Workshop 1: Variable Annuity Plans

1 Workshop 1: Variable Annuity Plans James E. Holland, ASA, FCA, EA, FSPA, MAAA Cheiron Andrew W. Ferguson, FSA, EA, FCA, MSPA, MAAA Altman & Cronin Benefit Consultants, LLC 2 1. Background Today s Agenda 2. Why Variable Annuity Plans? 3. Lump Sums 4. Funding Rules 5. Non-Discrimination 6. 415(b) Limits 7. Q&A 3 1

Background What is a Variable Annuity Plan? Defined benefit plan Usually a career-average or flat dollar accrual 2016 accrual = $1,500 per year payable at age 65 OR 2016 accrual = 1.0% of pay Periodic investment adjustments VAPs have nothing to do with Insurance 4 Background Variable Annuity Plan: ONLY difference from traditional DB Plan: Periodic investment adjustments Otherwise, identical to traditional DB Plan Periodic investment adjustments: Monthly, quarterly, annual, etc. Andrew s VAPs have monthly adjustments for actives, and annual adjustments for retirees 5 Investment Adjustments Investment Adjustments: Adjustments are similar to a COLA, except that: Adjustments apply to all accruals for each year Even applies pre-commencement Even applies to active participants as they accrue benefits Example: In 2015, Kevin accrues $1,500 as NRbenefit Plan assets earn significant investment gain in 2016 Kevin s 2015 accrual adjusted to $1,625 by year-end 2016 6 2

Investment Adjustments Investment Adjustments: Apply against a hurdle rate Fixed interest rate (usually 5.0% to 6.5%) If 0%, then total adjustment ( pure VAP) If investment return exceeds hurdle rate: Normal retirement benefit increases If investment return falls short of hurdle rate: Normal retirement benefit decreases! 7 Investment Adjustments Investment Adjustments: Investment return for adjustment based on: 1. Return on all plan assets 2. Return on subaccount of plan assets 3. Return on RIC (mutual fund) 4. Return on investment index (e.g., S&P 500) 5. Return on separate account 8 Design Variations Variable Annuity: Design Variations 1. Apply invest adjustments only BEFORE commence Participants hold investment risk during career Fixed annuity upon retirement Plan sponsor holds investment risk post-retirement, or purchases an annuity 2. Apply invest adjustments only AFTER commence Plan sponsor holds investment risk during career Investment risk shifts to participant upon retirement 9 3

Design Variations Variable Annuity: Design Variations (cont ) 3. Floor benefit Adjustments cannot reduce benefits below floor benefit More common with VAP conversions 4. Limit investment adjustments each year As with market-rate Cash Balance Plan, limit investment adjustment either up, down, or both Example: investment adjustment, limited to 8% May need cap for non-discrimination 10 Design Variations Variable Annuity: Design Variations (cont ) 5. Differences in timing of Adjustments Monthly adjustment for benefits pre-commencement Annual adjustments for annuities Allows more current updated for employees, without burden of monthly annuity adjustments 11 Investment Adjustments Ben [After] = Ben [Before] * (1 + int) / (1 + hurdle) Example: Kevin accrues $1,500 NRBen for 2015 Hurdle rate = 5.0% 2016 return = -2.0% (i.e., 2% loss) NRBen [After] = $1,500 * 0.98 / 1.05 = $1,400 Reduction is actually 7%! 2% for the investment loss, and 5% for the hurdle rate 7% total reduction 12 4

Investment Adjustments Can Investment Adjustment be Negative? YES: Similar to reduction in Final-Average-Earnings benefits if earnings average decreases Similar to negative Cash Balance interest crediting rate 13 Why Variable Annuity? Why use a Variable Annuity Plan? VAPs shift investment risk From employer to participants Participants bear 100% of investment risk Similar to market-rate Cash Balance plan How does this apply for: Tax-motivated plans? Rank-and file plans? 14 Why Variable Annuity? Example: Traditional DB Plan One participant: Age 63 now $2.4 million lump sum payable at age 65 (in two years) Discount rate = 5.0% How to invest current assets of $2.18 million? Can t get 5.0% per year in short-term Short-term investing would leave shortfall Long-term investing too volatile 15 5

Growth of Obligation $2,500,000 $2,400,000 $2,300,000 $2,200,000 $2,290,000 $2,400,000 $2,100,000 $2,180,000 $2,000,000 2016 2017 2018 16 Obligation vs Asset $2,500,000 $2,400,000 $2,300,000 $2,200,000 $2,100,000 $2,180,000 $2,400,000 $2,300,000 $100,000 Shortfall $2,000,000 2016 2017 2018 Returns: 8% (2016) and -2% (2017) 17 Why Variable Annuity? Results with Traditional DB Plan: Open-ended obligation for employer to fund In this example, $100,000 shortfall Owner might (or might not) appreciate the opportunity to contribute additional tax-deferred funds But what about a multiple-owner situation? Would fixed obligation per participant ($2.4 million in two years) cause difficulty with funding? 18 6

Why Variable Annuity? Variable Annuity Plan instead Apply investment adjustment to Obligation Ben [After] = Ben [Before] * (1 + int) / (1 + hurdle) 2017: $2.40 million * 1.08 / 1.05 = $2.47 million 2018: $2.47 million * 0.98 / 1.05 = $2.30 million Results: NO underfunding Obligation automatically adjusted to match assets 19 Growth of Obligation $2,500,000 $2,400,000 $2,300,000 $2,200,000 $2,100,000 $2,180,000 $2,350,000 $2,300,000 $2,000,000 2016 2017 2018 20 Obligation vs Asset $2,500,000 $2,400,000 $2,300,000 $2,200,000 $2,100,000 $2,180,000 $2,300,000 Obligation is exactly fully funded! $2,000,000 2016 2017 2018 21 7

Why Variable Annuity? Notes on Example: Indexing applies to the benefit ultimately paid 2017: $2.40 million * 1.08 / 1.05 = $2.47 million PV(2017) = $2.47 million / 1.05 = $2.35 million Thus PV(2017) = 2017 assets No contingencies in example. In real life, have funding variations due to: Vesting Mortality Design subsidies (early retirement, J&S) 22 Asset Allocation Impact of Asset Allocation In Example, we assumed equity-type returns: 2016: 8% gain 2017: 2% loss Same Result regardless of asset returns E.g., fully funded if returns were 0.1% (money market) Plan s asset allocation: Affects year-to-year benefit amounts, Does NOT affect initial amount needed to fully fund 23 Why Variable Annuity? Tax-Motivated Plans: Define owner s contribution as amount needed to fully fund her/his VAP benefit Annual contribution = amount needed to fully fund the current year s accrual Investment adjustments will automatically align the owner s benefit value with the Plan s asset value Avoid design subsidies, manage the vesting and mortality, and watch the IRS benefit limits ( 415(b)) BEWARE THE ERISA ISSUES! 24 8

Why Variable Annuity? Rank-and-File Plans: Pool large number of participants Benefits are adjusted by Plan investment return Annuities only (no lump sum offered) Advantages over DC Plan: Participants protected for longevity Professional investment direction See work of Lee D. Gold of Mercer on this subject 25 ERISA Issues 1. Lump Sum determinations Minimum value requirements under 417(e) 2. Funding issues How to determine Funding Target, Target Normal Cost? 3. Non-discrimination How to equate ( normalize ) VAP benefits to other types of benefits? 4. IRS Benefit limits Application of IRC section 415(b) 26 Lump Sums in VAPs Lump Sum calculation: Traditional DB Plan: Fixed benefit payable (e.g., Kevin s $1,500 per month) Discount using mortality (PPA) and 417e segment rates Variable Annuity Plan: Future benefits vary by investment adjustments What is the value of these adjustments? Current actuarial controversy... 27 9

Lump Sums in VAPs Options for VAP Lump Sums: 1. Don t offer LS Reasonable approach for rank-and-file plans, whose goal is to provide lifetime income to participants Unreasonable approach for tax-motivated plans 2. Offer LS using assumed future investment returns LS unpredictable due to whipsaw 3. Offer LS at hurdle rate LS stable and predictable BEWARE THE ERISA ISSUES! 28 Lump Sums in VAPs VAP Lump Sums with Assumed Invest Return: 1. Assumption about future invest adjustments Cannot allow discretion in LS calculation LS must be definitely determinable Plan document must describe how LS is calculated 2. Assumptions usually made based on existing facts Future investment return assumptions usually based on analysis of asset allocation What if asset allocation is changed after Plan adopted? 29 Lump Sums in VAPs VAP Lump Sums with Assumed Invest Return: 3. Any resulting LS will be greater than, or less than, the amount needed to fund the benefit 4. Amount needed to fund benefit is independent of Plan asset allocation (see Slide 22) Why should LS depend on asset allocation, when amount needed to fully fund the VAP benefit does not? Allocate to money market to low-ball Lump Sum? An aggressive allocation would pay participant for risks not taken 30 10

Lump Sums in VAPs VAP Lump Sums with Assumed Invest Return: 5. Compensates participant for forfeited investment opportunities Participant may be unable to replicate VAP investments Particularly with hard-to-value or esoteric VAP assets Participant loss compensated by projecting and discounting assumed future returns Similar to Rohm & Haas case (COLA adjustment) 31 Lump Sum at Hurdle Rate Third Alternative: LS at Hurdle Rate Make explicit assumption for invest adjustments Investment adjustment rate = 417e segment rate First 5 years of payments adjusted by 1 st segment rate Next 15 years of payments adjusted by 2 nd segment rate Remaining (20+ years) payments adjusted by 3 rd seg rate Plan document states this assumption Definitely determinable criteria met Not subject to discretion 32 Lump Sum at Hurdle Rate Advantages of LS at Hurdle Rate 1. LS = amount needed to fund benefit LS = economic value of benefit 2. LS is stable and predictable Owner gets funded amount, with investment adjustments to date of payment Similar to market-rate Cash Balance Plan 33 11

Lump Sum at Hurdle Rate Advantages of LS at Hurdle Rate (cont ) 3. Reflects relative value of hurdle rate High hurdle rate >> smaller future invest adjustments >> smaller lump sum Low hurdle rate >> higher future invest adjustments >> higher lump sum Example: a 6% hurdle rate results in a smaller lump sum than a 5% hurdle rate, which is appropriate, since future adjustments would be greater with the 5% hurdle rate 34 Lump Sum at Hurdle Rate Advantages of LS at Hurdle Rate (cont ) 4. LS doesn t pay participant for risks not taken If, instead of using hurdle rate, future investment adjustments were based on asset allocation, then LS would include discounted value of future expected returns, which the participant did not actually invest his/her money to earn Participant gets paid twice once in the LS for returns not earned, and then again by investing the LS proceeds 35 Lump Sum at Hurdle Rate If Investment Adjustment = Discount Rates, what is investment return assumption? Suppose 417e segment rates: 1.5%, 4.0%, 5.0% Years 1 to 4: 1.5% per year Year 5: 14.63% (Discount at year 5 = 1.04 5 = 1.2167%, divided by return in first four years = 1.015 4 = 1.0614%, results in 1.1463%) Years 6 to 19: 4.0% per year Year 20: 25.94% Years 21 and later: 5.0% per year 36 12

Lump Sum at Hurdle Rate Hmm where have we heard this before? Berger vs Xerox (7 th Circuit, 8/1/2003) The Xerox plan computed the lump sum differently. Instead of adding future interest credits to the departing employee's cash balance at the plan's future-interestcredits rate, it added interest at a rate exactly equal to the discount rate... The two rates, the interest rate and the discount rate, being identical, canceled, with the result that the lump sum was his cash balance Result: $300 million judgment against Xerox 37 Lump Sum at Hurdle Rate ERISA Exposure: If lump sums are determined without an explicitly independent assumption as to future investment adjustments, then the Variable Annuity Plan could be at risk for a participant lawsuit Although, for lawsuit to be successful (in counsel s eyes), must be reasonable to conclude that future investment adjustments would exceed VAP s hurdle rate Set high hurdle rate to discourage litigation? Restrict participants to owners 38 Sample VAP Tax-Motivated Variable Annuity Plan VAP normal retirement age = 62 VAP hurdle rate is 5.5% Actuarial equivalent is RP-2014 adjusted, with MP-2015 Owner-participant is age 50 Wants $100,000 as current funding Solve for normal retirement benefit: $100,000 = NR Benefit * 12.97 / 1.055 (62-50) NR Benefit = $14,659 39 13

Sample VAP More on Tax-Motivated VAP 1. Funding obligation will increase annually by hurdle rate $105,500 funding obligation next year Increases post-nra are smaller 2. Mortality assumption must be finessed Benefit value = PV of NRA benefit PV depends on mortality assumption Small increases each time mortality is improved May wish to incorporate mortality improvements upfront, so that funding occurs currently 40 Funding Issues similar to Lump Sum: How to determine Present Value of Benefits? 1. Present Value = the current amount that will provide the future cash flows if the current amount consistently earns a return equal to the discount rate. [Exposure Draft of VAP Practice Note, December 2015] OR 2. Present Value = the discounted current value of future expected cash flows under stipulated assumptions 41 Present Value determinations For traditional DB Plans with fixed benefits, the two Present Value definitions have same result! If the PPA Target Liability is exactly funded today, and assets earn the segment discount rates, and all contingencies match assumptions, then benefit cash flows will be met exactly by the Plan s assets What about a Cash Balance Plan crediting market rate of return? 42 14

Present Value for Cash Balance Plan crediting investment return on Plan assets: Due to the variable nature of the benefit and the inherent connection between investment experience and the benefit adjustment, the rate used to discount liabilities should also be used to determine the benefit adjustments in order for the present value to represent the amount needed to provide the benefits [Exposure Draft of VAP Practice Note, except that the ellipse represents my omission see slide 47] 43 Present Value for Cash Balance Plan crediting investment return as interest credit If quote on preceding slide were to apply, then: Assumed future interest credits would equal the mandated funding discount rates Assumed interest credits would cancel out discount rates Target Liability = sum of Cash Balance accounts (with adjustments for POC, vesting, and any subsidies) Hmm this doesn t sound familiar What do the IRC 430 regulations say? 44 Present Value for CB Plan crediting return Regs 1.430(d)-1(f)(9) Example 13 Cash Balance Plan crediting market rate of return Participant age 61 has $150,000 current account balance Actuary s best estimate: Lump Sum at age 65 Actuary s best estimate: 7% future interest crediting Projected lump sum in four years (age 65): $196,619 First segment rate: 5.07% Target Liability = $158,526 (2009 active male mortality in discount) 45 15

Present Value for CB Plan crediting return For CB Plans at least, the Reg Example rejects the view that future investment adjustments should equal the discount rate Assumed future interest credits EXCEED the discount rate Target Liability = $158,526 Account Balance = $150,000 They differ because the Target Liability is determined by making a separate and independent assumption about future Plan investment returns (here, 7%) 46 Present Value for Variable Annuity Plans Exposure Draft of VAP Practice Notice Slide 43 Quote: applies to Variable Annuity Plans States that, at least in one view, the Target Liability should equal the economic value (the funding amount) To the extent that regulatory concerns about apply equally to CB Plans and VAPs in this Reg example, IRS could be viewed as rejecting this approach 47 Funding Regulations: General Rule The general rule for setting such assumptions: Each of those [non-prescribed] actuarial assumptions must be reasonable (taking into account the experience of the plan and reasonable expectations). The [non-prescribed] actuarial assumptions must, in combination, offer the plan s enrolled actuary s best estimate of anticipated experience under the plan [Treasury reg 1.430(d)-1(f)(3)] 48 16

Funding Regulations: General Rule (cont ) Tension between two quotes: Each individual assumption must be reasonable In combination, the assumptions must result in best estimate of anticipated future Plan experience Could the in combination requirement over-ride the individual assumption requirement? Would it be reasonable to assert that, for instance, the Target Liability for a market-rate Cash Balance Plan is the sum of account balances? 49 Variable Annuity Plans - two views: 1. Target Liability = funding amount The in combination requirement prevails We assume that future investment adjustments are equal to discount rates, so that the two cancel out, and the effective discount rate is the hurdle rate 2. Target Liability = discounted value of proj benefits The individual requirement prevails We set the future investment assumption independently, and discount back at the PPA segment rates (or FYC) 50 If Target Liability = funding amount (1 st view), can you defend the implicit assumptions? 2016 MAP-21 segment rates: 4.43%, 5.91%, 6.65% Years 1 to 4: 4.43% per year Year 5: 12.04% Years 6 to 19: 5.91% per year Year 20: 21.73% Years 21 and later: 6.65% per year Elect full yield curve instead, to avoid discontinuities? 51 17

Q&A 6 of 2010 EA Gray Book (in part): Q: Would it be reasonable for the actuary to assume future investment returns equal to those implied by the full yield curve? A: The actuary develops the best estimate of benefits using the actuary s best estimate of the return on plan assets. The simplifications described in this question are appropriate only if they represent the actuary s best estimate. IRS response seems to indicate supremacy of individual assumption setting 52 Bottom Line on PPA Funding: For similar type of plan (market-rate CB Plan), IRS specifically rejects the TL = funding amount (1 st view) Not necessarily an indicator of where guidance might fall on Variable Annuity Plans But difficult to see why there would be a difference Some support, although only implicit, for TL = discounted value approach (2 nd view) 53 Implications for TL = Funding Amount (1 st view) Assuming no special additional funding is made: 1. Minimum funding exactly satisfied 2. No quarterly contributions required 3. No PBGC variable-rate premiums 4. Top-25 restrictions apply For top-25, consider either restricted IRAs or special additional contributions 54 18

TL = Discounted Amount (2 nd view) Assuming no special additional funding is made: 1. Minimum funding may fall short 2. Quarterly contributions may be required 3. PBGC variable-rate premiums almost surely due 4. Top-25 restrictions almost surely apply Advancing funding from following year into current year may address most or all of these issues 55 Non-Discrimination How do Investment Adjustments accrue? 1. Adjustments accrue year-to-year as they occur, OR 2. Once the benefit is accrued, all future investment adjustments on that benefit are accrued as well Similar to Cash Balance: once a contribution credit is accrued, all future interest on that credit is also accrued, even though the interest has not yet been credited Since adjustments apply even if participant terminates, our view is that 2 nd view is correct 56 Non-Discrimination General Non-D Test Must normalize Plan benefits: Normal accrual: usually single-life annuity Most valuable accrual: spousal J&S annuity How to treat the assumed future investment adjustments? 57 19

Non-Discrimination General Test Normalization: 3 approaches 1. Assume adjustments occur at hurdle rate Equivalent to ignoring the investment adjustments Assuming VAP benefits directed mostly to HCEs, this is most favorable to Non-D testing results 2. Reflect investment adjustments post-testing-age Normalize using testing assumptions (e.g., 8.5%) Suggested at 2015 EA meeting presentation on VAPs 58 Non-Discrimination General Test Normalization: 3 approaches 3. Reflect investment adjustments at all ages, pre-testing-age and post-testing-age Normalize stream of future benefits using testing assumptions (e.g., 8.5% interest) What rate to reflect future investment assumptions? Current year s rate? What if rate is 15%? Use 5-year average of Plan rates? Use reasonable actuarial assumption? Use testing interest rate? 59 Application of 415(b) Under 1.415(b)-1(c)(5), no adjustment in the limit is made for an automatic benefit increase feature if: Form is not subject to 417(e)(3) Annuities Not lump sums Plan language provides that increased amount will not exceed otherwise applicable limit 60 20

Application of 415(b) Under 1.415(b)-1(c)(5)(ii), the definition of automatic increase feature includes a form of benefit that automatically increases the benefit paid in that form to share favorable investment returns on plan assets. Variable Annuity Plan investment adjustments seem to fit this definition Although no mention of negative adjustments 61 Application of 415(b) Example 10 of 1.415(b)-1(c)(6): Variable Annuity Plan with 4% hurdle rate To value future investment adjustments, the plan must assume a 5 percent return on assets Since hurdle rate lower (4%), benefit is increased for comparison to 415(b) limit If higher hurdle (e.g., 5.5%), would benefit be decreased? Create more room under 415(b) limit? Applicability beyond annuity forms of payment? 62 Application of 415(b) Conclusions regarding 415(b): With proper plan language, life annuity forms in a VAP should not need an adjustment factor for the variable feature Lump sums, however determined, will need to be watched and tested 63 21

Questions Questions Jim will answer all your questions now 64 22