A perspective on retirement security: Who stands behind America s pensions?

Transcription

1 A perspective on retirement security: Who stands behind America s pensions? This article broadens the discussion of the security of pension promises by considering the funding of those promises as well as investment strategy and the question of whether a backstop will step in should additional future contributions be required. In particular, I argue that too little recognition is currently awarded to the importance of the plan sponsor as a backstop and that too little thought is given to how this role affects funding and investment decisions. This role should not be seen as a contingency but as a fundamental component of retirement security. A more solid foundation for debating retirement provision Retirement provision is a big business. A huge amount of effort and a large part of the financial services industry is devoted to providing income to individuals in their retirement years. The approaches to retirement provision include state-provided benefits, employersponsored plans, and individual savings vehicles. The merits and robustness of these various approaches are the subject of considerable debate. The challenges are made all the greater by a weak economy and volatile markets. However, the debate is not always as informed and rational as it should be. Advocates of a particular approach can be guilty of seeing only its strengths (and thus fail to take the necessary steps to ensure the potential weaknesses are properly managed) while critics can be equally focused only on weaknesses. Too often the important questions get lost in the rhetoric. This article offers a more-solid foundation for this debate by providing a better-defined framework for thinking about the security of pension promises. 1 Collie, R. (2012, September/October). A perspective on retirement security: Who stands behind America s pensions?. Investments & Wealth Monitor by Investment Management Consultants Association (IMCA), This article was first published in Investments & Wealth Monitor, Sept/Oct Russell Investments // A perspective on retirement security: Who stands behind America s pensions? Frank Russell Company owns the Russell trademarks used in this material. See Important information for details.

2 Nothing is certain Nothing is certain in life, and the provision of retirement income played out as it is over decades is an especially uncertain game. Let s consider three aspects of this uncertainty: 1. Funding. How much money is set aside today? 2. Investment. How much risk is being taken in the investment of those assets? 3. Backstop. What happens in case of a shortfall? Each question is relevant to a proper understanding of the security of the benefits provided by the various approaches to retirement provision. The third question the question of a backstop in the event of a shortfall is, however, often overlooked. It is an important question because it addresses what happens if the funding regime proves inadequate and also because it affects the approach to the first two questions. The stronger the backstop, the wider the choices in funding and investment strategies. So it is important not only to look at each of the three questions listed above, but also to consider how they interact with each other. First, a quick word about Social Security. I treat Social Security here as a given, a fixed reality on top of which other systems operate. In reality, of course, Social Security has a funding regime, an investment program (albeit an investment program that takes place entirely within the government s books), and a backstop the U.S. government should funding prove inadequate. However, the size and legal basis 1 of Social Security put its further discussion beyond the scope of this paper. Funding: Money set aside today to provide for tomorrow s retirement Most approaches set money aside to back the targeted retirement income. The amounts vary considerably. At one extreme are employment-based pensions provided to federal employees before 1986 under the Civil Service Retirement System (CSRS). A significant part of these promises have not been pre-funded; they are paid when they fall due out of current federal government revenues. Despite a substantial unfunded liability of roughly $750 billion as of September 30, 2010 (OPM, undated), these pensions are backed by the full faith and credit of the U.S. government. The funding arrangement is exceptionally weak, but the backstop is exceptionally strong. By contrast, consider the assets that must be set aside to fund benefits paid by insurance companies. Insurance companies are required to hold reserves against their book of annuity business based on cautious assumptions about interest rates and mortality. Those required reserves are materially larger if the assets are invested in anything other than the safest investments. This approach reflects the fact that insurance companies have no backstop, nowhere to turn for additional funding in the event of a shortfall. So if the insurance industry is to survive through thick and thin, it must take a cautious and long-term approach to funding and investment. Between these two extremes lies a range of approaches to funding. At the heart of any funding approach is a discount rate, which provides a means of placing a present value on future money. In other words, how much of today s money will it take to get a payment of $1 at some point in the future? Table 1 shows the value that would be placed on a payment stream of $1 a year for each of the next 40 years using a variety of discounting approaches. The stronger the backstop, the wider the choices in funding and investment strategies. So it is important not only to look at each of the three questions listed above, but also to consider how they interact with each other. Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 2

3 Table 1: Present value of a 40-year, $1/year liability stream under various discount rates Discount rate Value Fixed rate of 8% $11.92 Fixed rate of 7% $13.33 IRS Yield Curve as of January 1, 2012 $17.69 IRS Yield Curve as of January 1, 2009 $13.61 IRS Smoothed Segmented Yield Curve as of January 1, 2012 $13.25 Treasury Yield Curve as of January 1, 2012 $24.72 Public pension plans (such as those for state or local government employees) tend to use a fixed discount rate in their funding; 8 percent has been typical though lower rates are now becoming more common, reflecting the fall in yields on most fixed income investments over recent years. Corporate plans use discount rates that are tied explicitly to high-quality corporate bond yields. We see that the same liability stream, priced off those yields, would have increased in value by around 30 percent between January 1, 2009, and January 1, 2012, due to the fall in interest rates. The average segmented yield curve is not strictly a separate yield curve but rather a 24-month moving average of the full Internal Revenue Service (IRS) yield curve, as adjusted under the provisions of the Moving Ahead for Progress in the 21st Century Act of 2012 (provisions that were intended to stabilize funding requirements at a time of unusually low interest rates). The average segmented curve is widely used in practice to value liabilities because it reduces the volatility of the valuation results. As of January 1, 2012, it produces a liability value some 25 percent below that based on the full IRS yield curve. Pension arrangements in the United States typically are funded based on corporate yields, but this is not the case elsewhere in the world. Funding rules in the United Kingdom and Japan, for example, key off of government bond yields. The Treasury yield curve represents the closest thing available to a U.S. risk-free discount rate and hence is an indication of the impact of basing funding policy on risk-free rates, without counting on future investment returns greater than those that can be locked in today. (This sum includes no margin for mortality risk or other contingencies, so it is only risk-free on the investment side.) Table 1 shows the assets that would produce a 100 percent funded status using each of the various discount rates. The funded status of a plan varies in practice, and today most arrangements are less than 100 percent funded. The amount of money actually set aside against the same liability under different systems therefore varies even more than indicated in table 1. For example, a plan that is 95 percent funded using a fixed discount rate of 8 percent may hold $11.32, while a plan using the full IRS yield curve as of January 1, 2012, and holding $15.92 would be 90 percent funded and would have been more than 115 percent funded at the start of In other words, because of the uncertainty of investment returns and the possibility of future capital injections, funding can be seen as a question of choice. 3 That choice, however, is tied closely to investment strategy and the nature of the backstop, which I examine below. Because of the uncertainty of investment returns and the possibility of future capital injections, funding can be seen as a question of choice. 2 Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 3

4 Investment strategy: A trade-off of risk and return A cautious approach to funding, such as that required of the insurance industry, goes hand in hand with a cautious approach to investment, and more-aggressive funding approaches tend to be associated with more-aggressive investment strategies. This relationship makes sense to the extent that a risk premium exists, i.e., that riskier investment strategies tend to deliver higher returns over time. In table 1, we noted that a 40- year $1 liability stream would be valued at $11.92 using a discount rate of 8 percent and at $13.33 using a discount rate of 7 percent. In other words, $11.92 will be adequate to fully meet that liability assuming an 8 percent annual return, but if we are going to earn only 7 percent, then we need $ We see this expectation of earning a future risk premium in the return expectations published by various institutions. For example, corporate accounting statements (e.g., 10-K filings) indicate that the expected long-term return on assets for the typical corporate defined benefit (DB) plan is 7-8 percent a year. Because the effective yield on Treasuries when those expectations were published was around 4 percent a year, the implied expected risk premium is 3-4 percent a year over Treasuries. Table 2 shows my estimates of representative investment strategies for various types of retirement arrangements in the United States. Table 2: Estimated typical investment strategies of various retirement systems (U.S.) System Equity Fixed income Real estate Other Federal DB - 100% - - Public sector DB 55% 30% 5% 10% Corporate DB 45% 40% 5% 10% Multi-employer DB 50% 35% 5% 10% Insured arrangement - 100% - - Defined contribution (all types) 60% 10% - 30% The riskier investment strategy does not offset the weaker funding regime, but rather compounds it. Remember, however, that risk in the investment program opens up the possibility of loss. Risk may be rewarded over time and lead to higher investment returns, which is obviously the intention but this outcome is not certain. A riskier investment strategy should generate better returns, but it certainly will not do so over every time period and the periods of underperformance can be long and severe. The perspective of benefit security requires that we consider the likelihood that the backstop will be called upon (rather than the average expected outcome over the long term) so, from this perspective, the riskier investment strategy does not offset the weaker funding regime, but rather compounds it. Therefore a case could be made that increased investment risk should lead to an increased funding requirement. We can see this, for example, in the funding system used in the Netherlands, a country with pension regulation based on insurance principles. Those principles have been summarized by Ansley et al. (2010) thus: When you make a pension benefit promise, define its value by reference to the value of the assets that most closely match those liabilities in timing and size. No assets match perfectly, so add the requirement for risk capital to the extent of 5% of this value. The minimum acceptable funding level is therefore 105% of this value. It is perfectly reasonable for a sponsor to want to exploit the long-term likelihood of being rewarded for taking equity risk in the capital markets, and thereby reduce the long-term cost of providing benefits. But all risk first requires risk capital to back it. Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 4

5 Depending on the extent of the equity risk taken, there is a prescribed amount of additional risk capital required. For high equity exposures, this could require risk capital of a further 25% of the liability value, creating a minimum acceptable funding level of 130% of the liabilities. Shortfalls relative to the minimum acceptable funding level must be made up quickly, within 3 years (though this has recently been extended to 5 years). The Dutch insurance-type approach aims to minimize the likelihood of a shortfall. This leads to more assets being set aside and a cautious investment strategy, and if a less-cautious investment strategy is followed, then an even more-cautious funding strategy. Most U.S. approaches, however, aim to reduce the cost of retirement provision by targeting higher investment returns and being less cautious in funding. This increases the likelihood that at some point a shortfall will arise and additional capital will be needed from somewhere. A proper understanding of that somewhere is therefore essential to any analysis of the various systems in operation in this country. The backstop role should be seen as an integral part of the system design and a material element of benefit security. Contingency: Who provides the backstop? If the funding regime and the investment strategy prove inadequate, retirement security depends on a backstop and how far the backstop will go to ensure that the targeted benefit is actually paid. The weaker the funding regime and/or the riskier the investment approach, the more important the backstop becomes. FEDERAL EMPLOYEES, BACKED BY THE FULL FAITH AND CREDIT OF THE U.S. GOVERNMENT Consider, for example, federal government employees. We described above how no assets at all are set aside against a large part of the liabilities of the Civil Service Retirement System. The good news is that the backstop is the full faith and credit of the U.S. government, which would be high on just about anyone s list of preferred guarantors of a financial promise. Indeed, because that same full faith and credit backs Treasury bills and bonds, one could choose to see benefit security as similar to that of a cautious funding regime invested entirely in U.S. Treasury securities. So CSRS beneficiaries can probably rest easy. Taxpayers may be less happy with this arrangement, of course, because it can lead to overpromising; the true cost of a valuable employee benefit can be overlooked if it is not funded. Indeed, this is a large part of why CSRS was replaced in 1984 by plans with clearer accounting for the costs of benefits. For the DB component of federal employee retirement, the successor to the CSRS is the Federal Employees Retirement System (FERS) annuity. Unlike CSRS it is a funded system, although it is funded with budget authority, or special-issue bonds that involve intraagency accounting transfers. Because FERS is an agency of the U.S. government, not a separate legal entity, the books all roll up to the same place; hence the funding all takes place within the books of the U.S. government. As an aside, this is the same approach that is taken to funding Social Security. Thus, the funded liabilities depend on the U.S. Treasury making good on its obligation regarding the special class of bond, while the unfunded liabilities depend on the U.S. Treasury making good on its obligation regarding the benefit promise itself. In other words, in this case the main difference between funding and not funding seems to be its treatment in government accounts and the calculation of the national debt, not any substantive difference in the degree of benefit security. 4 If the funding regime and the investment strategy prove inadequate, retirement security depends on a backstop and how far the backstop will go to ensure that the targeted benefit is actually paid. Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 5

6 DEFINED CONTRIBUTION HAS NO BACKSTOP AT ALL A DC approach is quite different. DC includes individual retirement accounts, 401(k) plans, 403(b) plans, 457 plans, and the federal-employee Thrift Savings Plan (TSP). DC approaches have no backstop. The existing assets and the investment returns earned on them are the only layers of security; if the money turns out to be inadequate for a particular level of benefit, then the retiree must settle for less. (It s worth noting, however, that DC also provides its participants the benefit of any upside.) The absence of a benefit promise removes the possibility of an explicit shortfall and hence the need for a backstop. Which is not to say that DC plans cannot fail; they can. Failure simply takes a different, vaguer shape. A lifetime of saving may result in an inadequate level of retirement income if investment experience is poor. Indeed, it is the nature of a DC system that different individuals will experience different levels of investment return; cohorts with key savings years that coincide with the strongest markets will enjoy more-prosperous retirements than their unlucky counterparts a few years ahead or behind them. It is inevitable that some groups will fare far better than others. INSURED ARRANGEMENTS HAVE GUARANTY ASSOCIATIONS AS BACKSTOPS I described earlier the way in which the funding and investment regimes of insurance companies are designed to make insolvency unlikely. This means that the backstop plays a less-central role than in other arrangements. Nonetheless, occasional insolvencies can and do occur. When they do, there is a backstop in the form of state guaranty associations. The protection these associations offer is limited and varies from state to state, but the key point is that even with cautious funding and investment rules, the backstop role remains relevant. CORPORATE DB, WITH THE CORPORATION AS PLAN SPONSOR Having examined approaches where benefit security rests entirely on the backstop (CSRS), entirely on the funding reserves (DC), or almost entirely on the funding reserves (insured arrangements), we can move on to the finer nuances of other arrangements. A sizeable minority of U.S. corporations still offer DB pensions. Of the 3,000 largest U.S. listed corporations, more than 900 sponsor DB plans. Among these corporations, there is enormous variation in ability to underwrite fluctuations in pension plan experience. For example, Collie (2008) compares the airline industry to the oil industry (based on K filings as captured by Factset) and notes that: Seven airlines in the Russell 3000 Index have defined benefit plans. Six corporations in the integrated oil sector of the same index have defined benefit plans. The pension plans of the two industries, in aggregate, appear to be quite similar: somewhat underfunded, and with benefit accruals that are modest relative to existing assets The oil companies have total DB assets of $49 billion. Their combined projected benefit obligation (PBO) is $59 billion. So the funded status for the industry as a whole is around 83%. The combined service cost of the six corporations (i.e., the cost of the benefits accruing in 2007) is $1.66 billion, just under 3% of the PBO. On the surface, that is not very different from the airline industry. The seven airlines show total DB assets of just over $23 billion and a combined PBO of $31 billion: an industry funded status of 76%. The service cost of $537 million is slightly below 2% of PBO (However), the oil companies PBO is equivalent to about 6% of their combined market capitalization. For the airlines, the comparable number is more than 150%. Indeed, the unfunded portion of their PBO is equivalent to almost 40% of the airlines combined total market capitalization. Among these corporations, there is enormous variation in ability to underwrite fluctuations in pension plan experience. Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 6

7 This variation in the size of the plan relative to the corporation, which is variation that exists among corporations within an industry as well as across industries, is important in assessing the role of the corporation as backstop. If the plan is relatively small, the backstop role is easy to play and not disruptive to the general operation of the plan sponsor. If the plan is large, then even the normal year-to-year variation in plan experience can disrupt the corporation s financials. It is difficult for plan fiduciaries to question the strength of the plan sponsor s covenant when making decisions about funding and investment; doing so might be seen as disloyalty or being unsupportive. Thus it is uncommon to give meaningful consideration at the plan-byplan level to the plan sponsor s role as backstop. Nonetheless, that role is critical whether it is formally acknowledged or not. Should the corporation fail, the Pension Benefit Guaranty Corporation (PBGC) provides the next level of backstop. This independent agency of the U.S. government is funded by premiums charged to DB plans. The PBGC takes over plans of failed corporations by taking over the assets and assuming responsibility for paying the benefits, usually at a reduced level; individual benefits are capped at $4,653 a month for As of September 30, 2011, the PBGC was trustee for 4,292 single-employer plans, with assets totaling $79 billion and liabilities valued at $102 billion, for a shortfall of $23 billion (PBGC 2011). As the number of open DB plans continues to shrink, the premium base of the PBGC can be expected to fall. There is no explicit government backing for the PBGC, so more attention has been paid over the years to ensuring that it is able to meet its liabilities. The Pension Protection Act of 2006 (PPA) resulted in part from a desire to reduce the incidence and size of plan failures and the pressure on the PBGC caused by each new plan failure. The PPA includes measures designed to shore up funding of corporate DB plans, and represents a step in the direction of fuller funding and a reduced reliance on plan sponsors as backstops. But, as is made clear by the analysis in this paper, it did not remove that reliance; the backstop role of the plan sponsor remains important. CASH BALANCE BENEFIT SECURITY OPERATES LIKE A DB PLAN Cash balance plans are classified as DB plans but the benefit offered is based on an account balance rather than a targeted annual benefit amount. The account balance does not vary with actual investment experience (as in a true defined contribution arrangement) but is increased each year with an interest credit. Sometimes called hybrid schemes, cash balance plans are distinct enough from pure DB and DC that they deserve separate consideration. The cash balance plan benefit is more akin to a DC benefit than a DB benefit, but its security works like a DB arrangement. The plan sponsor funds the benefits as they accrue and investment policy typically involves some risk-taking in pursuit of higher returns. In the event of a shortfall, the plan sponsor is required to make additional contributions. If the plan sponsor fails, the PBGC can take on the assets and liabilities. So as far as benefit security is concerned, cash balance plans are very much like other DB plans. Public sector plans vary more than private sector plans because they are not governed by a single set of rules or regulations, but by legislation that is passed state-by-state. There is no PBGC or equivalent to act as a second layer of backstop. PUBLIC SECTOR DEFINED BENEFIT HAS SIGNIFICANT VARIATION Public sector plans vary more than private sector plans because they are not governed by a single set of rules or regulations, but by legislation that is passed state-by-state. There is no PBGC or equivalent to act as a second layer of backstop. Public plans vary in size from very small to the mighty CalPERS, which had 1.6 million members and $227 billion in assets as of May 31, 2012 (see Public plans vary in the strength of their funding and in investment strategy. They also vary in the nature of the backstop. An extreme example is Prichard, Alabama, which stopped paying Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 7

8 pensions in September 2009 because its pension plan assets completely ran out (Cooper and Walsh 2010). Alabama law requires the city to pay the pensions, but Prichard found itself unable to do so. Retirees sued, and a settlement was reached in March 2012 for benefits to be paid at a significantly reduced level. There is no PBGC backing or other place to turn apart from the municipality itself, which has twice declared bankruptcy. So the security of public sector pension plan promises in the event of a funding shortfall ultimately devolves to the municipality or state that sponsors the plan. As with corporate plans, it can seem inappropriate for those close to the plan to question the strength of this backstop. However, just as with corporate plans, it is only the existence of that backstop that permits the funding and investment strategies we observe in practice. MULTI-EMPLOYER DEFINED BENEFIT SHARES THE PAIN OF SHORTFALL We round out our overview of U.S. pension systems with some observations about multiemployer plans. The Labor Management Relations Act of 1947 (better known as the Taft- Hartley Act) established rules for the provision of benefits to unionized employees. These have much in common with single-employer private sector plans as described above, including the backing of the PBGC. One unique feature of multi-employer plans is that the response to a funding shortfall must be negotiated but generally will involve both an increase in contributions and a cut in future benefit accruals. Thus workers have even more direct interest in the health of a multiemployer plan than a typical single-employer plan. If the multi-employer plan sponsors fail, the PBGC can take over the liabilities, but the benefit cap roughly $36 a month per year of service is much lower than for single-employer plans. Conclusion: A full picture of retirement security must include the backstop It is confidence in the role of the backstop that allows the funding and investment strategies commonly seen in U.S. retirement provision. (The major exception is defined contribution arrangements, which have no party to fill the backstop role.) These funding and investment strategies are designed to reduce the cost of providing benefits, and it is a reasonable expectation that they will do so in most cases. But these strategies have no guarantee of success. Even if they are successful over the long term, we can be very confident that, markets being what they are, those strategies will periodically lead to funding gaps. For that reason, the role of the backstop is more central to retirement security than generally acknowledged. Security for a pension promise rests not only on the funding of that promise but also on what happens when investment returns fall below expectations and a shortfall emerges. The role of the backstop the plan sponsor or other entity that steps in to make good on a shortfall should be treated as an integral component of benefit security, not merely a contingency plan. The role of the backstop is more central to retirement security than generally acknowledged. Security for a pension promise rests not only on the funding of that promise but also on what happens when investment returns fall below expectations and a shortfall emerges. REFERENCES Ansley, Craig, Gerben Borkent, Don Ezra, Michael Hall, and Steven Low As DB dies. Russell Investments Viewpoint (September). Collie, Bob Where next for LDI? Russell Investments Research Report (December). Cooper, Michael, and Mary Williams Walsh Alabama Town s Failed Pension Is a Warning. New York Times (December 22). Pension Benefit Guaranty Corporation (PBGC) PBGC Annual Report. U.S. Office of Personnel Management (OPM). Undated. Fiscal Year 2010 Agency Financial Report. Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 8

9 1 The 1960 Supreme Court Case Flemming v. Nestor ruled that To engraft upon the Social Security system a concept of accrued property rights would deprive it of the flexibility and boldness in adjustment to ever-changing conditions which it demands and hence that entitlement to Social Security benefits is not a contractual right. 2 This comment is made in the context of funding, not accounting. I argue in this article that hoped-for gains from an investment program and the reassurance of a guarantor in the event that those gains do not materialize can provide acceptable grounds for setting aside less money today, provided all concerned are aware that this is being done. Extending that argument to say that it is reasonable to take credit for those future gains in current accounting statements would seem on the surface at least to be at odds with established accounting principles. Within an accounting context a completely different analysis is necessary. 3 ibid 4 If push ever comes to shove, we likely will find an unstated seniority of some U.S. government obligations over some others. This prioritization very nearly was tested on August 2, 2011, when political fighting over the raising of the debt ceiling almost led to the government defaulting on some obligations with contractor payments, welfare spending, and tax refunds rumored to be among the obligations at risk. Officially, though, there is no stated order of priority in the event of default. Author: Bob Collie For more information: Call Russell Investments at or visit russellinvestments.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Russell Investments ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the FTSE RUSSELL brand. Copyright Russell Investments Group, LLC. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: October 2012 (Reviewed May 2016 for continued use; Disclosure revision: July 2016) USI Russell Investments // A perspective on retirement security: Who stands behind America s pensions? / p 9