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!

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.

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.

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.

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.

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.

As we transitioned from winter to spring we’ve focused on moving from our winter of discontent toward a hopeful spring. If you haven’t been here in a while, we’ve got you covered with this Retirement Town Hall rewind.

Winter of our discontent
With the release of the 2012 Pension Funding Study, John Ehrhardt recently gave us his summary of the last year in pensions: Falling interest rates define 2011 for corporate pensions. In this post, Ehrhardt highlighted all of the major factors that led to 2011’s record funding deficit increase.

Tim Connor and Genny Sedgwick continued their series on What to Look for in 2012 with a look at Funded status and at-risk, in which they note that many plans will continue to be considered “at-risk” according to the Pension Protection Act’s definition in 2012. Further, Connor and Sedgwick anticipate that the debate over PBGC-related issues will continue through the year. Connor and Sedgwick also looked at plans De-risking in 2012 and offer several strategies plans can take to minimize and mitigate risk.

Hope springs eternal
More recently Ehrhardt’s look at the latest full month’s Pension Funding Index, Market rally and rising interest rates reduce corporate pension deficit in March, offered some hopeful news.

Enough about us…
The past few weeks have also included several opportunities for you to tell us how you see the future. First we asked How long is Social Security’s half-life? and found that a third of readers believe Social Security will make up 20%-39% of their retirement income.

Next, Julie Cannaday reminded us of The power of personal touch and asked who’s helping you plan for your retirement. This poll is still fresh so the votes are still coming in.

So now that you’re all caught up, why not share your thoughts and vote in this and other Retirement Town Hall polls right now?

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 March, these pensions experienced a $58 billion improvement in pension funding thanks to a $4 billion improvement in asset value and a $54 billion reduction in the pension benefit obligation (PBO). These results reflect the annual update of the Milliman 100 companies and their actual 2011 financial disclosures included in the Milliman 2012 Pension Funding Study.   

For the first time in months, interest rates moved in a decisive positive direction for these 100 corporate pensions. While the positive market performance was consistent with the first two months of 2012, the pairing of asset improvement and a significant reduction in liabilities makes March the best month we’ve seen this year.

In March, the PBO for these pensions reached $1.526 trillion as interest rates rose from 4.69% to 4.88%. The overall asset value for these 100 pensions grew from $1.295 trillion to $1.299 trillion.

Looking forward, if these 100 pensions were to achieve their expected 7.8% median asset return and if the current discount rate of 4.88% were to be maintained throughout 2012 and 2013, these pensions would narrow the pension funding gap from 85.1% to 88.3% by the end of 2012 and to 93.5% by the end of 2013.

In our age of technology ruled by Facebook and tweets, personal connections have become rare … but maybe even more important. Picture Anne Kendrick’s character, Natalie, from the movie Up in the Air. She has the “brilliant” idea of firing people online, with the ultimate goal of reducing cost. The takeaway from this lesson is that technology is not always the best way to handle situations and communicate. A human being with feelings might relate more to the movie’s central character, Ryan (played by George Clooney), who takes the time to travel to far-flung places to meet with people and deliver the news.

Though Ryan was delivering bad news, the principle applies to many situations. For example, helping people avoid bad news by preparing for their financial future. Personal interactions with participants about their retirement plans create a more powerful connection than could ever be achieved through technology. Clues from body language, along with audience participation (or lack thereof), allows the presenter to alter the presentation immediately to keep the participant engaged. Creating a need (money for retirement), providing a means (employer retirement plan), and offering immediate solutions (one-on-one assistance) give employees the ability to walk away with a sense of accomplishment immediately.

Face-to-face interaction is a critical component of your communication campaign and can be just the nudge people need to take action. Recently we had a client with a 9% participation rate. The client had a deep concern for its employees’ retirement readiness, and wanted to increase participation. After a week of meetings, including 24 group employee meetings (mandatory) and one-on-one appointments (optional), plan participation increased to 40%! Mission accomplished.

So, continue your tweets and emails, but just remember that, for many people, talking about hopes, dreams, and their financial future is deeply personal—something that deserves a personal touch!