The Milliman Pension Funding Index (PFI) published this month demonstrated that while the top 100 pension plans in the United States saw an optimistic $106 billion cumulative increase in funding in the first quarter of 2013, these pension plans have seen a $37 billion decrease in funded status for April 2013. Simply put, pension benefit obligations are increasing, while growth in assets, either by employer contributions or investment return, has failed to keep pace. This market volatility in the investment return experienced over the past five years is driving some plan sponsors to review plan design with an eye towards increasing stability. Many are considering a move to fixed cost defined contribution (DC) plans, while some are also considering variable annuities (VA). Although still not common, variable annuity pension plans have been in existence since 1953.

Milliman recently published a white paper by Mark Olleman, Kelly Coffing, and Ladd Preppernau, “Variable annuities: A retirement plan design with less contribution volatility,” which demonstrates how, with a variable annuity structure, both single and multiemployers as well as their employees share many of the advantages of both traditional defined benefit (DB) and defined contribution plans. The following chart highlights both important advantages and disadvantages of defined contribution and traditional defined benefit plans, as well as the advantages shared by variable annuity plans.

Many of us have focused on the “guaranteed benefits” of traditional defined benefit plans for a long time. It may be time to change our focus to “lifelong” benefits, where the exact dollar amount is not guaranteed, but participants are assured that they will not outlive their benefits and some inflation protection may be provided instead.

Note that although similar in name, these variable annuity plans are not your typical annuity product offered by an insurance company, although companies or individuals seeking to transfer investment risk may wish to purchase them.

As part of the proposed federal fiscal year 2014 budget, President Obama included a cap on the amount of retirement savings an individual could accumulate in tax-deferred retirement plans. The total accumulation amount for an individual includes all qualified tax-deferred savings plans such as traditional defined benefit (DB), cash balance, money purchase, profit sharing, 401(k), and 403(b) plans, as well as funded governmental 457(b) arrangements and Individual Retirement Accounts (IRAs), both traditional and Roth.

The proposal is most likely a result of the presidential campaign last year, during which it was reported that Governor Mitt Romney had qualified accounts in excess of $100 million. However, the administration’s budget proposal would not tax accumulated accounts in excess of the cap. If the accumulated accounts exceed the cap, the individual would not be allowed to make future deferrals or receive any future employer contributions under any retirement plan.

The proposal would essentially cap tax-advantaged retirement plans to an amount necessary to provide the maximum annuity permitted under a defined benefit plan. The current limit is $205,000 payable annually at age 62. The annual annuity amount would be increased by a cost of living adjustment.

After converting the annuity to a present value using current interest rates, the total accumulation amount is approximately $3.0 million to $3.4 million. Because of the current low interest rate environment, that total accumulation amount is inflated. If interest rates return to a historical level, the maximum accumulated amount could be as low as $2.2 million to $2.4 million for an individual age 62.

No real details are available on how account values would be reported or how the cap would be calculated. There is a concern small business owners could eliminate their retirement plans if they were at the accumulated cap, because they would not receive the benefit of tax-deferred treatment. As a result, retirement savings vehicles for many rank and file employees could be eliminated. As an alternative, consideration could be taken to limit only employee deferrals under the proposal or a portion of employer-provided contributions, allowing small business owners some incentive to keep their retirement plans.

Under the proposal, it is estimated that the accumulation cap would result in approximately $9 billion in additional federal tax revenue over the next 10 years beginning October 1, 2013. On the flip side, it has not been determined how much tax revenue would be lost in future years as a result of smaller account balances for these taxpayers. All distributions from qualified retirement plans (other than Roth accounts) are taxed at distribution.

It will be interesting to see if this proposal will gain traction with lawmakers.

In the inaugural Milliman Public Pension Funding Study,* the aggregate funded status of the 100 largest public pension plans was reported to be 69.8% using information reported by the funds and the market value of assets. Some observers have commented that, because the funded ratio is less that 80%, public pension plans are in trouble. Maybe, maybe not.

The funded ratio of a pension plan is the value of plan assets divided by the value of plan liabilities. It is sometimes calculated on an actuarial value of assets basis and sometimes on a market value of assets basis, depending on the purpose. For comparison purposes, the funded ratio calculated on the actuarial value of assets is 75.1%.

The funded ratio is a snapshot measurement as of a particular valuation date and is typically calculated once a year. Actuaries then use this information to develop a contribution strategy to reach a funded ratio of 100% or greater over a reasonable period of time. While a funded ratio makes it easier to compare plans on a plan-by-plan basis, or to quickly determine if a plan is “overfunded” or “underfunded,” it doesn’t tell the whole story needed to determine if a plan is in trouble or not.

There are many factors to consider when determining the health of a plan:

• Size of the unfunded liability compared to the financial resources of the plan sponsor
• Financial health of the plan sponsor (e.g., budget surplus, level of debt, cash flow)
• Ability of the plan sponsor to make changes to the plan design to reduce future plan liability
• Actions the plan sponsor has taken or is considering taking to reduce future plan liability
• Historical changes in the funded ratio of the plan over time
• Causes for the changes in funded ratios over time
• Funding or contribution policy
• Plan sponsor’s history of making actuarially required contributions
• Investment policy and the level of risk inherent in the investment policy
• Impact of the plan’s investment risks on future benefit payments and contribution requirements

After reviewing the plan and plan sponsor’s situation from these different angles, then a judgment can be made about the financial health of a plan. Among individual plans, there is a wide range of results of the status of the plan. In many jurisdictions where there are concerns about the long-term health of the plan, pension reforms have either been implemented or proposed to address the long-term funding.

*The Milliman Public Pension Funding Study independently measures the aggregate funded status of the 100 largest U.S. public pension plans using basic actuarial principles and reported plan liabilities and assets. The aggregate accrued liability information provided has been determined on a uniform basis with respect to the interest rate assumption across all of the plans in the study. This uniform approach allows for an accurate picture of the overall funded status of these 100 pension plans based on an independent application of Actuarial Standards Board (ASB) standards of practice, actual investment portfolios, and current capital market assumptions.

The U.S. Federal Reserve recently announced changes that will have major implications for investors and plan fiduciaries. The Fed’s decision to move to economic targets rather than date-based indications will result in a higher-rate environment. Plan sponsors and trustees would be wise to examine their plans and make adjustments now to prepare for the coming rate increases, as well as plan what actions to take when rates stabilize.

This paper offers several considerations for investors pertaining to the Fed’s policy shift from calendar to economic targets.

Since the global financial crisis of 2008, the U.S. population has struggled to recover and/or grow retirement savings. Employers providing defined benefit (DB) plans face overwhelming funding expenses, driven by increased life expectancy, stock market fluctuations, and low interest rates. The latter two factors, resulting from the severe recession and unpredictable economic environment experienced since then, have also severely impacted employers’ ability to fund defined contribution (DC) plans.

Kelly Greene, of the Wall Street Journal, recently discussed this issue and cited the Employee Benefit Research Institute’s latest retirement confidence survey. This study states that the percentage of U.S. workers demonstrating little to no confidence regarding the adequacy of their retirement funds is at an all-time high. Only 13% of workers surveyed report being very confident they have enough saved for retirement and 38% report some confidence in their preparedness. Five years ago, those two figures totaled approximately 70% of workers surveyed. Employers and employees need to work together to remedy this situation. Depending on the design of the plan, the answer could be a defined benefit plan, a defined contribution plan, or a strategic combination of the two.

Possible solutions can be categorized from basic to more radical. One proposal is to convert traditional pension plans to cash balance plans rather than merely freezing them. However, the advantage of this strategy is still diminished by the significant issue of longer life expectancies. Better stock performance and, hopefully, within the next few years, better interest rates will relieve some pressure on benefit obligation expenses. Discussing the results of the Milliman Pension Funding Study released March 25, John Ehrhardt stated that “pension funding status will continue to be tied to interest rates” and “until interest rates move favorably, the pension funding deficit is likely to endure.”

A middle ground solution might be to introduce a profit sharing element to the retirement plan package. There are a few drawbacks to a profit sharing plan, mostly increased administration, but the positives in many cases outweigh the negatives. Profit sharing plans are discretionary and, theoretically, self-funding. These plans tie employee incentives to company growth and form a strong partnership between employers and their employees. With the stock market showing some improvement and the economy demonstrating strengths (Wall Street Journal), companies could, over time, see an upswing in business. Plan sponsors can seize that opportunity and distribute some of those profits to employees, utilizing performance accountability measurements. Other, straightforward strategies include implementing auto enrollment processes and increasing employee retirement plan education. Employees need guidance. They are not professional investors. Companies can meet the challenges of today’s retirement savings environment and take pride in assisting their employees in this venture.

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.

Have you considered immunizing pension plan liabilities? If your pension plans are underfunded, is an immunization strategy an option? Many plan sponsors are looking for ways to immunize their pension liabilities and minimize volatility.

The benefit of fully immunizing a pension plan is that the funded status of the plan remains fairly stable and predictable given most economic conditions. Even for an underfunded plan, an immunization strategy is an option and can be implemented via a “glide path” investment approach. This approach moves assets into fixed income in favorable market conditions and as the plan becomes better funded. A glide path maintains a good balance of retaining equity investments and lowering volatility over time as the funded status improves.

In order to take advantage of an immunization strategy, it helps to know the funded status of pension plans on any given day. In order to do this, a daily discount rate must be developed. However, discount rate indicators are typically only available on a monthly basis. The most popular discount rate reference is the Citigroup Yield curve, but again, this is only available at the end of the each month. However, there are other tools available that can provide “live” market values of a pension plan, on a daily basis, by developing a daily discount rate. Whether the discount rate is developed with the Citigroup Yield curve or a custom bond model, this tool develops an accurate proxy of your plan’s discount rate.

Once a discount rate is developed, a dashboard or daily automatic tool that can measure the daily funded status of your plan is important with a glide path investment approach. To do this, the plan sponsor needs to define a market measure of liability (e.g., pension benefit obligation, or PBO), determine asset reallocation trigger points (based on a plan’s funded status), and have access to a tool that automatically determines the funded status of a pension plan on a daily basis.

During the summer of 2012, the interest rate environment continued to be volatile. Pension discount rates exhibited a downward trend and often jumped significantly from one week to the next. Plan sponsors who monitored the daily funded status of their pension plans were able to reallocate assets quickly during opportune investment windows and improve and/or maintain a favorable funded status.

Immunization of pension plans is not a new concept. This strategy is usually implemented when a plan becomes fully funded. The ability to implement an immunization strategy for underfunded plans, and to monitor daily market conditions and quickly make asset reallocations, is now available and even advantageous with recently available tools. In addition, the Milliman Managed Risk Strategy can be used during phased de-risking as a way to protect plan assets from the downside exposures of investing in equities. For additional information on this approach or tool, please talk to your Milliman consultant to learn more.

Longevity plans could one day address some of the financial uncertainty associated with longer life spans. The concept is designed to offer retirees a supplemental defined benefit (DB) pension (i.e., a longevity plan) alongside their defined contribution (DC) plan.

This article in Retirement Income Journal (subscription required) highlights the Milliman paper “Longevity Plan,” explaining how such a plan may reduce longevity tail risk while providing retirees sustainable income past 80 years old. Here is an excerpt from the paper outlining the plan’s features:

In order for the DB plan to be viable in its role as a supplementary retirement vehicle, its structure will have to be different from that of the traditional DB plan with which many are already familiar. The DB plan that is being proposed here is essentially a longevity plan. Key features of the proposed longevity plan include:

• Unit-accrual pattern such as in a career-average plan or a plan based on flat dollars per years of service
• Simplistic retirement options: No ancillary death, disability, or early retirement benefits would be offered (other than perhaps a lump-sum death benefit between termination and the pension actually starting)
• Life annuity options only: A single-life option for single participants and 75% joint and survivor option for married participants
• Participants would not begin plan participation before age 45 (although this could be extended to age 50)
• Participants would not commence benefits earlier than age 75 (and this could be extended to age 80 or 85)

Presently, ERISA prohibits employers from postponing pension payouts later than age 65 generally. Bill Most and paper co-author Zorast Wadia were quoted by Retirement Income Journal discussing the rule.

Here’s an excerpt from the article:

This “unit-accrual design” is still just a concept, not a product. But the authors of the paper think the only thing that prevents it from widespread adoption is an outdated ERISA regulation against delaying pension payouts past age 65.

“Everyone’s talking about this and lots of new products has been proposed,” said Bill Most, a Milliman principal who worked on the paper with principals Zorast Wadia and Daniel Theodore and consulting actuary Danny Quant.

“But we don’t need new products, we need changes from government. And the results will hopefully give us something that employers might embrace. We’re not kidding ourselves. We don’t deny that there’s a lot of bad faith toward defined benefit plans. But from a cost perspective, this makes sense.”

…“They’ve relaxed certain rules related to required minimum distributions starting at age 70½, but they have not made changes in the terms of defined benefit plans,” said Zorast Wadia. “If you’re no longer working, you must begin payments from a defined benefit plan no later than age 65. If you’re still working past age 65, they won’t force you to take benefits. But ERISA won’t let the company purposely delay payments beyond 65 if you’re retired.”

For more perspective on longevity plans, click here.

A recently published article by the National Institute of Retirement Security found that a whopping 85% of Americans surveyed are concerned about their retirement prospects. Also, 83% of Americans surveyed report favorable views of pensions (also known as defined benefit or DB plans) and 82% indicate they believe that those with DB plans are more likely to a have a secure retirement. What is also interesting is that about 59% of Americans surveyed say the availability of pensions was a factor in their decision to work for their current employer. Americans feel that our leaders in Washington do not understand families’ and individuals’ struggles to save for retirement.

This all comes on the heels of action that plan sponsors of DB plans are taking to freeze or terminate their plans and also as many participants are realizing that their 401(k) plans will not provide adequate replacement income when they retire. As many Americans continue to be concerned about outliving their retirement savings, longevity benefits are gaining interest. DB plans have built-in longevity features that provide a stream of annuity payments for a participant’s lifetime. Given that DB plans place all the risk on the plan sponsor and that defined contribution (DC) plans, such as 401(k) plans, place all the risks on the individuals, many employees overwhelmingly support congressional action to provide all Americans with access to a new type of privately run pension plan. The proposed new plan would be portable from job to job, allow for a regular check that lasts throughout retirement, and easy for employers to administer while offering professional money management. The characteristics are similar to a possible proposal by the U.S. Senate called Universal, Secure, and Adaptable (USA) retirement funds.

The survey also provides many interesting facts about Millennials. They believe the current retirement system is broken and about 95% of those surveyed believe lawmakers need to make retirement reform a higher priority.

About 65% of Americans surveyed support protecting Social Security and say that it is a mistake to cut government spending in such a way that reduces Social Security benefits. About 73% of Americans surveyed support pension benefits for public workers because some segments of the public workforce have high-risk jobs and/or lower pay. In addition, public employees contribute toward their pension benefits with each paycheck.

Finally, the survey confirmed that a majority of Americans, about 87%, believe that the increasing number of Baby Boomers retiring without pensions and adequate savings is straining families and the economy.

There is a long way to go before changes could potentially be made to fix the current retirement system. However, if more and more Americans believe that their retirement security is endangered, communicating that to congressional leaders may create a chance for change in the future. DB plans have been the cornerstone of retirement security for our parents and it should be available to new generations as they retire in subsequent years.

On February 11, the IRS released the Moving Ahead for Progress in the 21st Century Act (MAP-21) interest rates that will be used to compute minimum contribution requirements for single-employer defined benefit plans for 2013 plan years: 4.94%/6.15%/6.76%. These rates are down about 0.70% from 2012. What does this mean for the typical pension plan? Even with good asset returns during 2012, most pension plans will see their funded status worsen significantly. And this in turn means increased funding requirements, for both minimum funding requirements for 2013 and potentially for avoiding benefit restrictions.

If benefit restrictions are an issue for your plan, then a lot depends on the plan’s funded status for 2012. If the plan was between 80% and 90% funded for 2012, additional funding could be due as early as March 31, 2013 for calendar year plans. In addition, any remaining required funding for 2012 may need to be accelerated from September 15, 2013 to March 31, 2013. If the plan was over 90% funded for 2012, additional funding may be due by September 15, 2013, for calendar year plans.

If benefit restrictions are not a concern for your plan, the minimum funding rules allow you to put off the increased funding requirements until 2014. Holding off until then will likely translate into a hefty increase from 2013. Now is the time to look ahead and perhaps smooth out the contribution requirements over the next 24 months. Not only will this alleviate some of the volatility, but a second benefit is lower Pension Benefit Guaranty Corporation (PBGC) premiums for 2014, as the trust assets will be higher on January 1, 2014.

Speaking of lowering PBGC premiums, there may also be an opportunity to lower the 2013 premium with just a little planning and no extra funding. Here’s how. First step is to satisfy the 2012 funding requirement prior to or at the same time that the first quarterly contribution is due for 2013 (April 15, 2013, for calendar year plans), instead of waiting until the last possible day (September 15, 2013, for calendar year plans). Second step is to contribute whatever amount you planned at the first quarterly requirement date for 2013, and classify that contribution as for the 2012 plan year. Because the 2012 minimum funding requirement has already been satisfied, this creates an excess amount for 2012 that can be added to the prefunding balance. The prefunding balance can then be immediately used to satisfy the first quarterly requirement for 2013. The best part is that the process can be repeated for the second quarterly requirement (July 15, 2013, for calendar year plans), doubling the premium savings. Only caveat to this process is that the plan needed to be at least 80% funded for 2012 in order to use the prefunding balance in 2013. Most plans that adopted the MAP-21 rates for 2012 should be eligible.

While MAP-21 provided some welcome relief to defined benefit plan sponsors regarding plan funding, it is always a good time to assess the situation and see if any strategies beyond simply contributing the minimum required amounts might be worthwhile.