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The risks of de-risking

April 24th, 2014 No comments

Some sponsors are thinking about de-risking their defined benefit plans. Before deciding on a pension risk management strategy, plan sponsors should understand the financial implications associated with each approach. Zorast Wadia examines lump-sum windows, plan overfunding, and replacement benefits in his article “The risks of de-risking pension plans.”

This excerpt highlights the risks presented by lump-sum windows:

In the past couple of years quite a few plan sponsors have expressed interest in reducing their pension footprints. Several implemented lump sum windows during 2012 and 2013, giving former employees with vested benefits a one-time opportunity to receive single sum distributions. Once a lump sum distribution is taken by a participant, the plan sponsor no longer bears future pension risk with respect to that participant’s benefit. Besides risk reduction, there are also other good reasons for this de-risking technique, such as lowering flat-rate Pension Benefit Guaranty Corporation (PBGC) insurance premiums and reducing future plan administration costs. However, plan sponsors must consider the opportunity costs associated with implementing a lump sum window. These costs include:

• Missing out on investment gains as assets leave the plan upon a lump sum cash out
• Anti-selection from participants
• Higher plan contributions

Regarding plan overfunding, Wadia says:

With the announced rises in PBGC premiums over the next several years, many plans sponsors have attempted to de-risk their plans of the rise in premiums by accelerating funding.

…For plans that have achieved full funding positions, they will certainly have the advantage of showing pension surpluses on their balance sheets and recording pension income on P&L statements, all the while having the ability to take contribution holidays. However, should we experience another interest rate rebound as we did during 2013, or a sudden spike in interest rates should unemployment figures dramatically improve, several plans will find themselves greatly overfunded.

… A plan’s overfunding does not get returned to the plan sponsor, unless the plan is terminated, and even then, there is still the payment of a large premium to an insurance company for taking on the pension risk, not to mention a hefty 50% excise tax. Therefore, while it is prudent to fully fund a plan, the risk of overfunding does exist and plan sponsors must carefully plan out funded status lock-in strategies when their ultimate funding goals are reached.

Possible MAP-21 extension presents additional funding stabilization

April 16th, 2014 No comments

A provision appended to the Emergency Unemployment Compensation Extension Act of 2014 may offer defined benefit plan sponsors continued funding relief. The provision would extend the funding stabilization authorized under the Moving Ahead for Progress for the 21st Century Act (MAP-21) another five years.

In a recent Bloomberg BNA article, Zorast Wadia talks about the benefits of lengthening the MAP-21 provision. Here is an excerpt:

The MAP-21 provisions stabilize the discount rates used to calculate employers’ pension funding obligations by adjusting rates if they fall outside of an interest rate “corridor” tied to average rates over a 25-year period. Those corridors gradually widen through 2016, weakening their impact. The provisions were designed to raise revenue by lowering companies’ required pension contributions and thereby driving up taxable income and projected tax receipts.

As the MAP-21 smoothing provisions enter the midway point in 2014, plan sponsors are beginning to see the relief wear off, said Zorast Wadia, a principal and consulting actuary in the New York office of Milliman.

Interest rates continually declined from 2009 to 2012, and only began to rebound in 2013, so pension liabilities still remain at all-time highs, Wadia said. Lessening the relief could put many sponsors in a “tough situation again,” he said.

Under MAP-21, the corridor incrementally widens from 10 percent in 2012 to 30 percent in 2016. Under the unemployment insurance legislation, the corridor would remain at 10 percent through 2017 and incrementally widen to 30 percent after 2020.

There is a lot of incentive to fully fund plans more quickly, one reason being rising premiums set by the Pension Benefit Guaranty Corporation, Wadia said. “But those [plans] that are cash-strapped will probably welcome this opportunity, and continue to eke by, to do what they need to get on through,” he said.

Results from the 2014 Pension Funding Study (PFS) suggest that plan sponsors took advantage of MAP-21’s funding relief. Contributions declined significantly during 2013, according to the PFS.

The $44.1 billion in contributions during 2013 (down $18.1 billion from $62.2 billion in 2012) was the lowest level in five years. The lower-than-expected contributions were likely due to plan sponsors changing their contribution strategy in light of the MAP-21 interest rate stabilization legislation, passed in July of 2012. Seven companies decreased their contribution by more than $1 billion in 2013 compared with 2012, for a total of $13.3 billion….

Pension funded status drops by $5 billion in March

April 15th, 2014 No comments

Milliman today released the results of its latest Pension Funding Index (PFI), which consists of 100 of the nation’s largest defined benefit pension plans. In March, these plans experienced a $5 billion increase in pension liabilities in a month with flat investment return, resulting in a $5 billion increase in the pension funded status deficit.

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It was a brutal first quarter, with the deficit for these 100 pensions climbing by $79 billion, which was due to a combination of asset underperformance and interest rate decreases. Funded status greatly improved during 2013 but things have changed course in the first quarter of 2014 as the funding ratio has dropped to 84%.

Looking forward, if the Milliman 100 pension plans were to achieve the expected 7.4% median asset return for their pension portfolios, and if the current discount rate of 4.30% were maintained, funded status would improve, with the funded status deficit shrinking to $232 billion (86.1% funded ratio) by the end of 2014 and to $182 billion (89.1% funded ratio) by the end of 2015.

Can variable annuity pensions offer more retirement security?

April 4th, 2014 No comments

Senator Tom Harkin proposed the Universal, Secure, and Adaptable (USA) Retirement Funds Act intending to improve retirement security for individuals. In their article “Variable annuity pension plans: An emerging retirement plan design,” Milliman’s Kelly Coffing and Mark Olleman discuss how the variable annuity pension plan (VAPP) can address four principles Harkin proposes for reform.

Here’s an excerpt from the article:

The VAPP design responds to Harkin’s four principles as follows:

• Although not universal, the reallocation of risk allows more employers to maintain the “three-legged stool,” which includes pensions.
• By changing the focus from a “guaranteed” dollar benefit to a “lifelong” benefit, more people are able to have the certainty of a reliable stream of lifelong income without the fear of outliving their assets.
• Retirement risk is shared more evenly among participants. Risk is shifted from employers and active participants to all participants including retirees.
• Because retirement assets are pooled and professionally managed, larger benefits can be provided per dollar contributed.

In addition, some level of inflation protection may be provided.

So how exactly does this work? Figure 1 provides an example. The participant is hired on January 1, 2002 and enrolled in a VAPP with a 4% hurdle rate. For simplicity, the illustration shows the participant earning $30 per month of benefit each year, but benefits could be based on a percent of contributions or a percent of each year’s pay (a career average formula). The illustration uses actual historical returns based on a portfolio that is invested 60% in large company stocks (S&P 500) and 40% in long-term high-grade corporate bonds.

Figure 1 shows that at January 1, 2003 the participant has earned a benefit of $30 during 2002. The $30 earned in 2002 is adjusted at the end of 2003 for the trust’s investment return of 19.3% in 2003. The adjustment is 119.3%/104.0% = 114.7%, which increased the $30 to $34.41. Therefore, at January 1, 2004 the participant’s total accrued benefit is $34.41 plus another $30 earned in 2003, for a total of $64.41.

After 11 years, at January 1, 2013 the benefit accrued in 2002 has grown to $43.37, the benefit accrued in 2003 has grown to $37.82 and the total of the benefits accrued in all years has grown to $395.33. Although all benefits decreased by 21.8% after 2008, by January 1, 2013 the benefits earned in all years are larger than the original $30 accruals.

Figure 1 - VAPP benefit accrued example

Milliman consultant Grant Camp describes VAPP benefit features that can provide security for both retirement plan sponsors and participants in his blog “A balanced approach to retirement risk.” Ryan Hart also highlights the advantages that VAAPs may offer employers and employees in this blog.

In 2013, corporate pension plans with the highest equity exposure were the biggest benefactors

April 2nd, 2014 No comments

Milliman today released the results of its 2014 Pension Funding Study (PFS), which analyzes the 100 largest U.S. corporate pension plans. In 2013, these pension plans experienced historic improvement, with plan liabilities decreasing by 7.5% and assets improving by an average of 9.9%. This resulted in a $198.3 billion improvement in the funded status deficit from year-end 2012. While it was a “win-win” year for most sponsors, those with higher equity allocations performed the best.

Last year was a great year for pension funded status and helped reduce much of the underfunding that has persisted since the global financial crisis. Plans that held off on de-risking their plans were the biggest benefactors of the strong equity performance. With 18 of the 100 plans in our study now fully funded, and more hopefully reaching full funding this year, the timing for de-risking activities that can lock in funded status may be optimal.

Study highlights include:

Interest rate increases evident in financial statements. The discount rates used to measure plan obligations increased from 4.04% to 4.75% in 2013. While these rates are still down from a high water mark of 7.63% in 1999, the improvement in 2013 went a long ways toward minimizing the pension funded status deficit.

Investment performance exceeded expectations. The weighted average actual investment return on pension assets for the Milliman 100 companies’ 2013 fiscal years was 9.9%, which compares favorably to the expected return of 7.4%.

Contributions decline significantly during 2013. The $44.1 billion in contributions during 2013 (down $18.1 billion from $62.2 billion in 2012) was the lowest level in five years. The lower-than-expected contributions were likely due to plan sponsors changing their contribution strategies in light of the Moving Ahead for Progress in the 21st Century Act (MAP-21) interest rate stabilization legislation, passed in July 2012.

Pension expense decreased. Favorable investment returns in 2012 offset the impact of declining discount rates in that year, leading to a reduced level of pension expense: a $32.1 billion charge to earnings. This is $23.7 billion lower than the record high pension expense in 2012.

Market capitalization of these plans up more than 20%. The favorable equity market performance during 2013 increased the total market capitalization for the Milliman 100 companies by 21.2%. When combined with the decrease in pension obligations, this resulted in a decrease in the unfunded pension liability as a percentage of market capitalization, from 7.3% at the end of 2012 to 3.0% at the end of 2013.

Asset allocations remain relatively stable. The trend toward implementing liability-driven investing (LDI) continued in 2013, but at a slower pace. Overall allocations to equities remained largely unchanged in 2013. With strong 2013 returns across most equity markets and losses in many fixed-income sectors, it is evident that many plans rebalanced during the year by moving money from equities, and possibly other asset classes, to fixed income.

What to expect in 2014. Given the funded status gains in 2013, 2014 contributions are expected to decrease compared to those made in 2013. Plans already at surplus at the end of 2013 will have reduced incentive to further fund their plans in 2014. For some plans that had already engaged in LDI or other funded status lock-in strategies, higher contribution levels can be expected.

Given the compound effect of favorable investment returns in 2013 and higher discount rates at year-end, we estimate that 2014 pension expense will decrease to $19 billion, a $13 billion decrease compared with 2013. We may see more than 30 of the Milliman 100 companies with pension income in 2014, a level not seen since 2002.

To read the entire study, click here.

Watch Milliman’s Google+ Hangout where Zorast Wadia and I discuss the results of this year’s PFS with Pensions & Investments Executive Editor Amy Resnick.

GASB 67/68: Depletion date projections

March 25th, 2014 No comments

New accounting rules for public pension plans in the United States are set to take effect beginning in 2014. Successful implementation of the new rules will require an understanding of a variety of technical concepts regarding the various newly required calculations.

This article authored by William Winningham explores the requirement to calculate a depletion date and how the depletion date impacts the plan’s total pension liability (TPL).

To read Milliman’s PERiScope series on technical and implementation issues surrounding GASB 67 and 68, click here.

GASB 67/68: Relationship between valuation date, measurement date, and reporting date

March 20th, 2014 No comments

New accounting rules for public pension plans in the United States are set to take effect beginning in 2014. Successful implementation of the new rules will require an understanding of a variety of technical concepts regarding the various newly required calculations. This PERiScope article authored by Milliman’s Rick Gordon explores the relationship between the actuarial valuation date, the measurement date, and the reporting date—critical dates that should be strategically determined in the early planning stages of implementation of Governmental Accounting Standards Board (GASB) 67 and 68.

To read Milliman’s PERiScope series on technical and implementation issues surrounding GASB 67 and 68, click here.

Google+ Hangout: Pension Funding Index, March 2014

March 6th, 2014 No comments

The funded status of the 100 largest corporate defined benefit pension plans improved by $11 billion during February, as measured by the Milliman 100 Pension Funding Index. The deficit fell to $131 billion from $142 billion at the end of January, which was due to strong investment performance offsetting an increase in the pension benefit obligation (PBO). As of February 28, the funded ratio increased from 91.0% to 91.8% at the end of January. The funded ratio has declined in the first two months of 2014 when compared with the 95.2% funded ratio as of December 31, 2013.

Index co-author Zorast Wadia discusses the results on Milliman’s monthly PFI Google+ Hangout with Jeremy Engdahl-Johnson.

Pension funded status improves by $11 billion

March 6th, 2014 No comments

Milliman today released the results of its latest Pension Funding Index, which consists of 100 of the nation’s largest defined benefit pension plans. In February, these plans experienced a $32 billion increase in asset value and a $21 billion increase in pension liabilities, driving an $11 billion improvement in pension funded status.

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In February these plans were buoyed by strong market performance that offset yet another increase in pension liabilities. For the year we’ve seen liabilities increase by more than $80 billion in response to rate movement. These rates have defined pension performance for the last several years. We’ll need some cooperative rates to get back to full funding.

Looking forward, if the Milliman 100 pension plans were to achieve the expected 7.5% median asset return for their pension portfolios, and if the current discount rate of 4.46% were maintained, funded status would improve, with the funded status deficit shrinking to $58 billion (96.4% funded ratio) by the end of 2014 and turning into a surplus of $34 billion (102.1% funded ratio) accumulating by the end of 2015.

Note that the Milliman annual Pension Funding Study, which provides deeper analysis of these 100 pensions, will be released in early April.

Lump-sum payouts and tax implications

February 24th, 2014 No comments

Clark-CharlieOver the past few years, there is evidence to confirm that several employers sponsoring defined benefit (DB) pension plans have been settling their plans’ pension obligation to former employees via a single lump-sum payout. It is commonly referred to as a lump-sum cleanup strategy. Some commenters have said that not only has demand for such a strategy not abated, it has accelerated.

This blog post will remain neutral on the prudence of implementing such a strategy, as each employer’s goal is unique. Recognizing that employers who implement such strategies spend enormous energy and resources to communicate the consequences and financial impact on those electing the lump-sum payout, it’s questionable whether recipients completely understand the individual tax implications it could personally have on them. (And to be clear, this blog post does not implicitly or explicitly render any type of tax advice.)

If a participant chooses to roll over the lump-sum distribution to a personal tax-deferred IRA or to a tax-qualified savings plan of a new employer, the issues below are irrelevant. However, if the lump-sum is received as current income:

• The individual could move into the next higher marginal tax bracket, both federal and state (where there is a state income tax).
• The individual could face a 10% excise tax if that person is younger than age 59½.
• The individual could incur an underwithholding penalty in comparison to their prior year’s tax liability.
• According to the U.S. Department of Health and Human Services (HHS), eligible individuals and families with incomes between 100% and 400% of the federal poverty level (FPL) may receive premium tax credits for purchasing health insurance in the healthcare exchange. The 2013 FPL for a single person is $11,490 and this individual’s healthcare premium payment is capped at $228 per year. A lump-sum of approximately $29,000 would raise that premium cap to $3,816. A lump-sum of approximately $34,000 would raise income above 400% of the FPL and the individual would have to pay the full premium of the healthcare policy selected on the healthcare exchange.

Takeaway: The economic impact of a lump-sum payout must be carefully evaluated by the recipient. It may not be as advantageous as it appears. Plan sponsors implementing this strategy may wish to consider the impacts of the ACA as they draft the communications to the prospective payees.