Risk allocation, retirement adequacy, and annuities current issues for sponsors of DB and DC plans

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1 Risk allocation, retirement adequacy, and annuities current issues for sponsors of DB and DC plans Bill Bowden, Kai Petersen, Al Scherlie, and Martha Spano

2 Pension risk allocation

3 Key principles Liability driven approach Smart risk taking Better ER/EE risk sharing Recognize nature of the liability Measure performance in the context of the liability Equities: Adequate compensation for risk taken? Increased diversification: seeking new sources of return Glide paths: capturing improvements in funded status New employer/ employee investment risk sharing Reduce sponsor risk Employee reward opportunities Lower volatility pension designs 3

4 Nature of the liability and portfolio considerations 60% 40% 20% 0% -20% Tracking Error: -40% Long Corporate 1.9% Aggregate 4.5% Equities 19.4% -60% Private Sector Plan Asset Return less Liability Return Long Corporate Aggregate Bond Equity Equity risk takers want this Equity risk avoiders do not want this Long bond bias to hedge interest rate risk for a traditional plan. Cash balance plan requires allowance for a shorter liability duration Many plans are frozen, so return generating assets have diminishing utility as plan funded status improves Still a need for return generation but equities may not be the best answer 4

5 Nature of the liability and portfolio considerations 60% 40% Public Sector Plan Asset Return less Liability Return 20% 0% % Tracking Error: Long Corporate -40% 7.2% Aggregate 2.7% Equities 23.4% -60% Long Corporate Aggregate Bond Equity Liability is measured on EROA basis so bond discussion is about strategic and tactical returns not interest rate hedging Systems are open to new members and ongoing. Large legacy UALs and a need to fund future accruals, combined with limited financial resources, generally require more need for return generation than in the Private Sector over long run Some large state systems have internal staffs with resources, knowledge and the potential to evaluate and implement more complicated investment and risk management strategies 5

6 Risk decomposition (sample) interest rate risk often dominates Decomposition of Risk % Interest Rate Risk US Large Cap Equity Risk US Small Cap Equity Risk 5.00 International Equity Risk 6.00 Alternatives Risk 1.00 US Cash - Total 100% Interest rate risk tends to dominate all other sources of pension funded status risk 6

7 How should plan sponsors determine how much risk to take? Asset allocations should be dependent on the plan sponsor s financial strength, the funded status of the plan, and the plan sponsor s ability to use surplus Participant and shareholder interests are well-aligned Status: Assets & Liability Matched Status: Assets & Liability Matched Take low level, tax efficient, dynamic Take low level, tax - efficient, dynamic risk to develop risk to develop usable usable surplus surplus Negative investment performance could Negative investment performance trigger bankruptcy could trigger bankruptcy WELL FUNDED Status: Assets & Liability Matched Status: Assets & Liability Matched Take moderate level, tax efficient, Take moderate level, tax - efficient, dynamic risk to develop usable surplus dynamic risk to develop usable surplus WEAK STRONG Dynamically de-risk Status: Status: Materially Underfunded Sponsors Sponsors should should take take risk risk to to try to improve funded status May not be possible to avoid bankruptcy without taking risk PBGC end of game (private sector only) POORLY FUNDED Status: Partially Funded Unfunded pension liabilities treated as a hard debt Fund the plan to take advantage of any tax arbitrage that may exist As described in Morgan Stanley Investment Management s August 2008 white paper Asset - Liability Management within A Corporate Finance Framework, which was co - authored by Michael Peskin and Chad Hueffmeier. 7

8 Better expected market result 50th Percentile Millions Buck Global Investment Advisors Increased diversification: seeking new sources of return $1,950 Client XYZ - Accumulated Calendar Year Contributions + Deficit $2,000 $2,050 $2,100 $2,150 $2,200 $2,250 $2,300 $2,350 Equity 15% Fixed Income 80% Alternatives 5% Equity 30% Fixed Income 55% Alternatives 15% Equity 0% Fixed Income 100% Alternatives 0% Equity 45% Fixed Income 30% Alternatives 25% Equities reduced 15% Alternatives increased 15% Equity 60% Fixed Income 30% Alternatives 10% Equity 60% Fixed Income (short) 30% Alternatives 10% Short duration bonds sub optimal in traditional plan design $2,400 $2,900 $3,100 $3,300 $3,500 $3,700 $3,900 $4,100 Millions 95th Percentile Better downturn protection 8

9 Glide paths: capturing improvements in funded status Derisking glidepath #1 slower derisking first trigger at 95%-105% Derisking glidepath #2 faster derisking first trigger at 75%-85% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Current funded ratio = 60% Alternatives Equities Fixed Income Alternatives Equities Fixed Income 9

10 Glide paths: capturing improvements in funded status (cont d) A little too gradual Too rapid 10

11 Risk reduction through plan design Partial linkage of benefits to investments performance Traditional plan % of final average pay times years of service No linkage to plan investments Reduced volatility Notional account balance Annual pay credit, plus Interest credit of portfolio return less 1% but not less than 0% Diversified portfolio Low volatility Notional account balance Annual pay credit, plus Interest credit of portfolio return less 1% but not less than 0% Low return/risk portfolio 11

12 The reality of retirement adequacy de-risking your DC plan

13 DC plans have their own unique risks 13

14 Managing a DC retirement program What keeps employers up at night Plan cost Participant and sponsor Risk management Benefit adequacy Contributions Fees: Administration Investments Audit Legal Trustee/Custodian Fiduciary Operational Regulatory Participation Rates Contribution Rates Investment Products and Performance 14

15 How do your employees define retirement? 34% 17% 11% 11% Simply want to survive and live comfortably Want to be able to pay their bills Maintain their pre-retirement lifestyle Travel, leisure, eating out, enjoy hobbies Source: March 2011, National Institute on Retirement Security 15

16 PIMCO coins a new term the new normal to describe the current environment Based on historical view: No real capital appreciation over last 25 years No new high equity returns over the last 10 years Most DC participants have experienced at least 10 sudden unexpected market shocks since 1980 Shocks were more severe and frequent than expected Is retirement adequacy possible in today s environment? The New Normal is an environment of low returns and higher volatility Commission data from , and Schwert data from SOURCE: Research Affiliates, LLC, Standard & Poor s, Ibbotson Associates, Cowles Commission and Schwert The Real Stock Price Index is a hypothetical index developed by Research Affiliates that shows the priceonly real return for U.S. stocks using the S&P and Ibbotson from 1926 through June 2010, the Cowles

17 Three factors determine retirement adequacy and create accumulation risks- savings rate, investment return, and time horizon. But savings rate is the most critical DC participants typically contribute 5%-6% annually Academic studies indicate that 11%- 20% for 40 years is needed to replace just 40%-60% of final pay What is more revealing is that contributions are not steady due to job changes, periods of unemployment, and leakage These all play havoc with the contribution streams that are needed to reach retirement replacement goals PIMCO DC Practice - Volume 1, Issue 6 "Designing Outcome- Oriented Defined Contribution Plans (DC 2.0): Maximizing Absolute & Risk-Adjusted Returns for a New Normal Economy Assumptions: Starting salary - $50,000 Real wage increase 1% Savings rate 6%-9.8% over 40 years Employer match 3.5% SOURCE: PIMCO Hypothetical example for illustrative purposes only. Refer to Appendix for additional information about Glide Path and return assumptions 17

18 How can employers help participants get to the target replacement ratios? What can participants do? Four major areas: Auto-enrollment Auto escalation Stem the leakage Rethink the investment approach 18

19 Leakage risks are reducing retirement income Withdrawals During the financial crisis, 7% of participants took a withdrawal at an average of $5,500 Withdrawals are permanent and cannot be re-deposited Withdrawals with the 2 year cease of deferrals can affect retirement income 7%-25% What to do? Limit the reasons for hardships withdrawals Automatic re-start of savings after the suspension period Source: Fidelity, Plugging the Leaks in the DC System, 2/2/2010 Loans In 2010, 28% participants had average of 2 loans Deferrals continue but at a lower rate (8 versus 6%) Ceasing deferrals can decrease retirement income by 10%-13% Loans terminate with unemployment, and 70% of loans default What to do? Increase fees Reduce the number of loans Allow deferrals during repayment and loan payments after termination Cash-Outs 42% of terminated employees took a cashout, 29% rolled over, and 29% left in employer s plan Cash-outs can affect retirement income from 11%-67% What to do? Simplify the rollover process Provide more diverse distribution options i.e., more flexibility for partial distributions 19

20 Rethinking the investment approach Over 70% of DC assets are in equities Most DC plans have 7-8 equity options Timing is critical loss of 40% early in career is negligible because the account balance is smaller and there is a long time horizon to make up the loss Compared to a loss of 40% within 10 years of retirement, where have a much larger account balance and fewer years to recoup SOURCE: Bloomberg And timing is critical when purchasing an individual annuity 20

21 Inflation risks also affect DC retirement adequacy DC participants are long-term investors and managing inflation risk means protecting against the risk of negative returns Even low and moderate inflation can erode portfolio wealth Inflation disproportionately affects retirees Inflation has historically surprised on the upside Diversification is the key to navigate through different cycles of inflation since various assets classes respond differently 21

22 Retirement can last for a very long time Good news: people living healthier and longer lives Bad news: retirees may outlive their savings Participants tend to underestimate their life expectancies Participants have a short planning cycle they think in terms of 5 10 years when retirement can last as long as 30 years Participants think that they will reduce their spending if their investments decrease A 65 year old man has an 82 year life expectancy and a woman 85 years One in four men at 65 will make it to 90 and one in three women will 86% of DC participants surveyed want some guaranteed income Sources: National Vital Statistics Report May 2010 ING USFS Market Research Department May

23 Are participants ready for retirement? Age 70 is the new 65 Ready for retirement at age 66 Ready for retirement at age 62 The average DC account balance in 2011 for a man was $94,063 And for a woman was $59,104 23% will have to work an extra 1-3 years 17% will have to work an extra 4-6 years 9% will have to work an extra 7+ years Sources: Vanguard How America Saves, 2012 Center for Retirement Research, Boston College, How Much Longer Do We Need to Work? 23

24 Some companies are now letting participants invest in annuities 3 in 10 companies currently provide some type/form of retirement income solution inside or outside plan Still a minority of employers offering annuities as an option United Technologies recently became first Fortune 100 company to add an in-plan income option What plan sponsors are doing The beginnings of a trend 18% of plan sponsors offer a retirement income option outside of their plan 15% of plan sponsors offer a retirement income option inside of their plan 11% of these offer managed payout funds 8% of these offer managed accounts with drawdown feature 8% of these offer an annuity within plan 24

25 Group annuities for plan terminations, buyouts, and buy-ins

26 Objective Show sponsors and fiduciaries key issues to consider and how the process works Looks at annuities for DB plans but we note: Annuities are available for participants terminating from a DC plan Recent (February 2012) guidance shows IRS response to concerns about lifetime distribution options from DC plans Splitting a DB benefit between a lump sum and an annuity Qualifying Longevity Annuity Contract (QLAC) and Required Minimum Distributions QJSA and QPSA annuities in DC plans Rollovers from a DC plan to a DB plan 26

27 Terminology Group Annuity Contract issued to purchaser; certificates issued to participants; contract terms are negotiated between purchaser as plan fiduciary and the insurer Termination Annuity Purchased when a Plan (or a spin-off) terminates Buy-Out Purchased for a segment of Plan participants; Plan is not terminated; liability is irrevocably transferred from Plan to insurance company Buy-In Purchased for a segment of Plan participants (or all participants) but held as a Plan Asset; liability remains with the Plan 27

28 Price Two most frequently asked questions: What does it cost? Who has the cheapest price? Price has gone up as interest rates have declined: Table: Estimated Annuity Pricing Rates ( ) Source: Prevailing rates collected by Buck Consultants (Not actual case quotes.) 28

29 Plan fiduciaries Primary issue for fiduciaries is obtaining the safest available annuity, not price Price is a fiduciary concern, but it is insignificant in this context Fiduciaries: Must act for Exclusive Benefit of participants Decisions must be independent of the Sponsor (although fiduciaries can be employees) Must resolve questions of independence and conflict of interest in dealings with carrier Must avoid conflicts of interest Duty of prudence Thorough review and documentation Must seek expert help in areas where the fiduciary lacks sufficient expertise 29

30 Plan fiduciaries (cont d) Generally, first rule of prudent investing is diversification How can a fiduciary address diversification when selecting a group annuity? DOL Guidance (IRB 95-1) provides a roadmap: Cannot rely on NRSRO ratings alone Review carrier (investments, size, capital and business risk) Review contract (structure and guarantees) Review plan (benefits in comparison to state guaranty association protection limits) Strategies such as use of Separate Accounts or annuity splitting only feasible for large cases and benefits 30

31 Case studies general Adherence to fiduciary duties Establish and document process to meet regulations and guidance A Project Management process involving multiple parties: Sponsor, Regulators, Participants (represented by fiduciaries), Actuary, Trustee, Investment Advisor (for Plan assets), Investment Advisor, or Broker (for annuity purchase), other administrators (benefits, audit, participant searches, etc.), Insurance company/companies 31

32 Case study 1: full plan termination How annuity transaction works: Annuity advisor is often part of the project team as soon as termination decision is made (sometimes earlier) But little activity until well into the process Focus on obtaining annuity pricing generally starts when Benefit Election Notices are distributed and after the PBGC review period Lump Sum Elections have major impact on pricing (and sometimes on carriers willing to quote) Take up rate for Terminated Vested (especially) and Actives is substantial often exceeds 75% and can exceed 90% for small plans with small accrued benefits Often not offered to retirees in receipt 32

33 Case study 1: full plan termination (cont d) We send Plan data (detailed description of eligibility and benefits plus census without PI) to carriers listed in Notice of Annuity Information We review financial and other information consistent with DOL guidelines for safety/ability to fulfill payment obligations Carriers respond with preliminary quotes Primary purpose of preliminary quotes is to reconcile all data and terms to make sure all Plan benefits are correctly accounted for Advisors and fiduciaries will look at price but at this point it is rarely a consideration (except as a check on benefit accuracy and trust liquidity) Everyone waits, and waits, for the Determination Letter 33

34 Case study 1: full plan termination (cont d) When Determination Letter is received: We refresh carrier financial review and report to fiduciaries Fiduciaries authorize Final quotes Decision on final quotes is needed within hours (sometimes minutes) of quote Implementation steps following selection include: Application and contract signing Settlement Data transfer Payment of Lump Sums Trust reconciliation Annuity contract review PBGC and IRS filings and audit 34

35 Case study 2: buy-out Differs from Case Study 1 in several key ways: Not a termination changes regulatory filings and timetable Typically does not involve Lump Sum Elections Carves out identifiable groups: Retirees in receipt Terminated members in a discontinued business unit (but not a spin-off termination) Recommend following DOL guidance in selection of annuity provider Provides a process for meeting fiduciary duties Note that a buy-out removes investment and longevity risks but can reduce the funding level for remaining participants 35

36 Case study 3: buy-in New to the U.S. market Really an investment and accounting strategy liability (and asset) stays on company books Plan (not insurance company) pays benefits (Personal opinion) roadmap for fiduciaries is not yet clear Advantage for sponsor: removes volatility and avoids settlement accounting (obligation remains with the plan and transaction is not irrevocable) Advantage for plan: insurance company guarantee that liabilities will be paid (obligation is fully funded) Disadvantage for plan is exposure to insurer (or Separate Account) claims paying ability for entire duration of contract 36

37 Lessons learned What does it cost? has many meanings Popular rule of thumb is 10% greater than accounting liability BUT Depends on complexity and terms as much as size E.g. lump sum elections for Actives at retirement are more expensive Tends to be higher for smaller annuities (unit cost to administer is higher) Carriers specialize by size and plan demographics Cost of advisor for annuity selection is a small part of the total Actuarial and legal fees Data clean up can be very difficult, but is critical (and can achieve savings) Transaction costs: Converting investments to cash Due diligence if transferring assets in kind 37

38 Lessons learned (cont d) Lump Sum Elections have a very substantial impact Availability of State Guaranty Association protection is poorly understood Carrier capacity has changed Several carriers have either withdrawn or pulled back Low interest rates and capital requirements are having an impact Perhaps the best news: fiduciaries take their role seriously Spirited discussion of perceived carrier strengths and weaknesses Frequently do not choose the lowest bid 38

39 Questions Bill Bowden Director Kai Petersen Principal Al Scherlie Principal Martha Spano Principal

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