Session 80 PD, Cash Balance Plan Update. Moderator: Emily Brantley Donavant, ASA

Transcription

1 Session 80 PD, Cash Balance Plan Update Moderator: Emily Brantley Donavant, ASA Presenters: Alan R. Glickstein, ASA, EA Mary R. Hardy, FSA, CERA, ACIA, FIA SOA Antitrust Disclaimer SOA Presentation Disclaimer

2 Alan R. Glickstein Cash Balance Plan Regulatory Update October 25, 2016

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4 Presentation Disclaimer Presentations are intended for educational purposes only and do not replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of the Society of Actuaries, its cosponsors or its committees. The Society of Actuaries does not endorse or approve, and assumes no responsibility for, the content, accuracy or completeness of the information presented. Attendees should note that the sessions are audio-recorded and may be published in various media, including print, audio and video formats without further notice. 3

5 Cash Balance Plan Update 4

6 Agenda Brief History of Cash Balance and Current State Overview of the Final Regulations providing 411(d)(6) relief Areas in which Guidance is still Lacking 5

7 Final Hybrid Plan Transition Regulations IRS issued final transition regulations (11/13/15) addressing permissible interest crediting rates The 2015 final regulations: Delay most of the deadlines for required amendments to hybrid plans under PPA Delay effective date for corresponding provisions of 2010 and 2014 final hybrid plan regulations Provide some additional flexibility in changing an interest crediting rate to comply with the market return rules 6

8 Final Hybrid Plan Transition Regulations The delayed effective date is generally first day of the plan year beginning on or after January 1, 2017 The amendment deadline is generally the day immediately prior to the delayed effective date December 31, 2016 for calendar year plans A later date may apply for collectively bargained plans - could be as late as January 1,

9 Provisions Not Delayed The 2015 final regulations do not delay the deadline for: Three-year vesting requirement The preservation of capital rule, except as it applies to multiple annuity starting dates Multiple annuity starting date rules are subject to the delayed effective dates (rules needed since this provision only applies at an annuity commencement date) Required amendments for these provisions must generally be made on or before the plan year beginning on or after January 1,

10 Tension Between Market Rate and Cut-back Requirements Cash balance plans will not meet 411(b)(1)(H), if the interest crediting rate (ICR) exceeds a market rate of return 411(d)(6) does not generally allow for an amendment which decreases a participant s accrued benefit 411 regulations provide that the right to future interest credits under the plan is part of the accrued benefit If an ICR is in excess of a market rate and the interest credit cannot be reduced, a change is required, but can t be made These transition regulations resolve the conflict 9

11 Tension Between Market Rate and Cut-back Requirements 411 regulations provide that a plan can be amended to eliminate or reduce a protected benefit, if: Compliance with change in law needed for qualification; An exercise of 7805(b) by the Commissioner; and Changes made only to the extent needed Any changes to bring an ICR into compliance will apply to the cash balance account only in future interest crediting periods 10

12 Lump Sum Based Formula In order to be lump sum based The accumulated benefit is expressed as an account (including % of FAP) The amount of the lump sum, if any, is the account balance Exception for 411(d)(6) required amounts The annuity is the actuarial equivalent of the account balance Using reasonable assumptions At NRD or annuity starting date No exception for 411(d)(6) protected annuities if conversion basis changed Including no ability to change stability period or lookback month for 417(e) conversions with 12 month protection period If lump sum based Eligible for whipsaw relief Must meet market rate rules Eligible to use account based age discrimination safe harbors Still must pass similarly situated test 11

13 If Not Lump Sum Based Hybrid plans that are not lump sum based typically have an effect similar to lump sum based formulas Benefit includes right to future adjustments Total adjustments are greater for a younger participant than older Adjustments include any dollar increase in benefits Exception provided for unwinding of early retirement factors if normal retirement benefit for an older participant can t be less than for a similarly situated younger one Rule simply intended to ensure that traditional plans aren t labelled as hybrid plan due to unwinding of ERFs Must do whipsaw calculations if a lump sum is offered Can not test for age discrimination based on the account Must test annuities at Normal Retirement Date Typical hybrid plan with implicit or explicit interest credits could not satisfy age discrimination on this basis, BUT Can use index plan age discrimination rule if the plan qualifies 12

14 Indexed Plan Safe Harbor Plan is not age discriminatory solely due to the index Ignore indexing when testing annuities To be eligible for this a plan must Index at a rate that meets the market rate rules Apply the preservation of capital rule The indexing over any period is not greater for a younger participant than a similarly situated older one e.g., can t reduce interest crediting rate on account of age Would expect most plans to be able to meet these requirements 13

15 Conversion Basis - Reasonable Actuarial Equivalent? Client must make this determination Involve counsel as needed Unclear how or when to measure Does not appear that the plan can be changed to be lump sum based No anti-cutback relief provided for changing factors No exception provided in lump sum based rules for 411(d)(6) protection of annuities (as there is for lump sums) Seemingly can change factors using wear away or A+B approach Whipsaw calculations can be avoided for future participants And perhaps after wear away period if that approach is chosen 14

16 Early Retirement Subsidies The 2014 regulations introduced a new similarly situated test for early retirement benefits Benefit payable before normal retirement to a participant can not be greater than for a similarly situated (i.e., same account) older participant AE J&S reductions do not cause failure This could happen if the early retirement benefit is based on the normal retirement benefit rather than the account Project with interest and apply ERF that is less than the interest crediting rate This could also happen if a more favorable annuity conversion basis is used at early retirement This test is to enable the value of early retirement subsidies to be disregarded when testing for age discrimination 15

17 Early Retirement Subsidies Unclear what to do if this test is failed One argument is that if testing on the account balance passes (i.e., account for younger person is not larger), failing the test has no consequences Since nothing needs to be excluded Regulations seem to look only at account balance, but preamble to regulations suggests there is a problem If there are consequences, addressing them may be problematic No anti-cutback relief provided to reduce early retirement benefits IRS informal reaction is that sometimes you have to increase benefits for older participants However increases could be dramatic 16

18 Implicit Interest Some plans do not have interest credits but incorporate interest implicitly Primarily Pension Equity Plans (PEPs) using deferred annuity factors (DAFs) Are these plans subject to the market rate rules? it seems so If so, transition rules and anti-cutback protection must apply to them as well If not, they would seem unable to pass age discrimination with a rate that wouldn t meet the market rate rules Why would an interest credit of 10% be impermissible but a DAF at 10% potentially be acceptable? Why would IRS field directive address implicit interest credit plans rather than prohibiting them? But not easy to get there from the regulations and IRS has not commented Plan sponsor/counsel should make this determination 17

19 SOA Annual Meeting October /38 HEDGING CASH BALANCE PENSION LIABILITIES Mary Hardy University of Waterloo SOA Annual Meeting October 2016

20 SOA Annual Meeting October /38 Outline 1. Hedging and Valuation 2. Valuation principles for CB plans a) TUC b) PUC c) Actuarial 3. Hedging the liability under different valuation principles 4. Examples factual and counterfactual

21 SOA Annual Meeting October / A way out of Pa. pension mess 3 This year, Simpson proposed a cash balance pension compromise, in which new employees would be offered an investment plan with a guaranteed 2 percent earning rate. Sources: Kravitz 2012 National Cash Balance Research Report; Lancaster Newspapers, April ; MarcoNews.com April5, 2014

22 SOA Annual Meeting October /38 Cash balance plans do not represent a low-risk arbitrage opportunity, but rather are a leveraged investment in risk assets, similar to a traditional DP plan. Segal Rogerscasey Cash-balance pension plans face much more complex interest rate risks than do defined-benefit plans. Plan sponsors need to understand the risks and respond with customized hedging programs. Treasury & Risk

23 SOA Annual Meeting October /38 What are we hedging? Valuation and hedging are connected How we value determines how we hedge. Does the liability valuation allow for future interest credits? Does the liability valuation allow for future salary credits? Are we hedged even if members exit earlier or later than anticipated?

24 SOA Annual Meeting October /38 DB actuarial valuation principles Accruals-based use past service credits only TUC future increases to past-service benefits are not pre-funded PUC future increases to past-service benefits are pre-funded For FAS DB plans, increases to past-service benefits are from salaries. For CB plans, increases to past-service benefits are from interest credits

25 SOA Annual Meeting October /38 DB actuarial valuation principles AL t = actuarial liability = target asset requirement NC t = Normal Contribution = contribution needed to fund the expected increase in AL, from t to t+1 Assume: No exits until retirement at T Valuation rate of interest i t in t to t+1 Contributions paid at start of each year Under consistent valuation assumptions, we have ( ALt + NCt)(1 + it) = AL t + 1

26 SOA Annual Meeting October /38 More notation for CB valuation F t = Notional Fund Value at t S t = salary in t t+1 c = salary crediting rate v(s) denotes the s-year valuation discount factor For level discount rate v(s) =(1+i) -s i c (t) denotes the crediting rate for t t+1 Examples use 30-year treasury spot rates

27 SOA Annual Meeting October /38 CB Actuarial Valuation Actuarial Approach Assume future salary credits to retirement Assume future interest credits to retirement Pro-rata projected liability for current service Discount at subjective valuation interest rate

28 SOA Annual Meeting October /38 CB Actuarial Valuation Let BB tt (TT) denote the projected final benefit, and let n denote service at the valuation date Using deterministic salary and crediting rate assumptions AL = B T v T t NC ( ( ) ( )) t t i t = AL n t n n+ T t

29 SOA Annual Meeting October /38 CB TUC Valuation No allowance for future salary credits to participant s fund No allowance for future credited interest in AL NC pays for next year s interest credits AL t t = F t ( ) ( ) c (1 ( )) (1) 1 NC = cs + F + cs + i t v t t t Use the 1-year risk free rate for v(1) to give the liability hedge.

30 SOA Annual Meeting October /38 CB PUC Valuation No allowance for future salary credits to participant s fund Include future interest credits up to time T Using stochastic interest rate model (eg Hull- White) with risk neutral valuation V(t,T) = value at t of projected benefit at T, per $1 of notional fund Market/Fair value of liability

31 SOA Annual Meeting October /38 The PUC Valuation Framework (continuous time version) T T T c r ( s) ds r ( s) ds r ( s) ds Q t Q t t Ft V(, t T) = E t FT e = FE t t e e T c ( ( ) ( )) Q t V(, tt) = E t e r s r s ds

32 SOA Annual Meeting October /38 CB PUC Valuation V(t,T) can be calculated analytically or using Monte Carlo Analytic method assumes crediting at the spot rate rather than par yield Fitted to the yield curve at valuation Valuation formulas: AL = FV(, tt) NC = csv(, tt) t t t t

33 SOA Annual Meeting October /38 V(t,T)-1 : 30-year crediting rate

34 SOA Annual Meeting October /38 V(t,T)-1 : 30-year crediting rate

35 SOA Annual Meeting October /38 Legend... Spread: 30 year treasury rate 1 month treasury rate 30-year rate : Spot rate from yield curve 1-year, 5-year, 7-year, 10-year curves Plots V(t,T)-1 for T=t+1, t+5, t+7, t+10 Represents the additional assets required over the notional fund amount, per $1 of notional fund EG: V(t,T)-1=0.1 Cost of guarantee is 10% above the notional fund.

36 SOA Annual Meeting October /38 Example comparing AL and NC Employee A 20 years service 1 year to retirement S=$75 000, F= Employee B1 15 years service 10 years to retirement S=60 000, F= Employee B2 10 years service 10 years to retirement S=60 000, F= Employee C 1 year service 20 years to retirement S=50 000, F= % salary crediting rate

37 SOA Annual Meeting October /38 Liability as % of Notional Fund

38 SOA Annual Meeting October /38 Normal Cost for 6% Plan

39 SOA Annual Meeting October /40 HEDGING

40 SOA Annual Meeting October /38 TUC Approach Hedge to next valuation: Use 1-year risk free bonds to hedge liability to the next valuation Never over-funded (eg if employee leaves early) Never under-funded (eg if employee leaves early) Normal contribution rates vary. No model or parameter risk No subjectivity

41 SOA Annual Meeting October /38 TUC Approach AL AL t = F t ( ) c 1 = F + cs (1 + i ( t)) t+ t t The crediting rate i c (t) is known at the start of the year So AL t+1 is known Hence, investing AL t+1 e -r 1 in 1-year risk free bonds completely hedges the costs in t to t+1 NC = AL t+ 1 e r 1 ( ) F c = F + cs (1 + i ( t)) e t F r1 t t t

42 SOA Annual Meeting October /38 Example Employee enters in 2001 and retires in % of salary plan 30-year treasury crediting rate Entry salary of 50,000, say First year crediting rate is 5.39% 1 year risk free rate at entry is 3.55% F = , = TC0 = = = 6.107% of salary

43 SOA Annual Meeting October /38 TUC Example The total contribution rate will be greater than the nominal contribution rate whenever the crediting rate is greater than the 1-year rate. That is most of the time Could use the same principle but with out hedging Eg invest 60%/40% equities long bonds

44 SOA Annual Meeting October /38 TUC Example Contribution Rates

45 SOA Annual Meeting October /38 PUC Hedging PUC is forward looking Can derive a hedge strategy using the valuation approach For example, Delta or Delta Gamma hedging Dynamic hedge strategy to projected exit date. Assets are bonds and cash Model and parameter risk Early exercise risk

46 SOA Annual Meeting October /38 PUC Delta Hedging example Assume one factor Hull White interest rate model. Select hedge instruments zero coupon bonds with T 1 years to maturity at start Cash Use the derivative of V(t,T) (valuation factor) and P(t,T) (zero coupon bond price) to determine the position in the T 1 ZCB. Rebalance long bonds and cash as contract moves toward expiry.

47 SOA Annual Meeting October /40 PUC Delta-Gamma Hedging example

48 SOA Annual Meeting October /40 Actuarial Method Funding valuation liability is not matched to a hedge. Consistent underfunding requires risky investment strategy Assume 60% equities, 40% bonds Compare with TUC and PUC

49 SOA Annual Meeting October /40 Actuarial Method Example

50 SOA Annual Meeting October /38 Counterfactual example Previous examples were all set in a period of falling interest rates Leading to strong returns on long bonds Would the three methods perform similarly in a period of rising bond rates? Assess by reversing the path of bond rates and equity returns

51 SOA Annual Meeting October /38 Counterfactual example

52 SOA Annual Meeting October /38 Assets/Fund

53 SOA Annual Meeting October /38 Assets/Fund -- Counterfactual

54 SOA Annual Meeting October /38 A few takeaways... The risks for CB plans comes from steepening yield curve. The risks are greater than some proponents suggest The era of lower than nominal contribution rates may be over. The actuarial approach is an arbitrary funding plan with no connection to hedging Hedging the year end liability is simple, but costs more than the nominal contribution rate. There are significant risks when full funding is less than the nominal fund, in normal circumstances.

55 SOA Annual Meeting October /38 A few takeaways... The PUC approach is based on fair value principles. The valuation is not useful without implementing a hedge strategy Despite model and parameter risk, the HW deltagamma hedge appears to work quite well.

56 SOA Annual Meeting October /38 Acknowledgements and references Co-authors Dr David Saunders Xiaobai Mike Zhu Funding from NSERC (Discovery Grants and ) and the SOA CAE research grant. For details of PUC valuation and hedging, see Performance of Dynamic Hedging Strategies for CB Pension Plans.(2015) X Zhu, Masters thesis, University of Waterloo.