Vanguard Research June 2015

Transcription

1 The Dynamic buck investment stops here: policy Vanguard statement A money plan market for action funds Vanguard Research June 2015 Paul M. Bosse, CFA Regulatory changes in pension accounting over the past decade, and ongoing market volatility, have raised awareness among defined benefit (DB) plan sponsors to the importance of controlling risk within their plans. Funding level is a key determinant of the risk that a traditional DB plan should take. Since a plan s funding level can be volatile, the portfolio design should therefore be dynamic hence, the birth of derisking and glide-path strategies. Execution of these strategies, however, can be a challenge. As this revised paper emphasizes, an investment policy statement with a built-in glide-path offers a road map for a plan sponsor and greatly enhances the chances of the plan s success.

2 Dramatic changes in both the investing environment and in pension accounting over the past decade have served as a wake-up call for DB plan sponsors. New pension regulations and volatile markets have led to funding-level gyrations that have taken many pension plan sponsors by surprise. Vanguard s anecdotal observations indicate that focusing on controlling or managing the funding risk with more forethought has thus become fundamental to many pension strategies today. Derisking glide-path strategies are a popular way to reduce risk while controlling costs. The challenge, however, can be in executing the strategy. Vanguard believes a dynamic investment policy statement (that is, one that is responsive to a plan s funded status) is fundamental in guiding the investment policy committee through glide-path implementation. In the process, it s important to keep in mind the following points (each of which is discussed in this paper): Pension risk/return objectives can dramatically shift with a plan s funding level. Implementation of a glide-path strategy is dependent upon the methodical changing of a plan s asset allocation at certain key points. Time spent early on hard coding the glide-path implementation will pay off later. Be prepared for implementation derailers. Pension strategy first, some history For traditional pension plans, pension assets exist to fund the long-dated pension liability. Before the federal Pension Protection Act of 2006 (PPA) and pension accounting changes issued first by the Financial Accounting Standards Board (FAS 158; codified in 2009 into Accounting Standards Codification [ASC] 715), most corporate pension plans held an asset mix typical of a total-return strategy. This asset mix (for example, 60% equities/40% bonds) often earned returns in excess of liability growth. The accounting rules smoothed both asset and liability growth, which encouraged higher-risk portfolios. This strategy was the standard for decades and worked quite well as a surging stock market resulted in decades-long funding holidays that is, no pension plan funding was required. But then, in 2006, the PPA and accounting rules shortened the smoothing measures, which led to closer marked-to-market (or, fair-value) accounting methods. Plus, by 2007, the broad equity market was seeing major declines. Along with dropping interest rates, pension funded levels decreased dramatically all of which begs the question: Is an aggressive investment strategy still the best choice? Determining the optimal level of a pension plan portfolio s risk involves many factors, such as the corporate sponsor s view on risk-taking; the sponsor s tendency (or not) to take a paternalistic attitude toward its employees; and the company s financial situation. Another factor, funding level, has an especially large and dynamic impact on investment strategy. This is because of the asymmetrical nature of pension plan funding. A sponsoring company is responsible to fully fund the pension promise (obligation). If a plan falls below the fully funded level, the company must contribute money to make it whole. If the plan assets exceed the promise, however, the company cannot reclaim the gains, since these pension assets belong to the participants the law severely taxes reclaiming efforts. You can see the asymmetrical gain/loss situation: Bad asset performance means the company pays; good asset performance means the participants win. Notes on risk: All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. Investments in bond funds are subject to interest rate, credit, and inflation risk. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 2

3 For a plan that s still open, overfunding often just means a funding holiday, with the surplus used to pay for future promises, as happened in the 1980s and 1990s. But if the plan is closed to new participants or all future accumulation is frozen, such gains could mean a surplus that continues to build and the company cannot reclaim. This can lead to what is called a stranded surplus. Although there can be ways to use the surplus for participants, the process can get complicated and isn t an attractive way for a company to take risk. Thus, it s best for a company to avoid an excessive surplus. As has been demonstrated dramatically over the past 15 years, the funding level can be volatile. And it is not just the stock market s gyrations interest rate change has had a major impact, too, given the pension liability s long duration (and therefore high sensitivity to interest rates). As PPA/ASC 715 rules now more quickly recognize these two volatile pension components, there has been growing interest among plan sponsors in managing the pension risk, either by reducing the funding volatility to acceptable levels or by exiting the pension plan entirely, but at a reasonable cost. Pension strategy today it s dynamic In essence, derisking investment strategies set up a plan to reduce risk as the plan s funding level improves. The logic: Staying aggressive while underfunded gives the pension plan the chance to collect the equity risk premium. In contrast, reducing risk while at low funding levels would lock in those levels and require larger company contributions usually not a popular option, although the predictability of the contribution is appealing to some. However, maintaining a high-return strategy at higher funding levels runs the risk of either a downside surprise (and again the need for company contributions) or a stranded surplus. The solution to this dilemma is to be dynamic with the amount of risk taken throughout the funding stages. The accompanying box, What funded status measure should you use? outlines elements driving the liability valuation and defines three different benefit obligation measures according to a plan s funded status. Depending on the measure selected, the asset allocations at each funded status will vary, but the key is that the liability measure selected reflects the goals of the sponsor, whether those involve a future plan termination or long-term growth to help defray the cost of benefit accruals. What funded status measure should you use? In general, the funded-status calculation is determined by dividing plan assets by the plan s liability. The assets should be their market value. Two elements drive liability valuation: 1. Discount factor: The liability present-value calculation applies discount rates based on market interest rates so that the value represents a form that is investable. The value is based on AA-rated U.S. corporate bonds. 2. Cash flows to be discounted: The measurement and application will vary. Here are three rules of thumb for calculating an appropriate measure for your plan. The measure you choose is determined by your plan s current funded status: Accumulated benefit obligation (ABO) All benefits earned to date without a projection of future pay or service. This represents the assets needed today for benefits already earned. Projected benefit obligation (PBO) All accumulated benefits, plus future accruals due to pay increases. This is a good measure for open or closed plans that are sensitive to accounting results. Present value of benefits (PVB) All accumulated benefits, plus future accruals for pay increases and service. A good measure for open or closed plans concerned about the long-term costs of the plan. 3

4 Figure 1. Funding level s impact on pension objectives Underfunded Funding objective: Improve funding status Asset objective: High returns: Equities dominate Funding status Future Overfunded Funding objective: Maintain funding status Asset objective: Match liability: Bonds dominate Source: Vanguard. What should your pension strategy be? It depends What drives the pension strategy? Figure 1 looks generally at how funding affects pension objectives. Funding differences between plans will be based on risk preferences, plan design, and corporate objectives, but overall, when a pension is underfunded, most would agree that the overarching need is to improve the funding. This can be done with plan contributions or by achieving asset returns that outpace the liability growth, or both. U.S. plans tend to take more risk when they are underfunded, thus leading to an equity-heavy strategy, assuming the risk is acceptable to the plan sponsor. If higher risk is not acceptable, larger contributions are needed. As funding improves, the objectives begin to change, from further improvements in funding to maintaining the funding achieved. The portfolio s asset mix should change to accommodate this shift in objectives. Asset allocation drives results The components of investment strategy are often defined as three major factors: asset allocation, markettiming, and manager performance (that is, alpha, or achieving returns that exceed an appropriate benchmark). A groundbreaking study in 1986 by Brinson, Hood, and Beebower demonstrated that the asset allocation decision explains close to 90% of both the variability of return and the volatility of an investment portfolio. Brinson and colleagues further claimed that market-timing and manager performance, on the other hand, each accounted for only about 5% of return variability. Over the past 30 years, numerous academic studies (e.g., Ibbotson and Kaplan, 2000; Vanguard research by Davis, Kinniry, and Sheay, 2007) have supported Brinson et al. s (1986) finding that investment strategy should focus on the asset allocation, given its overwhelming influence on results. What does a derisking asset allocation strategy for a pension plan look like? Figure 2 provides a typical example for an open plan. Such strategies have become popular over the past several years within the pension community. 1 The asset allocation changes in Figure 2 align with the shifts in objectives and are substantial, moving from a typical equity allocation of 60% to perhaps just 20% for open plans (there may be no equities at all for a frozen plan). An investment committee s makeup and experience are key factors in the team s ability to meet derisking challenges head on, as outlined next. 1 Sources: Vanguard observations and Cogent Wealth Reports, U.S. Institutional Investor Brandscape: Select Findings Prepared for Vanguard. Livonia, Mich.: Market Strategies International, May 19. 4

5 Figure 2. Common derisking strategy for an open pension plan 80% funding 95% funding 110% funding 125% funding Stocks Long-term bonds STRIPS Intermediate-term bonds Note: STRIPS = U.S. Treasury separate trading of registered interest and principal securities. Source: Vanguard. Risks in executing a derisking strategy Investment committees face a number of challenges throughout the derisking glide path. For most companies, the investment committee includes several corporate officers, such as the chief counsel, human resources head, treasury officer, and often one or more of their core business leaders. Larger companies may have a dedicated pension officer, but pension responsibility often lands on the treasurer s desk and the investment committee. Despite this team s normally high intelligence, pension-investing acumen is not always a strength, as pension investing is wholly different from the total-return investing most team members are familiar with. Plus, committee members most likely did not volunteer for this responsibility it came with their job description. As a consequence, investment committee membership can represent a career risk to a team member more than a career opportunity. For most people facing risk without reward, the tendency is to do nothing rarely does one get in trouble for not changing something. But the derisking glide path we advocate calls for dramatic action, and that poses a dilemma how to encourage action when the natural inclination is to avoid doing so? There are other hurdles too. For one thing, investment committees often meet only quarterly, yet important events within portfolios are happening continuously. Meeting just once every three months can thwart timely decision-making. Two other issues are related: turnover and corporate memory. Although some decisions need to be made swiftly, others can involve a lengthy process. Since the makeup of the committee membership is often in flux, however, the continuity of processes and decisions can be lost. Add to this the typical behavioral finance issues (such as fear and greed) surrounding any investment decision. Efforts by the committee or individuals to forecast markets can thus derail strategy execution, so that, in the end, the decision process comes to a standstill. Yet, as we have said, a glide-path strategy requires timely action when opportunity presents itself. What is a committee to do? 5

6 The dynamic IPS a plan for action The bottom line is that the investment committee needs to install a plan to execute a derisking strategy when the opportunity presents itself. We call such a plan the dynamic investment policy statement, or dynamic IPS. In essence, it installs the glide path or derisking strategy allocation shifts within the policy statement itself. Figure 3 shows a typical setup for portfolio change for a frozen plan. The key to smoothly executing the strategy is that the decision and action points for portfolio change are laid out so that the committee knows what to do and when. As Figure 3 indicates, the portfolio alterations resulting from funded status change are substantial. But these big changes serve to align the objectives of the plan and the company, so that the execution is ready when the opportunity arrives. Setting the asset-allocation triggers for the derisking strategy is the most important part of the investment committee s work. This document serves to change the default decision from debate and inaction to specific action that moves the plan along its designed path. Investment committee decisions: What s required To install such a derisking schedule requires up-front planning to ensure that the glide path is in the right form, that is, to account for the company preferences, future plans, and pension-plan profile. This time up front is well spent, as the committee now has a road map for future events. Execution will be quick and appropriate. But a number of questions must be addressed to make this work well: Is the current portfolio asset allocation appropriate to start the derisking glide path? Often, committees simply use the current portfolio to embark on the glide path, but that may not be the best portfolio to start with. Take time to review both the corporate and the pension situation, which may lead to allocation changes now, not just at the first trigger point. What is the maximum funding level (MFL)? The MFL is the level of funding the plan sponsor wants to ultimately achieve, and is also the level at which the investment risk should be reduced to a minimum. MFL will vary depending on a number of factors, but plan status (open, closed, or frozen) is a primary driver. Clearly, an open plan will have a higher MFL than a frozen plan. If the company expects a change in pension plan status, that should be addressed in the dynamic IPS. What are the appropriate triggers for changing portfolio allocation? What spacing should the funding triggers have? We default to 5% steps (e.g., 90%, 95%, etc.), although some plans investment committees prefer other levels of gradation, particularly as the plans approach their MFL. Figure 3. Derisking asset allocation framework for a frozen plan, triggered by funded status Funded status Asset class Sub-asset category <90% 90% 100% 100% 105% Terminal: >105% Equity U.S. equity 35% 25% 15% 0% Non-U.S. equity 15% 10% 5% 0% Policy targets U.S. long-term Treasury 10% 10% 15% 15% Fixed income U.S. long-term credit 25% 45% 55% 80% U.S. extendedduration Treasury Asset-class deviation tolerance range 15% 10% 10% 5% +/ 5% +/ 5% +/ 4% +/ 2% Source: Vanguard. 6

7 How is the change implemented? Does the investment manager automatically execute the agreed-upon derisking strategy when the funding trigger is reached, or does the manager communicate with the committee before execution? We strongly encourage committees not to debate the execution of a derisking step; rather, respect the discipline of your agreed-upon strategy by allowing the built-in triggers of your IPS to complete the process. What can go wrong? Any number of aspects can threaten a dynamic IPS. Here are some of the most common: Behavioral finance derailers. Topping the list of potential derailers is when behavioral finance enters the picture and the investment committee decides to override the portfolio changes when a funding-level trigger is hit. The reasoning behind this derailer is often: since interest rates will soon rise, the move into bonds to reduce pension risk should be delayed. Similarly, as the stock market rises, committee members may be reluctant to sell a rising asset, hoping for further gains. These are all normal behaviors for many investors, but they must be combatted with discipline that is what a dynamic IPS provides. To limit such acts of obstruction, we recommend that investment committees document decisions that override the dynamic IPS process. The prospect of being held accountable is often enough to control the activities of rogue market-timers, although the anonymous nature of committee decisions can overcome even this check. The key aspect to keep in mind here is that the IPS lays out the decision, the default decision. Any decision to override this plan should be documented with appropriate accountability. Changes in corporate plans. A plan sponsor may suddenly decide to freeze an open plan. That can quickly make the current IPS obsolete. All is not lost, however. You already have a good working document that only needs to be tweaked, in terms of its MFL, the glide path, and perhaps the final portfolio, which can now be set up for immunization. These adjustments can be inserted into the original dynamic IPS, if a possible change in plan status is expected (for example, if plan closure is anticipated, that possibility can be built into the plan now, rather than revising it subsequently). Changes in rules. Changes in funding require ments, mortality tables, and so forth, can lead to investment policy statement adjustments, but chances are good that the IPS will remain effective. For instance: Actuaries have determined that people are living longer; this increases the size of a plan s liability. As a consequence, the pension plan s funding may not be as high as was expected. Does that change the dynamic IPS? Not really, although the maximum funding level might get tweaked and the starting asset allocation might merit revisiting. Another example of changing rules is in the accompanying box, Calculating the liability, highlighting recent federal changes in the determination of pension relief funding. Calculating the liability HATFA provides more leeway The federal Highway and Transportation Funding Act of 2014 (HATFA) offers funding relief to corporate pension plans. The act applies long-term historical discount rates (based on the past 25 years, historical is read as higher ) to the calculation of defined benefit plan liabilities (high discount rates lead to lower liabilities, higher funded status, and lower plan contributions). This funding relief was modeled on provisions of the federal 2012 Moving Ahead for Progress in the 21st Century Act (MAP-21). Both HATFA and MAP-21, based on the Pension Protection Act of 2006, apply a 25-year average corporate bond discount rate, around which a corridor or range is established to provide contribution relief for pension plans. The MAP-21 corridors have now begun to ease, however, leading to lower discount rates and rising funding requirements. HAFTA provisions thus further delay the rate reduction, and therefore also the need for more required funding. Example: The discount rate curve is split into three segments. To simplify, consider just the third, or long, segment. The 25-year average discount rate for 2015 of the third segment is 7.57%. Under MAP-21 the discount rate would be at least 75% of the 25-year average, or 5.68%. With HATFA, the discount rate would be at least 90% of the 25-year average, or 6.81%. The change to HATFA potentially reduces a plan s liability by 10% 20%, reducing required pension contributions, for now. 7

8 Re-risking. Volatile market conditions will likely lead to dropping funding levels. We are often asked if a plan s return-seeking allocation (usually, equities) should be increased as a consequence of lower funding, or re-risking. Generally, we argue no. Here s why: Although the logic for increasing a plan s risk allocation may at times seem reasonable, consider that you are actually asking the derisking strategy to become a market-timing tool: This is not what the strategy is designed to do. Rather, it is a method to reduce risk when opportunity presents itself in a methodical fashion. To use the strategy for market-timing assumes the market is meanreverting. This may be the case, but a trending market also happens, and to assume it s a reverting market, instead, could prove disastrous to the plan and likely break the discipline of the process. Keep in mind the objective of derisking: to reduce risk. To re-risk is to break from that mission when the justification is based on market movements. An exception to the re-risking rule is when your liability changes materially owing to updated demographic or benefit information. For example, as mentioned earlier, new mortality tables have recently been published that likely have increased plan sponsors pension liability by 5% to 10%. The resulting decline in many plans funded status is not based on market events but, rather, on a change in one of the measured components: the liability. In this case, re-risking may be an option to help close the funding gap. Conclusion Pension plans, often representing a large corporate asset, merit best-in class care on behalf of both participants and the sponsoring corporation. Some companies will choose to keep their plans, while others are looking to exit. Either way, Vanguard strongly recommends that plan sponsors establish a strategy to help control the impact of risk on the company and to fulfill the promises made to pension participants. A derisking glide-path strategy can be the solution but that is only half the battle. The other half involves controlling execution risk and installing this strategy within the investment policy statement. Together, a derisking strategy and its execution can greatly improve your chances of a successful pension journey. References Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance. Financial Analysts Journal 42(4): Reprinted in Financial Analysts Journal (50th Anniversary Issue): 51(1): Davis, Joseph H., Francis M. Kinniry Jr., and Glenn Sheay, The Asset Allocation Debate: Provocative Questions, Enduring Realities. Valley Forge, Pa.: The Vanguard Group. Financial Accounting Standards Board of the Financial Accounting Foundation, Accounting Standards Codification Topic 715; available at Ibbotson, Roger G., and Paul D. Kaplan, Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal 56(1): International Financial Reporting Standards Foundation and International Accounting Standards Board, International Accounting Standard 19; available at default.aspx. Pension Protection Act of 2006, U.S. Public Law th Cong.; available at 109publ280/pdf/PLAW-109publ280.pdf. Vanguard Research P.O. Box 2600 Valley Forge, PA Connect with Vanguard > vanguard.com CFA is a registered trademark owned by CFA Institute The Vanguard Group, Inc. All rights reserved. ISGDIP