A financial services company emerging from a divestiture sought Milliman’s assistance with the subsequent re-risking of its defined benefit (DB) pension plan’s investment portfolio. The plan sponsor wanted to explore investment options that would best allow it to meet its future contribution requirements while limiting the risk of being underfunded on either an accounting or Pension Benefit Guaranty Corporation (PBGC) basis. The plan sponsor also wanted to understand the impact on accounting expense and balance sheet volatility as a result of investment allocation changes where the employer would take on more equity exposure.
Milliman consultants performed an asset liability modeling (ALM) study to review the company’s investment policy statement, understand its risk tolerance, set achievable financial goals, and present projections of assets and liabilities. The goal of the ALM study was to estimate expected levels, trends, and possible variability over the next 10 years of the plan’s annual required contributions, funded status, and accounting expense under the current policy asset allocation and several alternative asset allocations based on the client’s input.
Reducing an investor’s exposure to growth assets as retirement is approached is common. However, this strategy may increase the chance that an investor will outlive retirement savings. This is a predicament that many Australians face. In his article “Australia’s retirement challenge,” Milliman consultant Wade Matterson offers some perspective on how strategies employing derivatives can help Australians manage longevity and investment risks.
A U.S. Securities and Exchange Commission (SEC) amendment, which will take effect on October 14, 2016, has important financial implications for retirement plan participants and individual investors that own nongovernment money market funds. The amendment made to the Investment Advisors Act of 1940 (IA 1940) replaces the stable net asset value (NAV) for money market funds with a “floating” NAV.
In this article, Milliman consultant Jeff Marzinsky explains the SEC’s reasons for amending IA 1940. He also discusses how the amendment affects investors and retirement plan sponsors and provides steps people should consider to prepare for the new regulation.
Recent market declines appear to be driven by a few primary factors: the purported North Korean hydrogen bomb test, tensions between Iran and Saudi Arabia, an oil glut causing the lowest price per barrel in a number of years, along with continuing concerns about growth in China, have all contributed to global market instability in recent days. Not to mention, we are entering into a presidential election year in the United States. While we have no way to predict the outcomes of these economic and geopolitical issues, we do view them with some historical perspective and insight.
We are seeing some positive aspects in domestic economics with the U.S. Labor Department indicating better job growth during the last three months and hourly pay rising 2.5%. The U.S. unemployment rate remains steady at 5% and is the lowest it’s been since 2008.
Since the end of December, the Dow Jones Industrial Average has dropped nearly 1,000 points and the S&P 500 has fallen nearly 121 points, amounting to percentage declines of around 6% in the first week of 2016. If you look back to January 2015 and January 2014, we began both years with declines in the U.S. equity markets early in the month, continuing into negative territory to finish off January. In both of those years, the market rebounded during February and ended the quarter with better results than January might have predicted.
This is not to say that we are expecting or predicting the same type of rebound during February 2016, but it shows that, from a historical perspective, the January effect doesn’t provide the full story. As you can see, rocky starts were followed by healthy rebounds as we moved into the mid part of the first quarter in each year.
More currently, during August 2015, the markets experienced a sharp correction of more than 11% over a period of six trading days from August 18 through August 25. During that period, market volatility rose significantly, as noted in the VIX Index (see chart below). The VIX, a market volatility indicator, jumped significantly during this time from the 10-to-15 level prior to the correction to over 40 during the first couple days of the decline, and remained moderately high through September.
During this time, we saw the market attempt a rebound on a couple of occasions, but ultimately it dipped again in the last week of September. The return of the market to pre-correction levels took the entire month of October, finally ending the first day of November with the S&P 500 hitting 2,100.
At this point, as an investor, you are most likely asking yourself what, if anything, should be done. Looking at historical market patterns and movements, there is a tendency for investors to be cautious when the market ventures into near-correction territory. Concerns associated with market declines often lead to unwarranted or ill-timed actions. Remember to look at the long-term aspects of your investment strategy. Market setbacks and corrections are always a part of long-term investing. Keep in mind your risk tolerance while thinking twice before making any significant portfolio adjustments.
Milliman’s Kamilla Svajgl recently participated in a Pensions & Investments’ roundtable discussion focusing on the current climate of investment risks and behavior.
Here’s an excerpt:
P&I: What kind of strategies would work to help pre-retirees manage risk in this new world of higher volatility and lower returns — and help to keep them invested?
Kamilla Svajgl: Let’s start with the way people define asset allocation and risk. It used to be that “risk” was defined by an investor’s level of equity allocation. For example, 60% equity/40% bond portfolio was used as a proxy for “moderate risk.” There is a fundamental problem with that — a 60/40 portfolio would have experienced mere 7% volatility in the fourth quarter of 2006, but 67% volatility in the fourth quarter of 2008. I don’t think anyone is a moderate risk investor when they’re experiencing 67% realized volatility. These kinds of large swings in portfolio risk are not only highly correlated with sharp declines in the market, but also expose investors to significant behavioral risk of selling when asset values are deeply depressed.
A better way to define risk is by portfolio volatility. For a moderate investor, that might mean an overall portfolio volatility of 12%, for example. So the first step is to stabilize volatility. And the good news is that volatility lends itself very well to short-term predictive modeling. Therefore, while I will not be able to tell you if the market will go up or down tomorrow, I can be very accurate in assessing whether it will be calm or volatile.
The second step of the strategy is to add some additional downside protection for extra cushion. We achieve it by synthetically replicating a long-dated put option within the portfolio. This further reduces losses during periods of significant and sustained market decline. This approach has been used by large life insurance companies during 2008 to successfully hedge their balance sheets.
Combining volatility management and capital protection allows investors to stay invested in equity during calm market conditions, and at the same time protects them during times of crisis.
For a transcript of the entire roundtable discussion, click here.
During December 2014, U.S. equity markets peaked at all-time highs—over 18,000 for the Dow Jones Industrial Average and 2,090 for the S&P 500 Index. Then, in January, equity markets became more volatile and both indexes pulled back dramatically, as international economic uncertainty rose and oil prices fell. Some thought interest rates couldn’t go any lower during 2014 with the U.S. Federal Open Market Committee (FOMC) hinting at an upward adjustment. But interest rates on the longer end of the maturity spectrum dropped during 2014, which most likely had a detrimental effect on defined benefit (DB) pension plan liabilities.
Now, more than ever, plan sponsors should be reviewing their DB plan investments as we react to these market movements, which are critical in the asset allocation process. For more perspective on the shifting landscape, see my paper “Developing pension plan investment strategy: A variety of considerations,” published last year to help DB plan sponsors understand the range of considerations and how they interact in the development of a pension plan investment strategy.
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