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How to avoid running out of money in retirement: Second of a series

November 24th, 2014 No comments

McCune-JanetOur first blog focused on the need to address the fundamental risks to sustainable income during retirement: market risk, inflation risk, and longevity risk. We identified “managed risk equities,” such as those offered by Milliman Financial Risk Management, LLC, as an important tool for managing those risks.

Plan sponsors seeking to provide a retirement income solution in their 401(k) plans are well advised to include managed risk equity funds in the 401(k) investment fund lineup. Because participants may need help with the investment decisions in their personal accounts, it’s wise to take it a step further and incorporate these funds into the plan’s automatic investing features. For example, Milliman offers a portfolio service called InvestMap that creates an asset allocation glide path for each participant, based on each one’s current age. Using the underlying core funds offered in the 401(k) plan, InvestMap adjusts the allocation each year on the participant’s birthday, and automatically rebalances to that allocation each quarter. Rather than selecting a “model,” participants elect to be enrolled in InvestMap, and their entire account balances are then invested according to the glide path. InvestMap is easy to understand, it meets the Qualified Default Investment Alternative (QDIA) requirements, and is easily integrated into the plan’s investment policy statement. In addition, it takes advantage of the best-in-class managers and funds selected by the plan sponsor and the advisor, particularly with regard to monitoring performance and transparency of fees. InvestMap is an ideal vehicle for delivering explicitly integrated, age-appropriate risk management for the individual participant.

Other recordkeepers and advisors offer similar solutions, and some provide custom model portfolios or proprietary collective funds, most of which include appropriate asset allocations for young investors, investors nearing retirement, and everyone in between. Any of these “do it for me” tools can be helpful in delivering professional help to participants. What is important is that the glide path continues to adjust for the participant, even in retirement, and includes larger allocations to managed risk equities, rather than to cash or bonds, as the time horizon shrinks. As discussed earlier, this may reduce the volatility and improve the risk-adjusted return of the portfolio. The desired outcome is an increase in sustainable retirement income.

For many years, recordkeepers and advisors have tried to educate participants into becoming good investors – with varying levels of success. A better approach would be to create good investors by providing the right tools. An automatic investment alternative, which provides a lifelong asset allocation strategy and incorporates managed risk equities at increasing amounts over time, may be the most effective way for participants to be good investors and become successful retirees in a 401(k) plan. That is Step 2.

How to avoid running out of money in retirement: First of a series

November 18th, 2014 No comments

McCune-JanetThe Schwab IMPACT 2014 conference, held this month in Denver, Colorado, was attended by independent financial advisors from around the country. Much discussion centered on how to help clients achieve financial security during their retirement years. So how can potential retirees protect themselves from the volatile markets that can quickly erode a lifetime of savings? Milliman presented some new ideas for achieving sustainable retirement income for 401(k) participants, and with applications far beyond.

First, a strategy should address the risks. We believe the key to success centers around the effective management of three fundamental risks: market risk, inflation risk, and longevity risk. Downturns in the market can erode a portfolio, and the timing of those downturns can make a significant difference. Market declines early in retirement can combine with portfolio withdrawals in a toxic way, because money withdrawn is not available to rebound when the market recovers. Conventional wisdom tries to alleviate the volatility by diversifying into bonds, but bonds generally have limited inflation protection, and the portfolio can experience a loss of purchasing power over time. Retirees must withdraw less during the early years of their retirement in order to “pre-fund” the damaging effects of inflation in the future.

Milliman Financial Risk Management, LLC offers a financial risk management strategy that seeks to reduce downside equity exposure during volatile bear markets, while minimizing drag during stable rising markets. The compelling track record of this pioneering technique for some of the world’s largest financial institutions has set the stage for application to personal retirement accounts. Available in the form of mutual funds, collective funds, and separate accounts, this simple, transparent futures-based risk management approach provides volatility management with a capital protection strategy. Any of these products are suitable fund selections for a company’s 401(k) plan.

Generally, managed-risk equities are a more effective tool to control market and inflation risk relative to bonds. We are not suggesting moving completely out of bonds or shifting all assets into managed-risk equities, but rather an incremental change that develops over time. For example, diverting 50% to 75% of the equity allocation into a managed-risk strategy, instead of increasing the bond allocation as the time horizon shrinks, can significantly improve the Sharpe ratio (the amount of return per unit of risk) for a retiree’s account. The result is an increase in the amount of retirement income that can reliably be withdrawn from the account over the life of the participant.

Including managed-risk equities as fund selection in a company’s 401(k) plan delivers professional risk management techniques previously available only to large financial institutions to the individual 401(k) plan participant. This is Step 1.

What to look ahead for in pension risk management

May 1st, 2014 No comments

Defined benefit plan sponsors are concerned about contribution and funded status volatility. Some recent pension risk management strategies have focused on liability-driven investing (LDI) and lump-sum distributions. In this article, Milliman consultants Tim Connor, Scott Preppernau, and Zorast Wadia discuss in general terms methods that plan sponsors may implement to de-risk their pensions moving forward.

Here is an excerpt:

We suspect that 2014 will see a continued trend of sponsors looking to de-risk their plans through the various methods mentioned above. In addition, we believe sponsors will investigate the benefits of a hybrid plan design such as the variable annuity plan for the reasons mentioned above.

Another trend likely to continue is the implementation of lump-sum windows or permanently increased lump-sum thresholds. These strategies have found favor with many plan sponsors, particularly in response to recent increases in Pension Benefit Guaranty Corporation (PBGC) premiums. Because PBGC premiums include a per-participant charge, and because that charge has increased substantially in recent years, sponsors will no doubt continue to take a hard look at the idea of offering lump sums if it translates into fewer participants for whom they must pay those premiums. In addition, the rates utilized to pay out lump sums have been fully phased in for a few years now, from the previous basis of 30-year Treasury rates. That old basis resulted in a period of time where lump sums were seen as costly to sponsors. That is no longer the case. On a U.S. GAAP accounting basis, plans are valuing liability at rates that are close to the rates that are now utilized to pay lump sums. In other words, there is no longer much of an accounting gain or loss to a plan that pays out a lump sum. Yet, it does accomplish de-risking by transferring management of the pension to the participant.

On the investment side, we also expect sponsors to explore some nontraditional de-risking solutions. Not all sponsors share the belief that leaving the space of equity investments makes sense in the long term. Some feel they can’t afford not to be seeking returns in the market. For them, a tail risk hedging investment strategy can be an attractive de-risking solution. A typical strategy allows for upside through equity investments, while at the same time mitigating downside losses that occur in volatile, declining markets. The concept of hedging tail risk is quite familiar to the insurance industry, which utilizes such strategies to manage its own risk in guaranteeing certain products, such as variable annuities. It makes natural sense for defined benefit plan sponsors to incorporate the approach to de-risk their own pension promises.

Read Grant Camp and Kelly Coffing’s article Making the case for variable annuity pension plans (VAPPs) to learn more about the variable annuity pension plan design. Also, for more Milliman perspective on lump-sum distributions, click here.

The risk tolerance paradox

January 24th, 2014 No comments

The risk tolerance level many investors expect to achieve over the long term rarely equals the same tolerance investors actually experience over shorter periods. This paper by Ken Mungan and Matt Kaufman describes this paradox, explores the main reason it might exist, and introduces a risk management strategy that seeks to solve the problem.

As more “low volatility” and portfolio risk management strategies hit the marketplace, it will be imperative that advisors and investors explore each strategy to uncover how risk is actually being addressed. Identifying those techniques that address both diversifiable and systematic risk is likely to provide better overall results for investors.

Strategies for reducing retirement plan risk in defined benefit plans

April 1st, 2013 No comments

This blog summarizes a presentation given by Steve Hastings and Mahrukh Mavalvala at the Mid-Sized Retirement & Healthcare Plan Management Conference in San Francisco.

The 21st century has been rough on defined benefit (DB) plans. The days in the ’80s and ’90s of pension plan “contribution holidays” have ceded to the current era of low interest rates and high market volatility, and plan sponsors face many risk factors. The types of risk inherent in defined benefit pension plans—interest, inflation, investment, longevity, and legislative risk—impact DB plans in complex ways, which may not end even if an employer has frozen its DB plan. So what is a DB plan sponsor to do? One answer is to work with its plan consultant to gain a deeper understanding of the issues at hand and the strategies available to alleviate the pain points.

Risk management strategies include both in-plan options (such as plan design changes, investment strategies, and annuity options), as well as settlement strategies (irrevocable actions that relieve the plan of benefit obligations). Plan design modifications, including hybrid and cash balance plans, can reduce longevity risk by reducing pension liabilities, and may transfer some investment risk to participants. Switching to a defined contribution (DC) plan may be another strategy, with the option of maintaining the DB plan as a longevity plan to provide annuity income at later ages. However, changing the plan design is a substantial undertaking that may include special ERISA compliance efforts and communicating what may be an unpopular decision to participants. In some cases, participants have filed lawsuits in response to plan design changes and settlement strategies.

Liability-driven investing (LDI) and tail risk management strategies have grown in popularity as in-plan strategies to manage risk via the plan’s investment policy. However, LDI strategies must balance reductions in volatility with hedging interest rate exposure and meeting asset return objectives—not always easily achieved. Tail risk management strategies, such as the Milliman Managed Risk Strategy™, can protect against debilitating investment losses over a short period of time.

Settlement strategies are another option for pension plan sponsors looking to reduce risk. One strategy is offering participants a one-time, irrevocable option to receive the present value amount of their benefit as a lump sum. Another strategy is purchasing an annuity contract where the insurer will provide the remaining annuity payments; in purchasing such contracts, the plan sponsor has a fiduciary obligation to select a financially strong, solvent insurer. Without plan termination, settlement strategies are only available to cover terminated and retired participants (and their beneficiaries). Ford recently implemented a single lump sum settlement strategy. GM recently terminated a frozen plan and purchased annuities to cover some of the pension liabilities. Verizon also recently purchased annuities for a block of retirees. In light of these and other events, this is an excellent time to reevaluate pension plan risk and risk mitigation strategies with your plan consultants.

Variable annuities see a resurgence in popularity

August 8th, 2012 No comments

This article in The Wall Street Journal (subscription required) takes a look at how life insurers have restructured variable annuities in recent years. Here is an excerpt from the story:

In a trend gathering momentum, the life insurers that sell these tax-advantaged vehicles for investing in funds are competing on the basis of investment choices. That’s what they did in the 1980s and 1990s, before launching an arms race of escalating promises of guaranteed-minimum lifetime income, even if underlying funds tanked.

That competition cost the industry dearly when markets slid in 2008 and early 2009, leading to price increases and less-generous features as insurers sought to repair their balance sheets. With the new offerings, insurers are drawing on the past but adding a twist: They are pitching variable annuities as a smart way to load up on alternative investments.

While many insurers did see losses in 2008 and 2009, those with sufficient hedging in place fared better. Milliman research indicates that hedging strategies saved insurers $40 billion in September and October of 2008.

The Milliman Managed Risk Strategy offers similar risk management techniques to pensions through hedging strategies that seek to maximize clients’ asset growth in bull markets while defending against losses in down markets.

For Milliman’s insight into the variable annuity industry, click here.

Managing risk in the face of uncontrollable situations

April 20th, 2010 No comments

A new article in Financier Worldwide looks at risk management in the financial services industry:

In the lead up to the credit crunch, [financial institutions] were generally guilty of overestimating the upside and underestimating the downsides of a given opportunity. “When recent experience of risk-taking is positive and when the rewards are perceived as high, this is an intoxicating mixture that can lead to unwise exuberance,” says Neil Cantle, a principal and consulting actuary at Milliman. “All too often, people think that they are controlling a situation which they really have not taken the time to understand properly. When trouble hits, it can unravel very quickly and the critical ‘point of no return’ is passed. The problem in complex situations is that time-lags in information flows and action-taking can make it exceptionally difficult to know where that critical limit is – and once you have passed it, then that’s it.” Firms that can interpret complex scenarios and predict their consequences more accurately have a much better chance of reducing risk where possible, and responding effectively to risks that do become a reality.

Read the full article here.

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Beyond caveat emptor for risk managers

April 1st, 2010 No comments

According to a recent article in the Wall Street Journal:

As companies assess the lessons of the global financial crisis and look for ways to safeguard their firms against the effects of another one, demand has surged for risk managers—professionals who analyze the risk in transactions, from investments in treasury bills to credit default swaps, and make recommendations about whether to move forward.

Who will guard these modern guardians of our financial health and well-being, or at least certify that they’re up to the task?

That question is apparently driving a burgeoning movement toward certification for risk managers, owing in large part to the complexity and sophistication of the financial environment. Think “global financial crisis.”

More from the WSJ:

With the profession in the spotlight, several industry organizations are vying to provide a standard certification for the field, which the U.S. Bureau of Labor Statistics predicts will grow in the next several years, in part due to the increasing complexity of financial transactions.

While no certification is required to practice risk management—and many companies don’t require one—there has been a jump in the number of people signing up for certification exams.

Certification not only serves clients—by assuring that their risk managers know their stuff—but also risk managers. It introduces a timely process for keeping up with the changes, and challenges, of the profession.

Certification is not new to the profession, as the article points out. But it’s becoming more relevant given the need to distinguish oneself in the marketplace and, perhaps more important, because of increased legislative, administrative, and media scrutiny of the profession.

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