Monthly Archives: April 2012

The need for (responsible) growth

Liability-driven investment (LDI) strategies have been around for some time now. The main idea behind LDI strategies is that pensions should invest in long-term fixed-income securities in order to match their long-term liabilities. The theory is certainly sound; if a pension is able to accurately match all sensitivities to the yield curve of both assets and liabilities then its future income statements would not be subject to future interest rate moves. But a reduction in volatility of future cash requirements does not necessarily mean a reduction in future cash requirements.

For instance, underfunded plans may simply be locking in large future cash requirements if they were to move to an LDI strategy. This would be caused by the need to make up their funding deficit through future contributions. Further, even some well-funded plans may lock in large future contributions, which is due to the potential discrepancy between the assumed earned rate on assets in the actuarial valuation (current funded status) and the actual rates available in the market currently. Locking in future contributions may be feasible, or even preferable, to some well-funded pension plans. But for others the need for growth remains.

Growth assets such as equities are necessarily accompanied by an increase in volatility. Generally speaking, asset allocation strategies comprising equities have focused on notions of the long-term expected returns and volatilities of these assets, along with their correlations with each other and other portfolio assets. But such methods have ignored short-term fluctuations in these expected values. For instance, at the beginning of the financial crisis in September 2008, short-term realized equity volatilities were around three times their historical average levels. Accordingly, portfolio volatilities were much higher than targeted and, as most of the volatility was on the downside, much pain was felt.

Therefore, the need for asset risk management, as part of a comprehensive risk management process, is greatest in those plans requiring investment in growth assets. As such, this has become a hot topic of discussion among investment advisors, risk professionals, fund managers, and academics.

The need for portfolio growth should not be viewed as a license for unmitigated risk-taking. Equity risk management strategies involving the purchase of put options have been around for some time, but they are very expensive and rigid in the long term and require precise market timing in the short term. Another fund strategy, risk parity, seeks to create a fund with equal risk contributions from different asset classes. Given the lower volatility of bonds, however, this necessarily means large bond allocations, which may not be desirable given the current interest rate environment.  Ideally, a pension plan would benefit from a futures overlay strategy that combines formula-driven volatility management plus capital protection to help mitigate equity risk. The Milliman Managed Risk Strategy offers exactly that, and when combined with an effective LDI strategy, the pension portfolio becomes well positioned for (responsible) growth!

Longevity risk and retirement

Over the last 25 years, defined contribution (DC) plans have replaced defined benefit (DB) plans as the primary retirement plan sponsored by employers. In the long run, this remarkable shift is problematic because having benefits from a DC plan as a primary retirement source subjects plan participants to longevity risk—the risk of running out of money during retirement.

Based on average life expectancy statistics, we know that half of the population will survive beyond its life expectancy and half of the population will not. This creates challenging circumstances for people to manage withdrawals from their retirement accounts. In addition, there is the added challenge of managing investments.

This article from the Spring 2012 issue of Actuarial Digest is not meant to compare the advantages and disadvantages of DC and DB plans; rather, it is meant to promote a new retirement paradigm where both types of plans can coexist and complement one another. This paper offers this new retirement model as a solution to the longevity risk problem.

Regulatory roundup

We’ve seen a string of regulatory issues come up recently that employee benefits practitioners should know about. The following succinctly explains the new changes and  includes links for you to learn more about each topic.

Governmentals guided
The IRS and the Treasury Department will issue guidance relating to the applicability of the normal retirement age rules to governmental plans (as defined in § 414(d)). In Notice 2012-29, the agencies describe and invite public comment on the guidance under consideration, which

  1. would clarify that governmental plans that do not provide for inservice distributions before age 62 do not need to have a definition of normal retirement age, and
  2. would modify the age-50 safe harbor rule for qualified public safety employees.

See this IRS Notice for more.

ERISA explained
The Department of Labor (DOL) release an update Health Benefits Advisor for Employers that explains the legislation, statutes and regulations in Parts 6 and 7 of Title I of the Employee Retirement Income Security Act of 1974 (ERISA). These laws include:

  • Consolidated Omnibus Budget Reconciliation Act (COBRA)
  • Health Insurance Portability and Accountability Act (HIPAA)
  • Mental Health Parity Act (MHPA) and Mental Health Parity and Addiction Equity Act (MHPAEA)
  • Newborns’ and Mothers’ Health Protection Act (Newborns’ Act)
  • Women’s Health and Cancer Rights Act (WHCRA)
  • Genetic Information Nondiscrimination Act (GINA)
  • Michelle’s Law

Derivatives defined
The Securities and Exchange Commission (SEC) has adopted a new rule to define a series of terms related to the over-the-counter swaps market. The new rule is intended to “clarify for market participants whether their current activities will subject them to comprehensive oversight in the coming months,” says SEC Chairman Mary L. Schapiro. A fact sheet on the new rule is available from the SEC website.

Check back here for more on new and updated regulations and how they affect you.

What to look for in 2012: Defined contribution plans

Defined contribution (DC) plans
July 1, 2012, is a significant date for defined contribution (DC) plan sponsors, including persons who have legal responsibility for managing someone else’s money, trustees, and investment committee members. By that date, plan sponsors should have received information from all plan service providers disclosing their status as it relates to the plan, such as an ERISA fiduciary and/or registered investment advisor, their estimated fees, how they are compensated, and the services they provide. The new U.S. Department of Labor (DOL) regulations are intended to improve fee disclosure to regulators, plan sponsors, and plan participants. Plan sponsors have a fiduciary responsibility to review, for reasonableness, the compensation of their service providers that is paid from plan assets both directly and indirectly. However, in our experience, some plan sponsors are not aware of the total amount of fees paid from the plan or how they are calculated.

Many plan fiduciaries may not be aware that it is both a fiduciary breach and prohibited transaction to allow the plan to pay more than what is considered reasonable expenses. In practice, how does a fiduciary determine if plan fees are reasonable? If you’ve taken your plan out to bid within the last three years, you should have current market information and documentation for your due diligence files to support the fees you are paying, or have taken action by going back to your service provider(s) to negotiate lower fees on behalf of plan participants. In lieu of going out to bid, there are other options available: for example, you can benchmark your plan. The DOL has developed fee disclosure worksheets that can be found on their website at: DOL Publications “Understanding Retirement Plan Fees and Expenses “ and “Cost Disclosure Sheet.”

There is nothing in the regulations to imply a plan must have the lowest fees, just that the plan’s fees be reasonable and commensurate with the services provided. Qualitative differences in services may impact fees. For example, quality of service varies with respect to the range of planning and guidance tools available to participants, which may drive up fees. We strongly encourage plan sponsors to develop a diligent process to evaluate fees on an ongoing basis and to document their processes. Costly litigation can be avoided by implementing a sound process, which shows that you have taken reasonable steps to fulfill your plan fiduciary responsibilities.

What to look for in 2012: Lump-sums

Defined benefit plans: Lump sums
Speaking of de-risking strategies, another idea that may gain more traction in 2012 is payment of lump sums from defined benefit (DB) plans. This year, 2012, marks the first year that the 417(e) interest rate required to calculate the minimum present value of a DB pension is equal to the interest rate used to calculate its liability for Pension Protection Act (PPA) minimum funding purposes (ignoring the 24-month averaging). In the past, the lump sum was based in part on 30-year Treasury rates, which often resulted in the payout of lump-sum amounts greater than the corresponding liability funded for in the plan’s funding target. With this no longer the case, the settlement of lump sums might be an attractive way to eliminate longevity risk from DB plans. Alas, the buyer must beware. The introduction of lump sums into a plan that otherwise had no accelerated forms of payment could lead to some unwelcome news should the plan ever fall below certain funding thresholds that introduce the sponsor to the world of benefit restrictions. Additionally, the other subtle point to consider is that just because the PPA requires the valuing of liabilities using corporate bond rates doesn’t mean a sponsor has to equate that to their idea of the true liability on the books. To the extent a sponsor is confident the plan’s asset mix will generate long-term returns on average in excess of corporate bond rates, lump-sum settlements are arguably still expensive and represent a lost opportunity cost. As is the case with almost any financial strategy, it’s all about the risk appetite.

To end this series, we’ll look at defined contribution (DC) plans.

Inflation nation

The Society of Actuaries (SOA) recently came out with the 2011 Risks and Process of Retirement Survey (see the full report). It is the sixth biennial study on post-retirement risks and how they are managed.  The next few weeks’ polls are part of our series highlighting some of the same concerns brought up in the SOA survey results. Afterwards, we’ll compare your answers, to those of the general public. To start things off we’re wondering how our readers foresee inflation affecting their retirement plans.