Variable Annuity Plans. Richard Hudson, FSA, EA, MAAA

Transcription

1 Variable Annuity Plans Richard Hudson, FSA, EA, MAAA

2 Why Alternative Pension Strategies Market losses highlighted problems: Investment risk Negative cash flow increases investment risk Plan surpluses Easy to increase benefits, difficult to reduce them later Investment volatility translates into contribution volatility Contribution volatility creates collective bargaining issues Financial statement volatility

3 Why Alternative Pension Strategies Rethinking pension investment risk Asset drawdowns can be severe Risk is as important as return Expected returns and benefit promise may be unsustainable Recognizing the implications of changing demographic trends Plan maturity Negative cash flow effects

4 Why Alternative Pension Strategies Traditional DB and DC plans are inadequate Need a plan that is financially sustainable and affordable Provide lifetime retirement security Neutralize investment risk and funding risk through risk sharing Create an attractive alternative for all stakeholders

5 Risk Considerations 1. Investment risk 2. Plan maturity risk 3. Mortality risk 4. Regulatory risk

6 Investment Risk Interest rates at historic lows Asset price assumptions trending lower Asset risk assumptions trending higher Asset valuations currently at 2007 levels Experts predicting 5-10 years of low returns Earning plan investment assumption has become a real challenge

7 Investment Risk Many people focus on expected returns Less focus on risk leads to volatility Lower risk leads to: Less volatility / more stability Lower returns Lower benefits This should be incorporated in plan design

8 Maturity Risk Plans tend to take equity risk with assets backing retiree benefits Consider immunizing the liability associated with retirees Reduces overall investment risk

9 Mortality Risk Underestimated when converting to DC plans DC plan have individual risk DB plan has pooled risk New valuation systems can account for future mortality improvement to lessen impact of future cost volatility

10 Maturity Risk Support ratios increasing to unsustainable levels Plan maturity generates negative cash flow Plan maturity makes pension plans more sensitive to sequence of return risk Will costs become overly sensitive to market returns due to maturity of plan How does Plan size compare to company market cap

11 Regulatory Risk PPA established a rigid set of funding rules: Annual PPA certifications and zone status certifications are difficult to manage Systemic funding risk within Multiemployer system threatens solvency of PBGC Will Congress raise PBGC premiums beyond affordability and create a death cycle for Multiemployer plans?

12 Pension Plan Finance C+I = B+E

13 Tough to Predict the I Part C+I = B+E Since the Interest is volatile, it will create volatility in the equation. Something else must also be volatile either Contributions or Benefits

14 The Times They Are a Changin...

15 The Times They Are a Changin...

16 KZ11 The Times They Are a Changin...

17 Slide 16 KZ11 I would add another slide on Times the are a Changin' on life expetancy Karen Zangara, 2/13/2017

18 Increasing Risk...

19 Life Expectancy Progression GAM 71 GAM 83 GAM 94 RP 2000 RP 2000 prj 2020 RP 2014, MP 2016 Male age Female age

20 Risk Sharing Employers Participants

21 Problems with Current DB Plans Equity risks taken to get higher returns But liability is fixed income (debt) Contribution Holidays taken Leads to negative cash flow DC plans do not have contribution holidays Maturity Plans have more retirees than actives Why take equity risk with retiree liability

22 Without Negative Cash Flows, Market Volatility Can be Managed Starting Assets $ 1,000 Net Cash Flow 0.0% Net Cash Flow Growth 0.0% Market Cycle du New Cash Level Volatile ASSETS Year Flow Returns Returns level volatile 1 2 $ - $ - 8.0% 8.0% -2.0% -6.0% $1,080 $1,166 $980 $921 3 $ - 8.0% -9.0% $1,260 $838 4 $ - 8.0% 5.5% $1,360 $885 5 $ - 8.0% 8.0% $1,469 $955 6 $ - 8.0% 11.0% $1,587 $1,060 7 $ - 8.0% 15.0% $1,714 $1,219 8 $ - 8.0% 18.0% $1,851 $1,439 9 $ - 8.0% 21.0% $1,999 $1, $ - 8.0% 24.0% $2,159 $2,159 reported return= 8.0% 8.0% actual return = 8.0% 8.0% Asset Loss/(Gain) $0 % of Level Assets 100% $2,500 $2,000 $1,500 $1,000 $500 $0 Level Returns Volatile Returns

23 With Negative Cash Flows, Market Volatility Difficult to Manage Starting Assets $ 1,000 Net Cash Flow -6.0% Net Cash Flow Growth 10.0% Market Cycle du $1,200 $1,000 Level Returns Volatile Returns New Cash Level Volatile ASSETS Year Flow Returns Returns level volatile 1 2 $ (60.0) $ (66.0) 8.0% 8.0% -2.0% -6.0% $1,018 $1,030 $921 $801 3 $ (72.6) 8.0% -9.0% $1,037 $660 4 $ (79.9) 8.0% 5.5% $1,037 $614 5 $ (87.8) 8.0% 8.0% $1,029 $572 6 $ (96.6) 8.0% 11.0% $1,011 $533 7 $ (106.3) 8.0% 15.0% $982 $499 8 $ (116.9) 8.0% 18.0% $939 $462 9 $ (128.6) 8.0% 21.0% $880 $ $ (141.5) 8.0% 24.0% $803 $361 reported return= 8.0% 8.0% actual return = 8.0% 4.2% Asset Loss/(Gain) $443 % of Level Assets 45% $800 $600 $400 $200 $

24 Many Options Adjustable Pension Plans (APP) Sustainable Income Plans (SIP) Variable Benefit Accrual Rate (VBAR) The Composite Plan (CP)

25 What Can Be Adjusted... The entire Benefit up or down depending upon plan experience During active service and even into retirement Only during active service, retired pension protected A floor benefit can be protected A cap on annual adjustment can create a surplus to offset downside risk later

26 The VDB/APP Concept 100% employer Shared risk Traditional DB 100% employee Traditional DC (e.g. 401k) VDB/APP Like a DB Plan Retirement and longevity risks are pooled amongst all plan members Monies pooled and managed professionally - no individual accounts Unlike a DB Plan Investment performance / risk is shared Investment assumptions and strategy far less risky

27 How it Works Active participant s accrued benefit is adjusted each year based on actual investment performance as compared to a pre-set hurdle rate (eg. 5%) Benefit adjusted up if investment performance exceeds the hurdle rate Benefit adjusted down if investment performance is less than the hurdle rate At retirement, benefit is no longer adjusted

28 How it Works Over Time

29 General Goals Share financial risk Lower financial volatility Better retirement security than a DC plan Pooled mortality risk Investments professionally managed Minimize Withdrawal Liability Exposure

30 Structural Problems Difficulties are the result of underfunding Contribution increases Benefit decreases Underfunding is caused by: Investment risk (mismatch between assets/liabilities) Longevity risk (people living longer) More difficult for mature plans to manage

31 Elements of Conservatism Lower discount rate = lower benefit accrual Conservative investment strategy minimizes risk of loss Use of career average earnings instead of final average earnings minimizes inflation and spiking risks Minimal or no subsidized ancillary benefits Forced immunization at retirement removes one of the primary risks facing DB plans today Minimal Risk of Unfunded Liabilities In the event an unfunded would arise, the size would be manageable due to low floor accrual and significant reduction in possibility of an unfunded retiree liability

32 Surplus Management If the surplus exceeds X% that surplus can be used to increase benefits Increase the unit values or number of units held Does not increase the Floor benefit and therefore does not increase the employer s risk for unfunded benefits Does not increase the member s ultimate benefit if investments ultimately tank

33 Considerations How often are benefits adjusted for asset returns Annually, quarterly, monthly? Cost of immunizing retiree liability Cost of annual benefit accrual Normal Cost = Contributions Impact of demographic assumptions Mortality Improvement

34 Considerations If hurdle rate is less than 5%, plan is considered a Hybrid plan 3 year vesting Investments Alternative investments may not be valued frequently enough to be viable for this type of plan

35 Considerations Claim that Plan is always fully funded Must adjust benefits for all participants (including retirees) Adjustments must be made monthly Must fully fund demographic gains/losses New benefit accruals are fully funded including difference between expected interest and actual interest Contributions made monthly Administratively complex

36 Multi-ER Valuations Discount rate equal to long term expected return on assets Set equal to hurdle rate Value current accrued benefit, no expected change in benefit

37 Single-ER Valuations Discount rate is not equal to long term expected return on assets Discount rate is set by IRS Liability is based on asset returns Various discount rates used for Minimum funding PBGC premiums FAS disclosure

38 Single-ER Valuations Argument for valuation to use discount rate as expected return on assets Argument for valuation to have independent return on asset assumption

39 FAS Considerations Plan design typically uses a career accumulation formula 1% times pay The accrual for a plan year is not dependent on future changes in salary Should PBO = ABO?

40 FAS Considerations Cash Balance plans provide pay credits equal to a percent of pay If the plan provides a defined, non-contingent interest-crediting rate that entitles participants to future interest credits at a stated, fixed rate until retirement Then PBO = ABO