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Retirement risks side by side: DB vs. DC vs. VAPP

June 5th, 2015 No comments

In this video blog, I discuss the retirement risk allocation between a plan sponsor and the plan’s participants in a variable annuity pension plan (VAPP) structure compared with risks associated with traditional defined benefit (DB) plans and defined contribution (DC) plans. I also explain how a VAPP can reduce risks of inflation, portability, and interest rate.

View our VAPP video blog series here.

For more information on VAPPs, click here, or visit our VAPP reading list.

Four-step DOMA repeal compliance process

May 29th, 2015 No comments

The U.S. Supreme Court’s repeal of Section 3 of the Defense of Marriage Act (DOMA) makes same-sex spouses eligible for the same protection that opposite-sex spouses have regarding retirement benefits when the marriage is legal in the state in which they were wed. How does this decision affect pension plan administration?

In her article “Same-sex marriage and defined benefit plans,” Milliman’s Emily Stadheim offers perspective on the following four steps plan administrators should take to ensure that their pensions are legally compliant with the repeal of Section 3.

1. Review plan documents and summary plan descriptions.
2. Review policies and procedures for spouses and domestic partners.
3. Review retirement packages and forms for compliance with post-DOMA regulation.
4. Communicate changes to benefit plans and policies and obtain same-sex marriage information from participants.

UK pension reform reading list

May 22nd, 2015 No comments

The UK’s retirement landscape has changed significantly. Pension reform now provides retirees with broader access to their retirement savings. However, reform has also shifted more post-retirement risk to the individual. This reading list highlights some of the issues at hand.

“Blended retirement solutions” (subscription required)
Individuals need financial plans that offer income solutions and address key retirement risks. This FT Adviser article  highlights a retirement framework development by Milliman and AXA Wealth that help advisers assess their clients’ needs based on a well-known psychological theory. The framework is detailed in a report entitled “Retirement planning: Bespoke retirement solutions are ‘the new black’ in 2015” by Milliman consultants Colette Dunn, Chris Lewis, and Emma Hutchinson.

One model which can be used to determine at-retirement choices in the context of these risks was set out by management consultancy Milliman along with Axa Wealth. It is based on US psychologist Abraham Maslow’s famous ‘Hierarchy of Needs’, which placed people’s innate requirements in order of priority to ensure psychological health. Axa Wealth transposed this hierarchy on to retirement spending ‘priorities’, to differentiate between essential and more discretionary costs.

In the retirement hierarchy, the money set aside to feed oneself, pay for a roof over your head and meet essential bills is defined as ‘essential’. Income to meet these needs would be subject to a very low attitude to risk.

More ‘discretionary’ spending, which could include everything from running a car to holidays, is less set in stone and so open to greater risk. Often objectives here might require significant investment growth to be fully realised.

The more important given needs are considered, the less risk your client will be willing to take. This could result in possibly several layers of risk needing to be met.

A final element is ‘legacy’, or the wealth your client may wish to pass on when they die. This is classified as the most aspirational of the needs and thus subject to the highest risk.

Once ranked, these income requirements can be placed into a framework.

• “Actuaries warn of retirement cash running out
Many experts believe retirees run a higher risk of depleting their retirement incomes, which is due to pension freedoms. Colette Dunn comments on results from a survey of industry experts at Milliman’s Forum.

• “Calculating pension income
Advisers need to develop new approaches to help their clients manage new retirement risks. Milliman’s Dunn and Russell Ward discuss solutions that address market risk and inflation risk.

• “A retirement planning model for the new pensions world
In this article, Dunn and Chris Lewis highlight a retirement framework that advisers can employ to match a retiree’s income needs to specific levels of risk.

• “Reform spells healthy future for advice
Reform offers advisers and providers an opportunity to innovative solutions that may help participants navigate the new retirement environment. Milliman’s Dunn and Ward provide their perspectives.

• “Blurred lines of retirement saving
In this article, Dunn highlights important conversations advisers need to have with people at different stages of their retirement planning.

The Dutch General Pension Fund, a new pension vehicle

April 30th, 2015 No comments

Wouda-MartinThe total of assets of Dutch pension funds is over 150% of gross national product and still growing. The number of Dutch pension funds, however, keeps falling: from 800 to less than 400 in the past 10 years.

The attention of the press on pension issues has increased from close to zero to daily reports. At the same time, the political and public debate has intensified—especially when it became clear that some pension funds had to cut benefits because the insufficient funding could not be solved over time. Until the day that the actual cuts were announced, this risk was quite underexposed. One of the last items that gets the attention of the press, politicians, and the public is the obligation to account for the cost per participant in the annual reporting.

The reaction of the supervisor is to aim for more control, more regulations, and more compliance. The Dutch Central Bank (DNB) has recently sent out a note to all small pension funds, asking them to consider their reasons for future existence and to contemplate their sustainability.

Regulations are relatively tight compared to other countries. For example, the discount rate to be used to value liabilities is prescribed and published monthly by the Dutch Central Bank. Also there are standard formulas to calculate the solvency buffer. This is in contrast to one of its neighboring countries: Belgian pension funds choose the discount rate and solvency buffer themselves and need to submit it to the supervisor (well documented).

New pension fund board members are heavily tested on capacities and integrity by the supervisor. Some of the candidates that have been rejected have shared their stories with the press, but in most cases the DNB silently advises the candidates to step down before actually refusing to let them join a board of trustees.

Many of the smaller pension funds have transferred all accrued benefits to an insurer in the past 10 years. The disadvantage of this option is clear. The security one gets from an insurer comes with a price. The pension funds are used to taking some investment risk: the indexation depends on how the investment returns turn out. In case of really poor investment returns, there is in some cases the possibility of extra contributions by the sponsor. Pension funds also have the emergency brake of cutting benefits. The insurers, on the other hand, would be bankrupt, so their pricing of annuities is more prudent. The insurers do have the advantage of cost efficiency, which is due to the larger scales of their operations. An alternative for the smaller pension funds is to join a larger sector-wide pension fund. Joining a sector fund means joining the scale and risk pooling of the pension plan in the sector and can be attractive if there is indeed a sector pension fund active and large enough in the sector of the particular employer.

For multinationals with operations in more than one European country, there is the option of a cross-border pension fund. There is a small number of successful cross-border pension funds with Dutch plans. It appears to be a time-consuming road, as many parties need to be convinced. That is not always based on rational arguments: How would the average American employee react if his or her pension moved to Canada? There are Dutch pension vehicles (PPI’s) that can execute pension plans for foreign entities, but by law they can only do defined contribution (DC) plans. The PPI’s are not allowed to carry biometric risks. The Dutch may believe their pension system is the best in the world, but there is less confidence that it is convincing enough to attract foreign plans. Becoming able to execute cross-border plans is not the driver for the latest development.

The law will be changed to allow establishing pension funds that execute more than one plan for any employer. It will be allowed to ring fence the assets for different (groups of) contracts. Up to now, having multiple employers within one pension fund is only possible either for employers that are connected (legally or historically) or without the ring fencing (e.g., the sector funds). The new vehicle will be called the General Pension Fund (GPF, or APF in Dutch). It will allow for options that can be situated between insurers and the classic pension funds. If done well, it combines the best of both worlds: economy of scale, optimizing the investment returns, good governance without being too time-consuming, and risk pooling that is acceptable to members. In our opinion, it opens the door for new and innovative pension solutions.

Risk sharing within pension plans in the Netherlands

April 28th, 2015 No comments

Sagoenie-RajishDutch pension system
Like many other European countries, the Netherlands operates a three-pillar pension system. This consists of:

1. A government-provided pension.
2. An employer-provided pension.
3. Personal pensions purchased through individual savings.

The first pillar, government pension, provides a basic income to retired people in the Netherlands. It is financed through taxes and is based on a pay-as-you-go system. The pension provided is linked to the country’s minimum wage. An amount of 2% of the state pension benefit is accrued for each year that an individual has lived or worked in the country until the age of 67, with a maximum period of 50 years taken into account. Depending on the increase in nationwide longevity, the age of 67 will increase.

The second pillar consists of occupational pension schemes. Companies offering their employees a pension plan are obliged to administer these plans externally via a pension fund or an insurance company. Funding for these schemes is provided through employer and member contributions and is based on capitalization. A majority of employers used to bear all the risk for these schemes but, in line with globally changing attitudes, there has been a move toward risk-sharing types of schemes. This pillar is discussed in further detail below.

The third pillar consists of annuities and pensions bought from individual savings. It is the main source of postretirement income for self-employed individuals and individuals working for organizations that do not provide a pension. To encourage people to make use of this pillar, tax incentives (within limits) are provided by the government.

In 2014 and 2015 the tax incentives in the second and third pillars were further limited. The annual salary on which the pension is based is limited to EUR 100,000.

Read more…

UK retirement planning model is more than a drop in the bucket

April 23rd, 2015 No comments

Pension reform in the United Kingdom has given individuals more access to their retirement money. As a result, post-retirement risk has also been shifted to the individual. This development is providing financial service professionals the opportunity to create new retirement planning models.

In this FT Adviser article, co-authors Colette Dunn and Chris Lewis offer perspective on a retirement framework that matches a retiree’s income needs to specific levels of risk. Here is an excerpt:

Using a bucket approach to discuss expected spending requirements throughout retirement can make it easier for individuals to understand their needs, their varying attitudes toward risk, and the necessary trade-offs. This approach can also be used by advisers to build a bespoke portfolio solution for a client…

The bucketing approach can be thought of as a ‘bottom up’ approach to determining the retirement solution, which is intuitive and easy to explain to clients. In addition, sophisticated modelling tools are available which an adviser can use to validate and/or fine-tune the overall asset allocation within and between buckets – that is, taking a ‘top down’ or diversified portfolio level approach.

Benefits of the framework
The framework can be used by advisers as part of the retirement planning process, and can be tailored to individual circumstances, taking into account both financial and emotional needs. It meets the three previously identified benefits, namely:

• Simplifying a complex retirement into a structured approach,

• Ensuring that an appropriate level of risk is taken for each prioritised retirement need, and that the overall level of risk for the portfolio is appropriate for the individual, and

• By segmenting into buckets, and thereby providing a higher level of certainty in the short to medium term, it provides individuals with peace of mind and helps to avoid the potential for overreaction to market shocks.

Benefits side by side: DC vs. DB vs. VAPP

April 22nd, 2015 No comments

Coffing-KellyVariable annuity pension plans (VAPPs) provide secure, lifelong, inflation-protected retirement benefits. VAPPs combine the best of what traditional defined benefit plans do regarding longevity protection and lifelong income and what defined contribution plans can do to combat inflation. In this presentation, I explain the advantages for retirees of VAPPs compared with these more traditional plan structures.

For more information on VAPPs, click here, or visit our reading list.

Plan funding side by side: Traditional DB and VAPP

April 16th, 2015 No comments

Coffing-KellyIn recent months, we have featured quite a few articles on the resurgence in popularity of variable annuity pension plans (VAPPs). They provide lifelong inflation-protected benefits to participants while employers make predictable plan contributions, similar to 401(k) plans.

In this presentation, I discuss how funding a VAPP compares with funding a traditional defined benefit pension plan. The presentation also touches on how Milliman helps plan sponsors stabilize benefits for retirees through reserves.

For more information on VAPPs, click here, or visit our reading list.

Pension summary plan description updates: Something easy to forget?

March 27th, 2015 No comments

Kamenir-JeffIt can be easy to lose sight of the requirement to periodically update a pension summary plan description (SPD) because SPDs no longer need to be filed with the U.S. Department of Labor. Plan sponsors can potentially find themselves more focused on annual governmental filings such as Form 5500, Pension Benefit Guaranty Corporation (PBGC) premium, Schedule 8955-SSA, and annual participant notifications such as the annual funding notice. But don’t overlook required SPD updates.

SPDs are required to be updated every five years if there have been any material plan changes since the last SPD update or every 10 years no matter what. SPDs should be carefully drafted to be consistent with the provisions of the official plan document.

Updated SPDs should be provided to all plan participants including actives, terminated deferred vested, retirees, and beneficiaries. New active participants should be provided an updated SPD within 90 days of becoming eligible to participate in the pension plan.

In the event there is a material plan change after the issuance of an updated SPD, a summary of material modification (SMM) should be provided within 210 days after the end of the plan year in which the change was adopted. An SPD updated to reflect the plan change can be provided in lieu of providing an SMM.

SPDs can be provided to plan participants either by mail, distribution at the plan sponsor’s work place, or posted on the plan sponsor’s employee benefits website.

Not having an updated SPD can become an issue when participants have questions about their pension benefits. Having an updated SPD facilitates responding to participant questions.

Plan sponsors should review the latest version of the pension plan SPD to see if an update is required.

Three cautions when considering public pension reform

March 24th, 2015 No comments

Barrett-SheilaOnce a mainstay in American society, there has been a growing trend among public and private employers over the past three decades to close or freeze defined benefit (DB) plans. More recently, public DB plans have been in the forefront of the news with dark headlines detailing bankrupt public sectors unable to make good on their pension promises to retirees. The trend to downsize pensions coupled with some notorious public pension crises has led many to question whether DB plans have any place in the public sector at all. However, focusing on the horror stories from a few states or large cities is surely taking a myopic view of the situation.

The National Institute on Retirement Security (NIRS) recently published a follow-up study comparing the expense of defined contribution (DC) and DB plans. The study, published in December 2014, follows up on the original study performed in 2008, which reported similar results. The authors, William Fornia and Nari Rhee, indicate there are several advantages to DB plans that should be considered over the long term. These authors and the NIRS study provide three specific reasons for the cost savings of DB plans:

Risk pooling: DB plans spread the risk associated with employee life expectancy across the entire participant population. An easy way to conceptualize this is a bell curve—while some employees will live an “average” life span, there will always be employees who live longer and employees who live shorter lives. Those who live longer will use more retirement income than expected, but this cost is offset by the savings from those with shorter life spans. Without risk pooling, an individual bears the entire longevity risk alone; there is no cost offset mechanism for an individual who lives beyond his or her life expectancy.
Asset pooling: DB plans have significantly larger asset pools than an individual will maintain in an individual account plan. DB plans are also able to make multigenerational investments. While an individual will shift an investment strategy to be more conservative in the years leading up to retirement, a DB pension trust has no need to behave similarly as the trust can continue to maintain an investment strategy with some degree of aggressiveness. This yields better long-term investment results.
Fee pooling: The microeconomic concept of economies of scale comes into play for investors. An individual managing a single 401(k) account will bear the burden of professional investment fees. A DB plan has two advantages in this area. The first is that professional fees are paid out of the pooled asset trust and essentially split up among all individuals in the plan. The second advantage involves “investor IQ.” The typical DC plan participant does not have the investor knowledge of a professional asset manager. While a DB plan can afford to hire a professional asset manager and glean good returns, an individual is left to navigate the murky waters of the financial economy without an educated guide (National Institute on Retirement Security, 2014).

The NIRS also published a study in September 2011 highlighting public employee perspectives on public DB versus DC plans. If public entities intend on remaining competitive in the job market, maintaining their public pension plans could be a key to successful recruitment. Private pension plans are scarcer than their public counterparts, so this can be a factor for highly talented individuals looking at stable career choices.

For these reasons, a DB plan has significant, long-term advantages. These structural factors are relevant in any employment sector, but for public pension plans there is an additional angle to consider. Because the cost of public employees’ retirement plans are ultimately laid on the taxpayer, it should be a priority of any such system to use tax-funded contributions as efficiently as possible.

Last year’s NIRS study demonstrates that DB plans are truly efficient mechanisms for generating retirement income. But recent public discourse has suggested that public employers move away from DB plans. Thus, many retirees may be at risk of having a shortfall in their retirement incomes and will need to turn to the government for means of additional financial support. Social welfare programs are already in place to provide for retirement shortfalls, but these resources are not equipped to handle the long-term risk associated with today’s retirees.

In a broad sense, taxpayers will be on the hook regardless—either by paying for government DB plans or for government-subsidized welfare programs to supplement inadequate retirement income. The factors brought to light by the NIRS study reaffirm that the taxpayer dollar is put to more efficient use in a DB plan.