YMPE, salary scale)
Assemblée générale 2006
 2006 General Meeting




                               –     Based on market yields
                          •        Demographic assumptions
                               –     Best estimate approach
                               –     Future mortality improvements
                                   Otherwise, further adjustments to the
                                       margin in the discount rate

                                                       17
                           Setting Reasonable Assumptions
                          Expected Return on Assets (CICA)
                          Actuaries often asked to provide input on
                             accounting assumptions including the
                             Expected Return on Assets (EROA)
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 2006 General Meeting




                          •  Same approach as setting the going
                             concern discount rate
                          •  No margin for adverse deviations since
                             it is a best estimate assumption



                                               18
                           Setting Reasonable Assumptions

                           Is 6.5% still reasonable for a plan that is
                                invested 40% bonds and 60% equities?
Assemblée générale 2006
 2006 General Meeting




                          7%           6.84%
                                               6.78%    6.65%    6.51%

                               1.1%=
                          6%
                                                                         = 1.8%
                                       5.72%
                          5%                   5.45%
                                                        5.15%
                                                                4.69%
                          4%
                                 Going Concern Discount Rate (FSCO Stats) 4.22%

                          3%     Long Canada Benchmark Bonds
                                       2002    2003     2004    2005      2006
                                                       19          January 1st
                             Setting Reasonable Assumptions
                          Let’s assume,
                          •  Discount rate is before expenses
                          •  Margins for adverse deviation = 0.5%
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 2006 General Meeting




                          •  Yield on universe bonds = 4.6%
                          Roughly speaking,
                          •  Implies equity return of 8.6%
                                [(6.50% + 0.50%) - (40% times 4.6%)]/60%
                          •  Implies an equity risk premium of 4.4%
                               (Assuming government bonds are 4.2%)
                                                   20
                            Setting Reasonable Assumptions
                          Wrap-up
                          • Challenging times for pension actuaries
                          • Actuaries must be able to justify their
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 2006 General Meeting




                            assumptions
                          • Leads to assumptions that are largely
                            driven by observed market conditions




                                               21

				
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