Managing Pension Volatility: The Three Legged Stool

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Managing Pension Volatility: The Three Legged Stool

  1. 1. Dietrich Papers May 2011  A New Paradigm For Managing Pension Volatility:  The Three Legged Stool Approach  By Jay DinunzioIntroductionThe management and oversight of defined benefit pension plan programs, has perhaps never been more challenging fororganizations than it is today. A convergence of funding and accounting reforms, historically low interest rates, and unprecedentedcapital markets volatility has challenged the existing pension management paradigm. In the wake of this transformational shift,prudent pension plan fiduciaries should seriously evaluate their current approach and consider alternatives which may help achievecost-effective benefit funding that limits company P&L volatility.The objective of this paper is to challenge the existing pension plan management paradigm as antiquated, having been born out ofrules which are being transformed. New rules require consideration of a new approach. We’ll discuss three tactical steps a pensionsponsor can implement in order to help ensure effective pension plan governance while limiting volatility. Before one can consider anew approach, it may serve as useful to briefly review the drivers which contributed to the evolution of pension plan management.Pension AccountingPension accounting rules established in the mid 1980’s with the issuance of FAS 87, typically allow for generous smoothing of gainsand losses which provides generally predictable income or expense (something which is desirable from a financial executive’sperspective). Strong equity returns throughout much of the 1980’s and 1990’s created an environment where many pension planswere self-funded and delivered consistent pension income to a company’s bottom line earnings (also desirable from a financialexecutive’s perspective). These factors led to many companies viewing pension plan obligations as an efficient, or at leastacceptable, use of their balance sheet.The introduction of pension liabilities as on on-balance sheet item, stemming from FAS 158 which required companies to reportpension surplus and deficits as part of their balance sheet, signified a first step in a broader FASB/IASB project to review pensionaccounting techniques. Recent decisions have been made by large US companies (AT&T, Honeywell, & Verizon) with significantpension liabilities to abandon smoothed pension accounting in favor of a “mark to market” approach. These actions may foreshadowan eventual move to new pension accounting standards which exposes pension sponsors to significantly increased incomestatement volatility. An ultimate shift away from smoothed accounting should help support the overall de-risking of pension plans ascompanies might then retreat from their historical reliance on risky assets to drive aggressive targeted returns.FundingThe funding requirements of a pension plan create an additional opportunity for pension obligations to have an impact on businessperformance. Prior to enactment of the Pension Protection Act (PPA) of 2006, pension sponsors enjoyed generous amortization orsmoothing of gains or losses based upon the allowable methodologies for funding pension plan benefits as required under IRSregulations.The Pension Protection Act profoundly impacted funding regulations by prescribing that liabilities be valued using discount rates thatwere much closer to “spot rates” (rather than smoother average rates) and forcing the amortization of gains or losses over ashortened period of seven years. These changes served to dramatically increase the volatility of a plan’s funded status ratio andconsequently the potential for company contributions. Additionally, PPA introduced key funded status ratio thresholds (i.e. 80%)under which “bad things” (i.e. benefit restrictions, “At Risk” funding) begin to happen. These rules have served as another importantreform that helps support the prudent funding of pension plan benefits which was the intention of PPA.All in all, PPA significantly increased the volatility of pension funding and created an environment where a company’s P&L isindirectly affected by the potential call on company cash in order to meet more stringent funding requirements. As such, effectivelymanaging funded status volatility has become a key concept in pension plan management. www.dietrichassociates.com Dietrich & Associates, Inc. (800) 966-8376
  2. 2. Dietrich Papers May 2011Investment PolicyWith the above accounting and funding construct established, (where (prior to PPA) organizations had the flexibility to minimize theimmediate impact of pension plan experience through generous amortization or smoothing techniques), lets discuss the resultantimpact of this on investment policy decisions.One could argue that a pension system that allows for long term amortization of losses, provides an informal insurance policy againstthe impact of a negative event. Additionally, the formal insurance provided by the Pension Benefit Guaranty Corporation (whose ownsolvency is becoming increasingly challenged by a system that relies on contributions from increasingly fewer healthy pensionprograms) provide an additional moral hazard that supports risk taking behavior. It’s not hard to see why 70% equity portfolioallocations were used to increase upside potential (limiting company contributions) with downside events being sufficiently smoothedaway. From a company’s perspective this approach provides an effective balance between funding benefits for plan participantswhile preserving capital for other business investments.AdministrationOur informal historical review has thus far concluded that liberal accounting and funding regulations combined with large equityportfolio concentrations created an environment where pension benefits could quietly reside on a company’s balance sheet.However, balance sheet implications set aside, a pension sponsor must also navigate a host of underlying functions which arenecessary to run a pension program effectively; valuations, investment management, investment monitoring and oversight, trustreporting, benefit calculations and payments, government filings, and data management. Moreover, in many organizations thepension plan is “owned” by a committee of stakeholders who share fiduciary responsibility but may delegate internally or outsourcecertain functions to service providers. It has been said that “it takes a village to raise a child” the same comment seems to hold truewhen it comes to pension plan administration. This complex landscape of direct (fiduciaries) and indirect (service providers)stakeholders involved in managing a pension program tends to create an environment with competing priorities and unclear agendasthat can challenge expedient and purposeful decision making.Though the funding and accounting environment has changed dramatically, many pension sponsors have implemented less thandramatic changes in how they manage their pension program. While many plans have frozen benefit accruals or tweaked staticportfolio asset allocations, there remains substantial room to make further changes that may more effectively control pensionvolatility.Where Are We Now?It has been a few years since the pension market was transformed by PPA. The current trends in the pension market can besummarized as follows:•Increasing plan freezes,•adjustments to portfolio asset allocations,•emergence of Liability Driven Investing or “LDI”,•large unfunded liabilities,•increasing and significant company contributions, and•uncertain capital markets.For many companies these challenges are significant, and will not be remedied by an asset liability study or through adding a longbond or hedge fund component to the investment portfolio. Companies are currently battling the lesser of two evils of increasing andpotentially volatile contributions or hedging future risks by locking in losses with increased fixed income allocations or exoticderivatives. There are no easy solutions to this conundrum. However, there are some tactical steps organizations can employ to putthemselves on a path that will enable them to more clearly understand, hedge, and ultimately transfer risks away from the company.This new paradigm, presumes that companies are frustrated with the current challenges of managing a pension program and areamenable to a new approach which allows them to divest themselves from the past practice of using their balance sheet to operate ade-facto insurance company that provides self-insured annuities to the participants in the company pension plan. www.dietrichassociates.com Dietrich & Associates, Inc. (800) 966-8376
  3. 3. Dietrich Papers May 2011A New Approach: The Three Legged Stool of Pension Risk ManagementAs has been discussed earlier in this paper, “easy” funding and accounting rules shaped the evolution of pension plan management.These rules served to further promote a culture of equity heavy portfolios (reducing company contribution potential), once a yearvaluations (masking underlying liability volatility), and consideration of settling liabilities (typically done through an annuity purchase)only under the context of a plan termination at a cost of 120% of plan liabilities. One might argue that the rules that were in effectfrom 1987 through 2006 incented sponsors and service providers to behave this way. However, the pension paradigm is vastlydifferent today in the wake of PPA and with “mark to market” accounting potentially looming. In order to meet these new challenges,pension sponsors should consider the following “Three Legged Stool” of pension risk management. Under this philosophy a pensionplan’s risks can be best managed by relying on:1. Ongoing funded status monitoring; the formal reporting and presentation to the pension committee, on a quarterly basis, anestimated measurement of plan funded status from a FAS, PPA, and Termination Annuity basis. This approach is similar to what iscommonly done with monitoring and oversight of investments .2. Dynamic asset allocation implementation; which formally prescribes within the plan’s Investment Policy Statement a portfolioasset allocation which automatically shifts (to hedge interest rate risk through increasing fixed income allocations) based upon thefunded status of the plan.3. Retained risk transfer analysis; ongoing analysis and evaluation of strategies to systematically transfer risks through purchasingannuities or issuing lump sums.#1: Ongoing Funding Ratio MonitoringFor years sponsors have relied on a once a year snapshot of their plan’s funding, provided through an actuarial valuation. Whilethese reports do a fair job of detailing the plan’s status as of one point in time, they are not without significant limitations. Typically,valuation reports are received several months following the end of the plan year, thus by the time the report is received theinformation is already stale. Furthermore, these valuations typically only show changes relative to the years prior valuation, so againthe once per year snapshot approach leaves much of the inter-year volatility hidden from sponsor view. Thirdly, valuation reports donot typically include a plan termination liability valuation which provides important insights into the required cost to settle benefitobligations. Plan sponsors may be surprised to know that it is not uncommon to experience a 3%-5% swing in funded status within athirty day period, especially during periods of capital markets volatility. Infrequent valuation monitoring creates an environment wherethe sponsor is unaware of the plan’s funding ratio and unable to position the portfolio to lock in gains as funded status improvementsare experienced. Increased monitoring of various plan funding ratios (FAS, PPA, & Termination) represents a key first step inimproving pension committee awareness of underlying asset/liability changes.#2: Dynamic Asset AllocationIncreasing the frequency of valuing plan liabilities and monitoring funding ratios provides an important foundation on which one canbuild a more effective approach for constructing portfolio allocations. Most pension sponsors have traditionally relied on strategicasset allocations which are built upon long term capital market assumptions. A dynamic approach to asset allocation relies onchanging portfolio allocations which become more heavily weighted towards fixed income as the plan’s funded status improves. Thisapproach provides a mechanism to help hedge interest rate risk and protect funding gains.For many sponsors who have frozen their pension plans, their investment horizon has typically been shortened to as soon as theyare in a position to terminate the plan. A dynamic asset allocation approach may prove useful for sponsors who are interested inlocking in gains in funding as asset values and/or interest rates rise. Dynamic asset allocation provides an elegant solution because itis agreed to in advance by the investment committee and codified in the plan’s investment policy statement. Without this tool, apension committee is left with an ad-hoc approach that may not support executing the portfolio transactions expediently enough totake advantage of funding improvements. While dynamic asset allocation provides an effective framework for a sponsor tosystematically hedge its interest rate risk, it still leaves the balance sheet fully exposed to all of the risks associated with planbenefits. Permanently removing benefit obligations from the company’s balance sheet represents an important final piece of thepension risk management puzzle. www.dietrichassociates.com Dietrich & Associates, Inc. (800) 966-8376
  4. 4. Dietrich Papers May 2011#3: Retained Risk Transfer AnalysisThe third and final leg of the pension risk management stool involves the ongoing evaluation and analysis of strategies thatcompletely remove benefit obligations from the sponsor’s balance sheet. The prevailing legacy view of settling pension benefits hadbeen limited primarily to a conversation around terminating the pension plan via a standard plan termination where all plan benefitsare distributed at the same point in time. Under this classical view it is typically understood that the cost to buy annuities to facilitate aplan termination is roughly 120% of the plan’s liabilities once fully funded on an IRS basis. For many organizations the thought of thisadditional premium makes annuities an unattractive option whose pursuit is perpetually deferred to some point in time which nevercomes, unless the plan sponsor is undergoing a bankruptcy, some sort of merger or acquisition, or in the enviable position of beingwell overfunded.Similar to the value provided by dynamic asset allocation where an interest rate risk hedge is phased into as funded-statusimprovements are recognized, an ongoing risk transfer analysis can evaluate the cost and funding trade-offs associated withstrategies that seek to permanently remove obligations from the sponsors balance sheet. This approach allows a pension sponsor toconsider settling pieces of its obligations in a series of transactions over time, similar to dollar cost averaging into an investmentpurchase or an installment payment on a debt.The complete removal of benefit obligations from the company balance sheet is the stated goal of many finance executives whooversee pension plans, especially those with frozen plans. However, many organizations lack a comprehensive approach forunderstanding and monitoring the many variables that impact a potential annuity transaction. Other retained service providers, suchas money managers, investment consultants, and actuaries do not typically have the specialization or incentive to effectively positionannuitization as a value-added strategy. In many instances effectively navigating the institutional insurance marketplace can best beaccomplished by engaging a specialist firm that works exclusively with group annuity products as a vehicle for transferring pensionrisk.As the pension risk market continues to evolve, it will be most interesting to observe to what extent consulting firms embrace ordownplay the value of solutions which completely transfer pension risks. Nonetheless, prudent fiduciaries should consistentlyevaluate risk transfer strategies that may over time allow them to downsize their plan in an efficient manner.ConclusionThe “Three Legged Stool” approach outlined in this paper discusses practical solutions that can be readily implemented to helpmanage pension volatility and the resultant impact on business performance.The pension landscape has clearly evolved rapidly in the wake of the Pension Protection Act. New ideas, buzzwords, and productshave flooded the pension marketplace competing for the attention and business of pension sponsors. Given this dramatic shift andinnovation, prudent pension committees should investigate the capabilities of their current service providers as well as consider theservices of outside firms whose capabilities and costs may be better suited to their organizational needs.For some innovative sponsors who are compelled by the “Three Legged Stool” approach it may mean a bundling of multiple serviceswith one capable firm. For other still progressive organizations, implementing the three legs may mean using a variety of serviceproviders in ways that are both similar and different to how they are being used today. There will also undoubtedly be firms whosimply rely on their incumbent consultants without exploring alternatives. These organizations will likely find one or two of the stool’slegs at some point as well. Finally, others may simply wait and hope to be bailed out by another asset bubble or perhaps protractedrising interest rates.In closing, it is my hope that pension plan stakeholders who read this paper will challenge themselves to think about the potentialvalue provided by the concepts on which the “three legged stool” is built, while contrasting this new approach with their currentprocess for managing pension programs.About The AuthorJay Dinunzio is Vice President & Senior Consultant at Dietrich & Associates, Inc., a leading benefits consulting and brokerage firmspecializing in annuity funded solutions for terminating defined benefit plans, annuitization strategies for defined benefit plans and retireemedical plans and annuities for 401k plans. He has over 12 years of experience working with institutional retirement plan sponsors of bothdefined benefit and defined contribution programs. Much of his career has been spent providing risk management solutions to defined benefitpension sponsors, including single premium group annuities, as well as bundled and outsourced pension administration arrangements.Jay can be reached at jay.dinunzio@dietrichassociates.com. www.dietrichassociates.com Dietrich & Associates, Inc. (800) 966-8376

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