Reducing Retirement Plan Risk in a Volatile Market

Transcription

1 Reducing Retirement Plan Risk in a Volatile Market Mid Sized Retirement & Healthcare Plan Management Conference Presented by: Steven Hastings, FSA, EA, MAAA Consulting Actuary Mahrukh Mavalvala, FSA, EA, MAAA Consulting Actuary March 18,

2 Agenda What is defined benefit pension risk? How did we get here? How do we mitigate risk? In plan strategies Settlement strategies How can Milliman help? 2

3 What is Defined Benefit Pension Risk? Simply put, defined benefit pension risk is cost variability or uncertainty in a pension plan Why do we care so much about pension risk? Large numbers Large cash calls or changes to annual expense difficult to plan or predict Increased scrutiny in the media around pension obligations It didn t used to be this way what changed? 3

4 How Did We Get Here? Pension risk first manifested itself during the perfect storm that occurred in late 2000 Interest rates declined to then historic lows and the dot com bubble/crash significantly lowered assets 4

5 How Did We Get Here? Typical long term cost of defined benefit plans was not well understood by plan sponsors Ongoing cost of a typical final average pay defined benefit plan is 10% to 15% of compensation Plan sponsors did not pay the long term cost of plan during 1980s/1990s Many plan sponsors even used excess plan assets to fund medical benefits or to improve plan benefits Common during this period for plan sponsors to enjoy contribution holidays that lasted several years, or even more than a decade 5

6 How Did We Get Here? Legislative changes enacted as interest rates dropped and market volatility increased Due to market volatility, the Pension Protection Act (PPA) of 2006 led to potentially large cash calls to keep plans 80% funded 6

7 How Did We Get Here? Many plan sponsors saw large charges to equity and/or large increases to minimum required contributions The situation is not expected to get materially better over the short term 7

8 How Did We Get Here? Increased cash funding costs and expense volatility led many plan sponsors to implement hard or soft freezes to their pension plans But freezes do not impact current accrued liabilities, so these measures did not materially reduce near term cost variability, or risk, to the plan sponsor So how do we mitigate the risk? 8

9 Causes of Risk What causes cost variability or uncertainty? Interest rate risk Investment risk Inflation risk Longevity risk Legislative / regulatory risk Adverse selection risk Others (demographic, etc.) If we can understand the factors that contribute to risk then we can form a strategy to mitigate them 9

10 Interest Rate Risk Defined risk in change of interest rates used to measure plan obligations Traditional defined benefit pension liabilities can be very sensitive to changes in interest rates For most plans, a 1% change in interest rate can lead to a 12% to 18% change in the plan s liability Similarly, an old rule of thumb is that a 1% change in the plan s assumed interest rate results in a 25% change in the ongoing cost of the plan (1) (1) McGill/Grubbs Fundamentals of Private Pensions 10

11 Interest Rate Risk Interest rates used to calculate pension obligations have declined significantly over the last decade 11

12 Investment Risk Defined risk in change of asset return used to pay benefits When asset returns are less then expected, either future returns or additional contributions must cover the shortfall Contributions plus investment returns must equal benefit payments plus expenses over the life of a plan 12

13 Investment Risk For example a 20% asset loss requires a 25% subsequent return just to cover the loss 13

14 Investment Risk The assets of many pension plans are invested in items that do not match plan liabilities (i.e., equities) Poor asset returns combined with a decrease in interest rates result in a double hit to funded status 14

15 Inflation Risk Defined risk in change of expected wage or price inflation used to calculate benefits Spikes in wages prior to retirement can significantly increase pension obligations in final average pay plans Similarly, unexpected increases in CPI can increase pension obligations for plans with inflation related cost of living adjustments 15

16 Longevity Risk Defined risk that retired participants live longer than expected Life expectancies have increased significantly over the last few decades The Society of Actuaries recently released a new mortality improvement scale (scale BB) which is expected to increase pension obligations up to 5% 16

17 Legislative / Regulatory Risk 17 Defined risk that changes in statute will result in unexpected changes in liabilities Pension Protection Act (PPA) of 2006 Requires corporate pension plans to calculate contribution requirements based on corporate bond rates Targets 100% funded status over 7 years Accelerated timing of funding for many plans Prior to PPA, minimum required contributions were calculated using a best estimate of future asset returns based on the plan s investment mix PPA also requires plans to maintain certain funding thresholds to avoid certain benefit restrictions

18 Adverse Selection Risk Defined risk that participants will take forms of payment that will result in an unexpected decrease in the funded position of plan For example, unhealthy participants will take lump sum distributions in lieu of annuity benefits when available 18

19 Risk Management Options In plan strategies Plan re design Liability Driven Investing Tail Risk Management Annuity buy in Settlement strategies Lump sums Annuity purchases Plan termination 19

20 Plan Re design Traditional DB Plan Typical features of a traditional DB plan Final average pay formula Early retirement subsidies Ancillary benefits Monthly annuity payments upon retirement Ongoing plan with future accruals Open to new entrants Before answers must come questions Employer goals? Do current DB plan features align with these goals? 20

21 Plan Re design Traditional DB Plan Final average pay formula Can become very expensive Cost escalate as service and pay increase Large increase in past service liability due to leveraging effect of pay increases near retirement Options Change the accrual formula Increase averaging period of pay Switch to a career average formula Reduce the accrual rate Modify the service definition 21

22 Plan Re design Traditional DB Plan Early retirement subsidies Can be expensive to provide Does early retirement (age 55) make sense today? Early retirement incentives aligned with employer goals? Consider increasing life expectancies Individuals living longer may need to work longer Social Security benefits start later Uncertainty for post retirement medical coverage Options Modify early retirement provisions or reduce subsidies 22

23 Plan Re design Traditional DB Plan Ancillary benefits Benefits not related to retirement Example: special death and disability benefits Usually non protected benefits Are these contingencies covered elsewhere? Example: group life insurance or LTD plan Options Reduce or eliminate ancillary benefits 23

24 Plan Re design Traditional DB Plan Annuity payments Unknown future benefit stream Plan retains all the risk Not portable Options Offer lump sums to terminated participants Can plan earn a better return than the lump sum settlement rate (corporate bond rates)? Reduces PBGC premiums Do not have to include early retirement subsidies 24

25 Plan Re design Traditional DB Plan Ongoing plan with future accruals Employer recruiting and retention tool? Options Freeze future benefit accruals ( hard freeze) New entrants Employer recruiting tool? Options Reduce benefit formula for new entrants New entrants ineligible for the plan ( soft freeze) 25

26 Plan Re design Hybrid Plan Typical features of a hybrid plan Designed to provide best of both DB and DC plans Accrual pattern resembles that of a DC plan Benefits accrue more evenly over employee s career Portable Can be tailored to mitigate investment and longevity risk Technically still a DB plan Required to meet minimum funding rules for DB plans Insured by the PBGC Most common type is a Cash Balance Plan 26

27 Plan Re design Cash Balance Plan Key attributes Fresh start or opening balance Pay credits defined as a fixed percentage of pay May vary based on age and/or service Interest credits can be tied to a financial benchmark Annual accrual = pay credit + interest credit Can provide guaranteed rate of return for participants (depending on design) Benefits communicated to participants as hypothetical account balances Require 3 year vesting 27

28 Plan Re design Cash Balance Plan Key Attributes (continued) Longevity protection through annuities Lump sum options Employer cost controls Limited impact of inflation risk Reduced cost volatility Cheaper alternative than traditional plan Defray costs by excess of investment return over guaranteed interest credit Employer still retains some risk Winners and losers from employee perspective 28

29 Plan Re design Pros and Cons Pros Lower costs Potentially less employer risk Cons Immediate cost impact may be less significant Employees generally get smaller benefits Retention issues Implementation costs Legal costs (e.g., plan amendments, participant notices) Potentially higher ongoing administrative costs 29

30 Plan Re design Shift from DB to DC Result of shift DC plans initially conceived as supplementary retirement savings plans DC plans now are the primary retirement plan for many employees Employees face many challenges Longevity risk Accumulation shortfall Managing investments Mishandling withdrawals Increased number of retirees as baby boomers reach retirement age 30

31 Plan Re design Longevity Plan DB and DC plan co exist Reduce lifetime income risk DC Plan Primary retirement plan Lump sum payment DB Plan Secondary retirement plan Annuity payments Longevity plan providing annuity income at later ages 31

32 Plan Re design Longevity Plan Longevity plan design features Career average or flat dollar formula 2% of pay each year $1,500 per year of service No ancillary benefits No early retirement benefits Life annuity option only Joint & survivor if married Delayed participation (e.g., age 45) Delayed normal retirement date (e.g., age 75) 32

33 Plan Re design Longevity Plan Key attributes of longevity plan Meets retiree needs in later years Provides steady lifetime income stream Supplements DC plan accumulations Low cost plan design Affordable for employer Simple design Employees may potentially appreciate Provides lower level of benefits than traditional plan Less valuable for high income earners Less volatility 33

34 Plan Re design Longevity Plan Barriers to creating longevity plans Minimum eligibility rules Current IRS rules: Eligibility to participate no later than age 21 and 1 year of service Normal retirement date Current IRS rules: Normal retirement no later than the greater of age 65 or 5 years of service Minimum distribution rules Current IRS rules: Benefits for terminated participants must commence no later than April 1 following age 70½ 34

35 Asset Strategies Total return strategy Investing to achieve a maximum return for a certain level of risk Typical 60% equity / 40% fixed income Ignores liability side Results in asset liability mismatches Reasonable option when liabilities measured using longterm interest rate assumptions Current pension reporting is marked to market basis Results in increased volatility of funded status, required contributions and pension expense 35

36 Asset Strategies Traditional liability matching asset strategies Immunization Match duration of assets to duration of liabilities Cash flow matching Match cash flow of assets to cash flow of liabilities Disadvantages Invest 100% in fixed income portfolio Eliminates opportunity to generate excess return Liability matching strategy can never be perfectly implemented 36

37 Liability Driven Investing (LDI) Key attributes Reduce volatility with a focus on more closely matching the duration of assets to the duration of liabilities Benchmark portfolio performance against plan s liabilities rather than arbitrary peer benchmark Flexible Involves risk and return trade offs Not a stand alone fixed income strategy Includes diversified growth focused exposure Does not remove all risk 37

38 Liability Driven Investing Dynamic Asset Allocation Glide path approach Current fixed income is reinvested to more closely match the duration of liabilities More long duration bonds Move more into fixed income as plan hits certain trigger points Example: funded ratio Portfolio gradually moves toward a heavier fixed income allocation Allows equity portion of portfolio to seek better returns 38

39 Liability Driven Investing 39 Careful planning to determine strategy Balance reducing volatility, hedging interest rate exposure and meeting asset return objective Consider Required level of annual return to close funding gap Desired time to full funding Cash available to shorten time to full funding Timing Employer risk tolerance Appetite for alternate investments Hedging strategies

40 Tail Risk Management (TRM) Background Current pension portfolios typically do not employ sophisticated risk management techniques Diversification primary means to manage risk Limited protection if all asset classes move similarly during a market downturn LDI hedges against interest rate volatility Employer may want to be invested in risky assets to a greater degree Dynamic hedging strategies Manage tail risk to protect against market volatility 40

41 Tail Risk Management What is tail risk? Risk of severe asset losses over a short period of time Curve hypothetically represents investment return on average pension portfolio (60% equity / 40% fixed income) Center is the mean return (most likely outcome) Shaded areas are the tails (least likely outcome) Probability of Occurrence Annual Return Tail events can have catastrophic effect on pension plan 41

42 Tail Risk Management TRM strategies Protect against the most adverse outcomes Sacrifice small portion of upside potential while eliminating a greater portion of the downside Invest in equity options, credit default swaps, etc. Designed to perform well in the worst market conditions Declines of at least 20% ( fat tail losses, black swan events) Example: Lehman Collapse (2008) Underperforms in strong markets or less severe decline markets 42

43 Tail Risk Management Other considerations Expensive and complex Recent volatility has driven up the price Influx of cash from tail risk hedge in severe market decline can be used to buy high quality assets on sale Do underfunded pension plans have the ability to withstand a severe market decline? Permanent damage Market downturn often followed by market recovery Long term investors should not be concerned with short term volatility Market recovery not guaranteed 43

44 Tail Risk Management How to implement TRM? Hedge fund companies have launched dedicated tail risk funds for institutional investors Milliman Protection Strategy Still in early stages for pension plans Anticipatory, not reactive What s the next trigger event? "It is often said that is wise he who can see things coming. Perhaps the wise one is the one who knows that he cannot see things far away." Nassim Nicholas Taleb, The Black Swan 44

45 Annuity Buy in How does it work? Plan sponsor purchases an annuity contract from insurance company Insurance company takes on all asset risk Benefit obligation remains with plan sponsor Plan is responsible for paying benefits Insurance company reimburses plan for benefits paid Assets and liabilities remain on plan sponsor books Reports assets equal to liabilities Always 100% funded on buy in piece May only cover a portion of the plan obligation 45

46 Annuity Buy in Advantages Hedge against longevity and interest risk Employer trades variable cost of paying out benefits for fixed cost of premium to insurance company Reduces volatility in cash contributions and expense Does not trigger FASB settlement accounting No immediate recognition of prior losses in P&L May convert to regular annuity purchase May include ability to terminate arrangement Pre determined cash surrender value and/or penalty Employer may remain paternalistic 46

47 Annuity Buy in Disadvantages Expensive Insurance company will price similar to regular annuity purchase Currently priced with low interest rates Employer continues to incur administrative charges PBGC premiums must still be paid Insurer credit risk remains Not yet common in the US First US case in 2011 Well established in the UK 47

48 Annuity Buy in Other considerations People are living longer than expected 1 year increase in life expectancy increases pension liability by roughly 3% Baby boomer retirements Insurance company competition Banks? Size of pension liability relative to company size Opportunity cost 48

49 Settlement Strategies 49 What is a settlement? General definition Irrevocable action Relieves the plan of benefit obligation Eliminates risks associated with the obligation and the assets used in the settlement Accounting definition essentially the same Threshold for special recognition not always met What are the different settlement strategies? Lump sums Annuity purchases Plan termination

50 Settlement Strategies Lump Sums Defined: an irrevocable one time present value amount offered in lieu of remaining pension payments Generally, must be separated from service (i.e., can t cash out active participants unless plan is terminated) Many plans at least offer small or de minimus lump sums (present values <$5,000) Generally a good idea to lower admin costs Can offer one time window or permanent option Many plan sponsors explored or adopted in 2012 Roughly 30% to 50% take up for vested terminated participants Additional interest in

51 Settlement Strategies Lump Sums Vested terminated lump sums Separated from service, so can make offer Young participants often have small liabilities Opportunity to reduce head counts / admin costs Retiree lump sums Generally, form of payment being received is irrevocable election Lump sums blessed by IRS in recent private letter rulings New lump sum offer to retirees allowed under premise of plan improvement (not previously offered) Run risk of adverse selection Healthy retirees elect annuity Unhealthy retirees elect lump sum 51

52 Settlement Strategies Lump Sums Pros Transfers risk to participant Interest rate risk Investment risk Longevity risk Reduces size of assets and liabilities subject to risk Eliminates annual costs based on head count Outsourced administration costs PBGC flat rate premium and possibly variable rate cap Accounting gain if lump sum interest rates higher than discount rate used for accounting Generally cheaper than annuity purchase cost 52

53 Settlement Strategies Lump Sums Cons Locks in liabilities when relatively high Low interest rate environment means higher liabilities Forgone investment upside on lump sum assets Adverse selection (e.g., the unhealthy take lump sum) Potentially trigger settlement accounting Likely immediate recognition of outstanding losses Cost of calculations, legal review, plan amendments, nondiscrimination testing, communications, etc. Amending plan might also require additional funding Possibly detrimental to retirement security of participants (e.g., new truck risk) 53

54 Settlement Strategies Annuity Purchases Defined: an irrevocable purchase of contract for insurer to provide remaining annuity payments Irrevocably eliminates plan sponsor s obligation Insurer takes over payment of ongoing monthly benefit Often associated with plan termination Requires due diligence search for annuity provider Want to make sure insurer is strong, solvent entity Considerably higher costs than lump sums Conservative assumptions used Loading for expenses, profit, and security margin Cost can be 25%+ higher than accounting liability 54

55 Settlement Strategies Annuity Purchases Pros Transfers risk to insurer Interest rate risk Investment risk Longevity risk Reduces size of assets and liabilities subject to risk Eliminates annual costs based on head count Outsourced administration costs PBGC flat rate premium and possibly variable rate cap Allows participant to continue to enjoy benefit of lifetime income stream No new adverse selection because no new choice 55

56 Settlement Strategies Annuity Purchases Cons High cost relative to lump sum settlement Locks in liabilities when relatively high Low interest rate environment means higher liabilities Forgone investment upside on annuity purchase assets Settlement accounting usually triggered Recognize accounting gains or losses associated with settled liabilities Participants no longer covered by PBGC State guaranty associations step in if insurer fails Coverage much lower than PBGC (e.g., $100,000 present value) Benefit less secure in theory (potential lawsuits) 56

57 Settlement Strategies Plan Termination 57 Defined: a complete shutdown of the plan, wind down, and settlement of all benefit obligations Set defined Date of Plan Termination ( DOPT ) No further benefit accruals Many action dates key off of DOPT Government filings, employee communications, etc. Assets need to be shored up to settle obligations Lump sums and/or annuity purchases for all Partial plan termination is a similar option One option is to spin off a block of participants to separate plan and terminate

58 Settlement Strategies Plan Termination Pros Transfers risk to insurer, participants, or both Interest rate risk Investment risk Longevity risk Reduces size of assets and liabilities subject to risk If plan sponsor wants to get out of the DB business entirely, full plan termination achieves goal Eliminates ongoing administration costs If annuity purchases, allows participant to continue to enjoy benefit of lifetime annuity stream 58

59 Settlement Strategies Plan Termination 59 Cons High cost of shoring up funding shortfall Any existing shortfall plus additional settlement costs Locks in liabilities when relatively high (now anyway) Forgone investment upside on assets Settlement accounting usually triggered Participants no longer covered by PBGC State guaranty associations step in if insurer fails Coverage much lower than PBGC (e.g., $100,000 present value) Benefit less secure in theory (potential lawsuits) Replacement plan might not be adequate to provide orderly retirement of active participants

60 Settlement Strategies 60 What were Ford and GM doing? Ford offering option of single lump sum instead of remaining payments Ford received IRS ruling for one time lump sum offer Retirees receiving the offer never had the opportunity to elect a lumpsum distribution in the past Roughly 100,000 retirees and vested terminated participants to be offered lump sum GM offer part of a plan termination Separating 100,000+ inactives in spin off; inactive plan terminating About 42,000 retirees (1997+) offered lumps sums Annuities purchased for retirees not receiving a lump sum Roughly $4 billion additional charge to settle $26 billion in liabilities

61 How Can Milliman Help? Plan design strategies Milliman Protection Strategy FutureCost Pension Performance Dashboard ALM studies Daily updates 61

62 Questions? Steven Hastings, FSA, EA, MAAA Consulting Actuary Milliman Mahrukh Mavalvala, FSA, EA, MAAA Consulting Actuary Milliman