Tag Archives: liability-driven investing

Discount rates deepen pension funding deficit and make 2014 a banner year for liability-driven investing

Ehrhardt-JohnMilliman today released the results of its 2015 Pension Funding Study, which analyzes the 100 largest U.S. corporate pension plans. In 2014, these pension plans experienced a funded status decline despite a 10.9% investment return, with plan liabilities for these 100 plans increasing by $189.2 billion and assets increasing by $57.9 billion. This resulted in a $131.3 billion increase in the funded status deficit, representing a funding ratio decline of 6.1%.

Pension plan sponsors may be feeling whiplash after the last three years. In 2012, plans with the heaviest investment in fixed income experienced superior returns. In 2013, we saw the opposite: Plans with heavy equity allocations fared the best. Now with these latest results, we’ve again reversed ourselves, as plans with the highest fixed income allocation once again outpaced the field despite a strong year for equities. This whiplash is the result of discount rates that hit a record low this year, and continue to define pension funding status.

Study highlights include:

Asset allocations shift toward fixed income. Equity allocations in the pension portfolios dropped to 37.3% by the end of 2014, the lowest in the 15-year history of this study. The companies included in this study have generally shifted toward higher allocations in fixed income investments.

Risk transfer trend continues. Some plan sponsors engaged in pension risk transfer activities, including two well-publicized pension buyouts conducted for two of the Milliman 100 companies (Bristol-Myers Squibb and Motorola).

New mortality assumptions increase pension liabilities by 3.4%. The magnitude of these increases is contingent on age, gender, and other demographic characteristics of each plan’s participants. Based on the footnote disclosures at year-end 2014, the new Society of Actuaries mortality tables led companies to update mortality assumptions, increasing pension liabilities by approximately $38.3 billion, or 3.4%, at least among those plans that disclosed the impact.

Contributions decline during 2014. The $39.8 billion in contributions during 2014 were the lowest level since 2008 and marked a $4.4 billion decrease from 2013 contribution levels. The lower-than-expected contributions were likely due to plan sponsors changing their contribution strategies in light of the Highway and Transportation Funding Act of 2014 (HATFA) interest rate stabilization legislation, enacted in August 2014.

Pension expense increases. Robust investment gains in 2013 were partially offset by the impact of lower contributions and increasing discount rates during 2013, producing a net increase of $4.8 billion and resulting in a total of $37.1 billion in pension expense. Pension expense hit an all-time high at $56.1 billion in 2012.

What to expect in 2015. The passage of HATFA may result in lower contributions on par with those seen in 2014. However, for plans already engaged in liability-driven investing (LDI), higher contribution levels can be expected. The lower discount rates at the end of 2014 are expected to lead to significant 2015 pension expense increases because discount rates for the coming fiscal year are set at the start of the fiscal year. This does not factor in any possible plan de-risking activity.

Funding strategies and policies for single-employer defined benefit pension plans

As far as determining the funded status of a defined benefit (DB) pension plan, many factors are out of the control of the plan actuary, such as investment performance, liability interest rates, and how much a plan sponsor is able to contribute to the plan. However, the actuary can discuss with the plan sponsor possible funding strategies and policies designed to maintain the funded status of a fully funded plan or to improve the funded status of an underfunded plan.

In general, the discussion can be broken down into three possible scenarios. If a plan is fully funded, the plan sponsor should consider ways to stabilize annual costs to avoid the possibility of becoming an underfunded plan. If a plan is underfunded, the plan sponsor can consider ways to stabilize annual costs and then commit to making contributions gradually over time to bring the plan to fully funded status. Alternatively, a plan sponsor can subject an underfunded plan to annual cost volatility with an equity-based investment allocation in the hope of bringing the plan to fully funded status through a combination of favorable investment performance and contributions.

Some cost stabilization strategies that can be considered are liability-driven investment (LDI) tactics or a change to a more conservative investment allocation that is much less based on equities. In an LDI strategy, the plan’s investment allocation is changed to primarily fixed income with the objective of plan assets and plan liabilities moving in tandem as liability interest rates rise and fall. In a more conservative investment strategy (e.g., an allocation of 35% equities and 65% fixed income), annual costs are more stable, which is due to less investment risk related to a low equity allocation.

One possible funding policy to consider is annual contributions in the amount needed to hit a given Pension Protection Act of 2006 (PPA) funding target (e.g., at least 80% to avoid benefit restrictions for the current year). Another funding policy to consider is having the actuary determine an annual contribution amount projected to meet a plan sponsor’s funded status goal (e.g., become 100% funded by the year 2017).

A plan sponsor can choose to combine any of the above strategies and policies to meet its goals. Reviewing long-term cost projections is suggested when considering any new strategy and/or policy.

Finally, plan sponsors need to be careful about taking full advantage of any type of legislative funding relief—e.g., Moving Ahead for Progress in the 21st Century (MAP-21) funding relief legislation passed during 2012—because later this may result in much higher minimum funding requirements. Therefore, plan sponsors should consider making higher-than-required contributions despite the availability of funding relief.

Strategies for reducing retirement plan risk in defined benefit plans

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.

What to look for in 2012: De-risking

Defined benefit plans: De-risking
Given the highlighted areas of concern already discussed, it’s likely that plan sponsors will look ever harder at the idea of de-risking their plans in 2012 and onward. The volatility of worldwide markets has been dubbed the “new normal” by many economic minds. Smoothing mechanisms are losing favor in the financial world, and the International Accounting Standards Board (IASB) has already moved toward a more mark-to-market structure, with the Financial Accounting Standards Board (FASB) likely not far behind. Sponsors have already been “encouraged” by the Pension Protection Act of 2006 (PPA) to take on less risk in their pension portfolios, and now the accounting world is joining in on the push. When you further consider the world of pain that comes with benefit restrictions under the PPA and the ramifications of being at-risk, not to mention higher Pension Benefit Guaranty Corporation (PBGC) premiums the more underfunded a plan is, it stands to reason that employers should be very attracted to pension risk management more so than ever.

Liability-driven investment (LDI) strategies have been one popular approach to mitigate risk by reducing the exposure to the most volatile assets in a portfolio, instead concentrating investments in assets that act more like liabilities, namely long bonds. However, the cost of implementing an LDI strategy is high right now because current yields on bonds are so low. Also, there is still a lost opportunity cost with regard to the impact on financial statements, at least with U.S. GAAP anyway.

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Pension accounting conjectures

From far away, we conjectured that the headline-grabbing stories about companies moving to “mark to market” pension accounting that occurred in the past 18 months were woefully incomplete in key details. At that time, the stories talked about changes companies made to their Financial Accounting Standards Board (FASB) financial reporting under Accounting Standards Codification (ASC) Topic 715. These changes, for the most part, meant that the annual gains and losses that plans experienced because of interest rate declines and poor equity returns would hit earnings immediately rather than be deferred. This was resulting in some pretty big numbers. Part of our conjecture was that these companies were first-movers in adopting what some believed were going to be mandates once international accounting standards became the rule.

Furthermore, our numero uno on the conjecture list of why they were doing this was that they would implement an investment approach based on liability-driven investing (LDI) to protect against those nasty interest rate and market declines, with their resulting losses. When we saw repeat headlines about some of those same companies again taking massive hits to earnings because of their pension accounting, I was dumbfounded. I hate being wrong but admit I was.

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Two longs make it right?

As mentioned in my prior blog post, I was invited by a client to offer an actuary’s view on a new LDI product for its pension plan. I had a lot of positive things to say, but also a significant concern.

The LDI vendor wanted to match interest rate sensitivity (called “duration”) of the assets and liabilities, while also generating return. As you might expect, they chose equities to generate return. But to match interest rate sensitivity, they proposed using Treasury STRIPS[1] alongside or instead of long corporate bonds.

LDI in pictures

The primary goal of LDI is to match assets with liabilities. A perfect match would be a package of bonds that delivers income on a monthly basis in the amount needed to pay benefits. However, this cash-flow matching idea isn’t often used because it comes with high fees and still retains some risk.

In practice, most LDI involves matching the duration of assets and liabilities. Matching duration reduces the risk that decreases in interest rates will drive up pension costs. Matching duration is like matching the liabilities “on average.” Buying STRIPS can be a potent, lower-risk tool for matching duration.

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Liability-driven investing: Putting it into practice

I’ve been working with a client on de-risking their $30 million defined benefit pension plan. My client had come to me with concerns that the accounting expense and cash requirements of its pension plan were volatile and often uncomfortably high.

After studying the issues, we helped my client to the conclusion that better alignments between pension investments and liabilities were warranted. This “liability-driven investing” (LDI) is a growing area of interest for defined benefit plans. But like most growth areas, the theory has been easier than the practice.

The theory is pretty simple. LDI usually involves buying longer-duration bonds (long bonds). The goal is to align long-dated pension obligations to long-dated investments. When the liabilities and assets are better matched, the funded status of a plan stays more stable. As a result, accounting expense and cash requirements tend to be less volatile. (For more on LDI, see here.)

Until recently, a major obstacle to LDI has been finding low-cost products for plans with under $100 million in assets. Consultants could tell you what LDI was in theory, but actually doing it? There were no standard products. Each pension plan needed an individually designed LDI program and specialized consulting. That can be an expensive proposition for smaller plans.

In the past few years, investment companies have started to roll out more long bond mutual funds and standardized LDI products. This is a significant step forward for smaller pension plans looking to implement LDI.

But not all LDI products are equal, of course. Before selecting a product, it’s worth performing some due diligence with your investment advisor. It can also help to consult your actuary.

My client found a relatively new LDI product and graciously invited me to kick the tires. Overall, I offered my opinion that the product seemed like a good fit for this pension plan.

With one caveat.

In a follow-up blog post, I’ll discuss the new LDI product, and a concern I raised about its design.

LDI and mark-to-market

Bart Pushaw

Susan Mangiero recently responded to our post of last week on a new reporting trend in retirement plans, one that calls for a more accurate reflection of liabilities and surpluses in a single year rather than “smoothing” gains and losses over longer periods. The back-and-forth has us thinking it may be useful to provide more clarification on liability-driven investing (LDI) and mark-to-market accounting.

First off, let’s be clear: When we refer to mark-to-market liabilities, it’s not necessarily accounting requirements that are of central concern. Financial Accounting Standards have been instrumental on the financial reporting side of things, but it’s really the Pension Protection Act that is central here, both because it introduced mark-to-market on pension funding and also because it makes LDI viable. The market crashes in 2008 and, previously, in 2001-02 verify the primacy of LDI. Without mark-to-market–which entails valuing liabilities based on current market interest rates/yields–LDI cannot exist. In this sense, mark-to-market enables LDI to work. Whle not a perfect congruence, reducing funding volatilities will also reduce accounting volatilities. Since funded and accounting rules require mark-to-market, LDI can be implemented with either as the primary cost metric.

Backing up even further, a primer may be helpful. For retirement plan sponsors, mark-to-market accounting tends to introduce risks, chiefly related to interest rates. It’s a factor many of them have never had to deal with before. In the simplest terms, the goal of LDI is to address those risks. The strategy is simple enough, calling for as close a match as possible between asset and liability returns over the course of a year. If asset returns match liability returns, then the funded level at the end of the year will be the same as at the beginning of the year, all things being equal. By operating on such an even keel, funded status volatility and thus contribution requirements are kept as manageable and predictable as possible.

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Liability-driven investing: Are we there yet?

Bart PushawFor a while there, liability-driven investing (LDI) was a hot item in employee benefit circles. You don’t hear as much about it these days, but the need is still there. Here are five frequently-asked questions I’m hearing from clients.

Q: There was a flurry of publicity surrounding LDI. Has that fad passed?

A: There certainly has been quite a lot of activity surrounding LDI. Much of the early wave of material varied in content and focus and much misinformation exists. I dare not refer to it as a fad, however. The nexus of LDI began with financial reporting rules requiring liability values be marked-to-market and it slowly grew important; the big change came with the Pension Protection Act of 2006, which also requires that liability values reflect market pricing in some way. Without any mark-to-market, there can be no LDI, and because it seems our lives will be tied to market values, we expect LDI to be around for the long haul.

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