Details of pension risks
This section further analyzes the pension exposure and possible risks thereof. Pension-related exposure to changes in financial marketsWith pension obligations in more than thirty countries, Philips has devoted considerable attention and resources to ensuring disclosure, awareness and control of the resulting exposures. Depending on the investment policies and the membership composition of the respective pension funds, developments in financial markets and changes in life expectancy may have significant effects on the Funded Status and net periodic pension costs (NPPC) of Philips’ pension plans. The pension plans in Germany, the Netherlands, the UK and the US cover approximately 95% of the Company’s total pension liabilities. To monitor their exposure to the respective risk factors, Philips uses a stochastic model. Amongst other things, the model allows both sensitivity analysis and stochastic simulations of the pension accounting figures of Philips. The sensitivity analysis presented and described in this chapter does not cover funding status or cost analysis on an economic or regulatory valuation basis. Sensitivity analysisAn indication of Philips’ accounting risk exposures related to pensions can be obtained by a sensitivity analysis of the Funded Status and NPPC for the above-mentioned countries. The bar charts in figures 1 and 2 show the sensitivities of the Funded Status to changes in equity price levels, interest rates, inflation expectations and longevity. Figures 3 and 4 show the same sensitivities for the NPPC. The changes applied in this analysis represent approximately one standard deviation and the absolute numbers of the impact for each factor/assumption are mentioned in the graphs. The risk numbers show how much the Funded Status and NPPC change relative to their (expected) levels at year-end 2010 if equity price levels, interest rates, inflation expectation and longevity trend deviate from their (expected) values at the end of 2010.     The sensitivity to changes in equity valuations is largest in the Dutch plan, even though in relative terms there is a larger percentage of equity exposure in the US. The size of the overall sensitivity to longevity is comparable to the sensitivity to equity prices. The plan in the Netherlands contributes most, which is due to its relative size. The aggregate Funded Status is less sensitive to interest rates. This reflects the impact of Liability Driven Investment (LDI) strategies in most countries. The interest rate sensitivity for the Dutch plan is opposite to the sensitivity in the other plans, because the LDI strategy adopted by the plan matches the higher value of the pension liabilities on a local valuation basis and not the lower value of the accounting liabilities as reported by the Company. Although an LDI strategy has been implemented in the US, this plan shows the highest sensitivity to interest rates. The aggregate Funded Status is least sensitive to changes in the inflation assumption. This is due to the fact that the Company has set its assumption for inflation for the Netherlands and Germany at the long-term target of the European Central Bank. The aggregate NPPC is particularly sensitive to changes in interest rates for the NPPC in the Netherlands. NPPC is to a lesser extent sensitive to changes in equity valuations and longevity. Due to the absolute size of the exposure to equities, the highest sensitivity to equities still exists in the Netherlands. The highest sensitivity to longevity also exists in the Netherlands. The aggregate NPPC is least sensitive to changes in inflation assumption due to the selection of the inflation assumption for the Netherlands as referred to in the previous paragraph. Stochastic analysisThe sensitivities described above reflect the impacts of separate changes in equity prices, interest rates, etc. As such changes are historically unlikely to happen simultaneously, a simple summation of the above-mentioned sensitivities would overestimate the total risk exposure. The difference between the total risk and the summation represents the so-called diversification effect. It results from the less than perfect (or even negative) correlation between the respective risk factors. The diversification effect may be captured by a stochastic analysis, i.e. by analyzing the outcomes of a large number of simulations. These simulations are based on the volatility of and correlations between the respective risk factors over the past 30 years. The bar charts below show the maximum deviations from the expected aggregate Funded Status at year-end 2009 and year-end 2010 and the expected NPPC for 2010 and 2011, if the 5% worst possible outcomes are excluded. These ‘Funded-Status-at-risk’ and ‘NPPC-at-Risk’ measures are based on the valuations of plan assets and liabilities on December 31, 2008 and December 31, 2009, respectively, and may therefore be seen as indicators of the accounting risks on these same dates. Figure 5 shows both the contribution of the separate risk factors and the diversification effect. Contrary to figures 1 and 2, it excludes the impact of longevity risk, but it includes the impact of credit risk and foreign exchange risk. Figures 6 and 7 show both the contributions of the risk exposures in the four biggest pension countries and the diversification between them.    The differences between the first and second bars in figures 5, 6 and 7 reflect plan changes, changes in assumptions for discounting future liabilities and changes in financial market conditions during 2009. The Funded-Status-at-Risk has increased compared to 2008. The credit risk, which is mainly driven by the volatility in credit spreads, has increased substantially, due to the increased market perception of credit risk. Credit risk results from the mismatch between the credit spread risk exposure of liabilities (i.e. in the discount rate curve used for accounting valuation) and the credit exposure of assets (through defaults, downgrades and changing credit spreads). On the other hand, the inflation element in the funded status calculation has decreased significantly by adoption of the ECB long-term target as the inflation assumption for the Netherlands and Germany. The contribution of equity risk has increased due to a higher absolute exposure resulting from the improved funding ratio of the Dutch plan and the increased volatility of equity prices. The steps taken during 2009 in Germany and the US to implement their new LDI driven investment strategies have led to lower contributions of interest rate risk. The contribution of interest rate risk results from the remaining interest rate mismatch between assets and liabilities. Both in absolute and relative terms, it is the highest in the US. The diversification effect is largely attributable to the small correlation between credit spread and equity returns. The Dutch fund still contributes most to NPPC-at-Risk. This is a reflection of its size.
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