Edward Roozenburg: What is the simplest way to substantiate the MPD?
This column was originally written in Dutch. This is an English translation.
By Edward Roozenburg, Senior Risk Management Consultant, Probability & Partners
The MPD (maximum permitted deviation) will play an important role in the transition to the new Dutch pension system. But how high or low do you set the MPD as a fund? And how do you ensure that you substantiate this limit value properly?
Earlier this month I attended the annual actuarial conference of the VSAE, the study association for all students of actuarial science, econometrics and operational research at the University of Amsterdam. The theme of the conference was 'data quality' and had the telling title: 'A renewed pension system: how to ensure data quality for a smooth transition.' I led an interactive session there with the aim of providing more insight into how the height of the MPD can be determined in a substantiated manner.
For those unfamiliar with the term MPD: funds must examine the quality of their data prior to the transition to the new pension system. If an error is found on an individual pension right that is greater than the MPD, the fund will only continue the transition after the data quality has been improved. Each fund determines prior to data research how large an 'error' may be. Or rather, what 'deviation' is acceptable. That limit value for what is considered acceptable is the MPD.
The MPD cannot be determined based on gut feeling. The amount of the MPD must be properly substantiated. The supervisor also monitors this. How high or low do you set the MPD as a fund? And how do you ensure that you substantiate this limit value properly?
Risk appetite
One option to determine the MPD in a substantiated manner is by aligning it with the existing risk appetite. Many funds have determined their risk appetite based on a numerical limit on probability and impact. For example, a value of 2x2 for chance and impact on a scale of 5x5. They compare the risks they face against this limit to determine whether additional control measures are necessary.
These numerical limit values for risk appetite are often provided with an explanation. This explanation usually includes a financial limit. Risks with a possible impact above a certain limit are therefore considered unacceptable by the fund. This also determines how much financial damage is acceptable.
This limit value from the risk appetite can be used to determine the MPD in a substantiated manner. If a fund with a capital of, for example, €5 billion has indicated in the risk appetite limits that a financial impact is acceptable up to, for example, €500,000, then a cost item of 0.01% (€500,000/€5 billion) applies to that fund. x 100%) on the total power as acceptable.
By extending this limit at the total level to a limit value at the level of an MPD on an individual pension right, it is in line with the risk appetite of the fund. And because the risk appetite is substantiated by the fund, the MPD is also substantiated. In practice, in this example, a discovered error in a pension entitlement of 0.01% or more would be a reason to postpone the transition to the new system until it is certain that the data quality is in order.
Correction policy
But funds have not only set financial limits when determining their risk appetite. Many funds also have a correction policy in which they indicate how they deal with discovered errors. Financial limits are also often set for when an error in an individual pension right will and will not be corrected. Can these boundaries also serve as a starting point for the MPD?
There is no indication that the MPD may not coincide with the limits of the correction policy, so the fund could align with this. However, the corrections policy has a clearly different objective than the MPD. Based on the correction policy, funds generally want participants to receive what they are entitled to. Some exceptions are often mentioned.
Simply put, if the damage to the participant from an error is less than the cost of the postage stamp on the letter informing the participant of the error and its correction, then the error is not corrected. The limits for the correction are generally set as sharply as possible. After all, the money belongs to the participants and many funds have the ambition to correct all errors.
The framework for the MPD during the transition is slightly different. The question is which deviation the fund finds acceptable to make despite the error. In other words: which results from the data studies give such a bad idea about the quality of the data that the fund does not want to participate?
It may be that a fund finds a certain deviation acceptable and does not want to stop the project for the transition. This does not alter the fact that the fund wishes to correct the identified error. As a result, the limit values for the correction policy are often lower than those for the MPD.
In short, a fund can substantiate its choice for the MPD by aligning with the existing limit values that the fund already uses. The connection with the risk appetite is usually more applicable than the connection with the correction policy. This is because whether or not to enter is separate from the need to correct any errors for the participants as much as possible.
Probability & Partners is a Risk Advisory Firm that provides integrated risk management and quantitative modeling solutions to the financial sector and data-driven enterprises.