Pension Investment Strategy and Pension Risk Transfer Adapted for Mid-Atlantic Actuarial Club Annual Meeting September 11, 2014
Derisking costs Cost as % of ongoing liability* ACTIVE VESTED RETIREE TYPICALPLAN TERMINATED Ongoing 100 100 100 100 liability (ABO) Annuities paid 110 120 105 115 105 110 110 from plan Group annuity 115 130 110 120 108 112 115 Lump sums 95 100 95 100 100 110 n/a Plan termination 105 115 105 110 108 112 110 * Prior to RP 2014/MP 2014 adoption
Termination immunization illustrations Immunization vs. termination for well funded frozen pension plans Look at 3 fully funded plans Typical, Mature, and Young Baseline liability of $500M using a PBO or PPA full yield curve measurement ($ Millions) PLANS Typical Mature Young Active Liability $166.7 $100.0 $400.0 Terminated Vested Liability $166.7 $100.0 $50.0 Retiree Liability $166.7 $300.0 $50.0 Total Liability $500.0 $500.0 $500.0
Variables impacting cost Immunization cost factors Termination cost factors Bond underperformance relative to the liability Administrative expenses Offering lump sums Group annuity costs Lump sum acceptance rates Early retirement benefits and plan features Lump sum offer to retirees
Termination - immunization results* Immunization and termination have similar costs Deciding factors may be qualitative ($ Millions) PLANS Typical Mature Young Baseline Immunization Liability Baseline Termination Liability Termination/Immunizati on Ratio $537.6 $536.9 $540.0 $532.8 $537.4 $530.3 99.1% 100.1% 98.2% Lower cost alternative Neutral Neutral Termination * Prior to RP 2014/MP 2014 adoption
True cost of pension plan example 700 650 $ Millions 600 550 500 500 57 6 542 450 (21) 400 Ongoing ABO + Net yield difference + Expenses Lump sum savings Immunization Liability Assumptions: Liability is 40% active, 40% retiree, and 20% terminated vested. 75% of active and terminated vested participants take a lump sum. Ongoing liability, lump sum benefits, and group annuity all use the same mortality assumption.
Plan termination cost example 700 650 $ Millions 600 550 500 450 500 57 6 (32) (6) 3 12 539 400 Assumptions: Liability is 40% active, 40% retiree, and 20% terminated vested. 75% of active and terminated vested participants take a lump sum. Ongoing liability, lump sum benefits, and group annuity all use the same mortality assumption.
Immunization Termination comparison example* Immunization Termination Ongoing ABO 500 500 Net yield differential 57 57 Expenses 6 6 Lump sum savings (21) (32) Insurer investments (6) Plan provisions 3 Capital/profit 12 Total liability 542 539 * Based on RP 2014/MP 2014 mortality for all purposes
The drivers of uncertainty/volatility (risk) 20% Plan design and other 40% Investing in equities 40% Interest rate sensitivity Traditional DB plan with 60% 70% invested in equities; fixed income in broad market bonds
Investment objectives Traditional asset only Liability driven Minimize volatility around return objective Assets and liabilities move together
Pension investment derisking Changes in funded ratio change plan objectives and the asset mix 80% Funded 95% Funded 110% Funded Stocks Long bonds Extended bonds Intermediate bonds Higher return to improve funded status Lower risk to maintain funded status
Immunization things to think about Portfolio construction Performance reporting Investment policy statements Investment committees Pension accounting
Long corporates vs. pension plan C a s h F l o w 180 160 140 120 100 80 60 40 20 Liability duration = 14.2 Portfolio duration = 12.6 Yield = 4.5%. Net Yield = 3.7% 0% Treasury Pension cash flow Bond fund cash flow 0 5 10 15 20 25 30 35 40 45 50 55 Year of Payment
Long corp + STRIPS vs. pension C a s h F l o w 160 140 120 100 80 60 40 20 Liability duration = 14.2 Portfolio duration = 13.4 Yield = 4.1% Net Yield = 3.4% 40% Treasury Pension cash flow Bond fund cash flow 0 5 10 15 20 25 30 35 40 45 50 55 Year of Payment
Long corp + long STRIPS vs. pension C a s h F l o w 200 180 160 140 120 100 80 60 40 20 Liability duration = 14.2 Portfolio duration = 14.2 Yield = 4.4% Net Yield = 3.6% 15% Treasury Pension cash flow Bond fund cash flow 0 5 10 15 20 25 30 35 40 45 50 55 Year of Payment
Net Yield Portfolio 1 100% long corporate Portfolio 2 add targeted STRIPS Portfolio 3 add long STRIPS Corporate yield 4.52% 4.52% 4.52% Add Treasuries (0.46%) (0.10%) Investment costs (0.20%) (0.30%) (0.25%) Downgrades/defaults (0.65%) (0.39%) (0.56%) Net yield 3.67% 3.37% 3.61%
u1 Credit headwind illustration Matching corporate bonds don t keep up with liability Bonds A & B make up liability universe Market sees more credit risk in Bond B Bond B is downgraded out of liability universe Y i e l d 6.0% 5.0% Bond A Bond B Bond A Bond B yield increases Bond A Bond B Discount rate = 5.0% Discount rate = 5.5% Assets: lose value Liability: decreases Discount rate = 5.0% Assets: no change in value Liability: increases
Slide 17 u1 unms 7/20/2012 Investment General\Pension Finance update SME: Nathan Zahm (Kyle Morrison) Updates: Q (some slides -- Nathan to decide) unms, 7/20/2012
Portfolio summary Portfolio 1 100% long corporate Portfolio 2 add targeted STRIPS Portfolio 3 add long STRIPS Hedge ratio 88% 94% 100% Curve match OK Good OK Basis mismatch no Treasuries 40% Treasury 15% Treasury Gross Yield 4.52% 4.06% 4.42% Net Yield 3.67% 3.37% 3.61% Which one do you like?
Portfolio construction issues Modeling performance Stochastic A-L modeling not very helpful How to calculate tracking error ex-ante? Do credit spreads revert to mean? Which liability/discount rate? Splitting portfolio amongst managers Keeping it simple for investment committees
Liability measurement alternatives The yield curve used to measure the liability is important AA downgrades Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 AA Curve 6A Curve PPA Curve Source: Vanguard
Performance reporting Assets Liabilities Beginning of period 1500 1500 Contributions/accruals 0 0 Benefit payments 100 100 Investment return Equity 0 0 Interest accrual 17 19 Interest rate change 40 41 Total return 57 60 End of Period 1457 1460 A simple overview is helpful
Performance reporting Is tracking error outside anticipated range? Compare ex-post hedge ratio to ex-ante hedge ratio What about negative numbers? Assessing individual manager performance What mismatches are arising from Level of rates Shape of the yield curve Basis mismatch Credit spreads Other noise (demographics, data)
Investment Policy Statement Some concepts and objectives must change Diversified Return in excess of benchmark Strategic asset allocation Long-term Balanced Performance measurement Rebalancing Must maintain fiduciary focus!
Investment committee Manager selection criteria Economic forecasts Return vs. benchmark return Peer group return comparisons Evaluation of manager performance Expected return Is the typical investment committee process relevant for overseeing immunization strategies?
Typical Accounting Paradigm: short-term Current yield on hypothetical corporate bond portfolio 5.20% Yield sacrifice (Treasury exposure) 0.20% Downgrade adjustment 0.60% Investment management cost 0.30% Net yield 4.10% Annualized impact of interest rate rise over 2 years 2.00% Expected 2 year return 2.10% Discount rate EROA
Typical Accounting Paradigm: long-term Yield on hypothetical corporate bond portfolio 5.20% Yield sacrifice (Treasury exposure) 0.20% Long term downgrade adjustment 0.60% Investment management cost 0.30% Net yield 4.10% Annualized impact of interest rate rise over 30 years +0.20% Expected long term return 4.30% Discount rate EROA
Rational Accounting Paradigm Yield on hypothetical corporate bond portfolio 5.20% Yield sacrifice (Treasury exposure) 0.20% Long term downgrade adjustment 0.60% Investment management cost 0.30% Net yield 4.10% Discount rate EROA
Immunization summary It s a whole new world!