White Paper That Provides Three Core Best Practices For Managing Pension Volality.

1. Dietrich Papers May 2011
A New Paradigm For Managing Pension Volatility:
The Three Legged Stool Approach
By Jay Dinunzio
Introduction
The management and oversight of defined benefit pension plan programs, has perhaps never been more challenging for
organizations than it is today. A convergence of funding and accounting reforms, historically low interest rates, and unprecedented
capital 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 achieve
cost-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 of
rules which are being transformed. New rules require consideration of a new approach. We’ll discuss three tactical steps a pension
sponsor can implement in order to help ensure effective pension plan governance while limiting volatility. Before one can consider a
new approach, it may serve as useful to briefly review the drivers which contributed to the evolution of pension plan management.
Pension Accounting
Pension accounting rules established in the mid 1980’s with the issuance of FAS 87, typically allow for generous smoothing of gains
and losses which provides generally predictable income or expense (something which is desirable from a financial executive’s
perspective). Strong equity returns throughout much of the 1980’s and 1990’s created an environment where many pension plans
were self-funded and delivered consistent pension income to a company’s bottom line earnings (also desirable from a financial
executive’s perspective). These factors led to many companies viewing pension plan obligations as an efficient, or at least
acceptable, use of their balance sheet.
The introduction of pension liabilities as on on-balance sheet item, stemming from FAS 158 which required companies to report
pension surplus and deficits as part of their balance sheet, signified a first step in a broader FASB/IASB project to review pension
accounting techniques. Recent decisions have been made by large US companies (AT&T, Honeywell, & Verizon) with significant
pension liabilities to abandon smoothed pension accounting in favor of a “mark to market” approach. These actions may foreshadow
an eventual move to new pension accounting standards which exposes pension sponsors to significantly increased income
statement volatility. An ultimate shift away from smoothed accounting should help support the overall de-risking of pension plans as
companies might then retreat from their historical reliance on risky assets to drive aggressive targeted returns.
Funding
The funding requirements of a pension plan create an additional opportunity for pension obligations to have an impact on business
performance. Prior to enactment of the Pension Protection Act (PPA) of 2006, pension sponsors enjoyed generous amortization or
smoothing of gains or losses based upon the allowable methodologies for funding pension plan benefits as required under IRS
regulations.
The Pension Protection Act profoundly impacted funding regulations by prescribing that liabilities be valued using discount rates that
were much closer to “spot rates” (rather than smoother average rates) and forcing the amortization of gains or losses over a
shortened period of seven years. These changes served to dramatically increase the volatility of a plan’s funded status ratio and
consequently 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 important
reform 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 is
indirectly affected by the potential call on company cash in order to meet more stringent funding requirements. As such, effectively
managing funded status volatility has become a key concept in pension plan management.
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2. Dietrich Papers May 2011
Investment Policy
With the above accounting and funding construct established, (where (prior to PPA) organizations had the flexibility to minimize the
immediate impact of pension plan experience through generous amortization or smoothing techniques), lets discuss the resultant
impact 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 against
the impact of a negative event. Additionally, the formal insurance provided by the Pension Benefit Guaranty Corporation (whose own
solvency is becoming increasingly challenged by a system that relies on contributions from increasingly fewer healthy pension
programs) provide an additional moral hazard that supports risk taking behavior. It’s not hard to see why 70% equity portfolio
allocations were used to increase upside potential (limiting company contributions) with downside events being sufficiently smoothed
away. From a company’s perspective this approach provides an effective balance between funding benefits for plan participants
while preserving capital for other business investments.
Administration
Our informal historical review has thus far concluded that liberal accounting and funding regulations combined with large equity
portfolio 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 are
necessary to run a pension program effectively; valuations, investment management, investment monitoring and oversight, trust
reporting, benefit calculations and payments, government filings, and data management. Moreover, in many organizations the
pension plan is “owned” by a committee of stakeholders who share fiduciary responsibility but may delegate internally or outsource
certain functions to service providers. It has been said that “it takes a village to raise a child” the same comment seems to hold true
when 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 agendas
that can challenge expedient and purposeful decision making.
Though the funding and accounting environment has changed dramatically, many pension sponsors have implemented less than
dramatic changes in how they manage their pension program. While many plans have frozen benefit accruals or tweaked static
portfolio asset allocations, there remains substantial room to make further changes that may more effectively control pension
volatility.
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 be
summarized 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 long
bond or hedge fund component to the investment portfolio. Companies are currently battling the lesser of two evils of increasing and
potentially volatile contributions or hedging future risks by locking in losses with increased fixed income allocations or exotic
derivatives. There are no easy solutions to this conundrum. However, there are some tactical steps organizations can employ to put
themselves 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 are
amenable to a new approach which allows them to divest themselves from the past practice of using their balance sheet to operate a
de-facto insurance company that provides self-insured annuities to the participants in the company pension plan.
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3. Dietrich Papers May 2011
A New Approach: The Three Legged Stool of Pension Risk Management
As 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 year
valuations (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 effect
from 1987 through 2006 incented sponsors and service providers to behave this way. However, the pension paradigm is vastly
different 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 pension
plan’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, an
estimated measurement of plan funded status from a FAS, PPA, and Termination Annuity basis. This approach is similar to what is
commonly done with monitoring and oversight of investments .
2. Dynamic asset allocation implementation; which formally prescribes within the plan’s Investment Policy Statement a portfolio
asset allocation which automatically shifts (to hedge interest rate risk through increasing fixed income allocations) based upon the
funded status of the plan.
3. Retained risk transfer analysis; ongoing analysis and evaluation of strategies to systematically transfer risks through purchasing
annuities or issuing lump sums.
#1: Ongoing Funding Ratio Monitoring
For years sponsors have relied on a once a year snapshot of their plan’s funding, provided through an actuarial valuation. While
these 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 the
information is already stale. Furthermore, these valuations typically only show changes relative to the years prior valuation, so again
the once per year snapshot approach leaves much of the inter-year volatility hidden from sponsor view. Thirdly, valuation reports do
not typically include a plan termination liability valuation which provides important insights into the required cost to settle benefit
obligations. Plan sponsors may be surprised to know that it is not uncommon to experience a 3%-5% swing in funded status within a
thirty day period, especially during periods of capital markets volatility. Infrequent valuation monitoring creates an environment where
the sponsor is unaware of the plan’s funding ratio and unable to position the portfolio to lock in gains as funded status improvements
are experienced. Increased monitoring of various plan funding ratios (FAS, PPA, & Termination) represents a key first step in
improving pension committee awareness of underlying asset/liability changes.
#2: Dynamic Asset Allocation
Increasing the frequency of valuing plan liabilities and monitoring funding ratios provides an important foundation on which one can
build a more effective approach for constructing portfolio allocations. Most pension sponsors have traditionally relied on strategic
asset allocations which are built upon long term capital market assumptions. A dynamic approach to asset allocation relies on
changing portfolio allocations which become more heavily weighted towards fixed income as the plan’s funded status improves. This
approach 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 they
are in a position to terminate the plan. A dynamic asset allocation approach may prove useful for sponsors who are interested in
locking in gains in funding as asset values and/or interest rates rise. Dynamic asset allocation provides an elegant solution because it
is agreed to in advance by the investment committee and codified in the plan’s investment policy statement. Without this tool, a
pension committee is left with an ad-hoc approach that may not support executing the portfolio transactions expediently enough to
take advantage of funding improvements. While dynamic asset allocation provides an effective framework for a sponsor to
systematically hedge its interest rate risk, it still leaves the balance sheet fully exposed to all of the risks associated with plan
benefits. Permanently removing benefit obligations from the company’s balance sheet represents an important final piece of the
pension risk management puzzle.
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4. Dietrich Papers May 2011
#3: Retained Risk Transfer Analysis
The third and final leg of the pension risk management stool involves the ongoing evaluation and analysis of strategies that
completely remove benefit obligations from the sponsor’s balance sheet. The prevailing legacy view of settling pension benefits had
been limited primarily to a conversation around terminating the pension plan via a standard plan termination where all plan benefits
are distributed at the same point in time. Under this classical view it is typically understood that the cost to buy annuities to facilitate a
plan termination is roughly 120% of the plan’s liabilities once fully funded on an IRS basis. For many organizations the thought of this
additional premium makes annuities an unattractive option whose pursuit is perpetually deferred to some point in time which never
comes, unless the plan sponsor is undergoing a bankruptcy, some sort of merger or acquisition, or in the enviable position of being
well overfunded.
Similar to the value provided by dynamic asset allocation where an interest rate risk hedge is phased into as funded-status
improvements are recognized, an ongoing risk transfer analysis can evaluate the cost and funding trade-offs associated with
strategies that seek to permanently remove obligations from the sponsors balance sheet. This approach allows a pension sponsor to
consider settling pieces of its obligations in a series of transactions over time, similar to dollar cost averaging into an investment
purchase 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 who
oversee pension plans, especially those with frozen plans. However, many organizations lack a comprehensive approach for
understanding and monitoring the many variables that impact a potential annuity transaction. Other retained service providers, such
as money managers, investment consultants, and actuaries do not typically have the specialization or incentive to effectively position
annuitization as a value-added strategy. In many instances effectively navigating the institutional insurance marketplace can best be
accomplished by engaging a specialist firm that works exclusively with group annuity products as a vehicle for transferring pension
risk.
As the pension risk market continues to evolve, it will be most interesting to observe to what extent consulting firms embrace or
downplay the value of solutions which completely transfer pension risks. Nonetheless, prudent fiduciaries should consistently
evaluate risk transfer strategies that may over time allow them to downsize their plan in an efficient manner.
Conclusion
The “Three Legged Stool” approach outlined in this paper discusses practical solutions that can be readily implemented to help
manage 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 products
have flooded the pension marketplace competing for the attention and business of pension sponsors. Given this dramatic shift and
innovation, prudent pension committees should investigate the capabilities of their current service providers as well as consider the
services 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 services
with one capable firm. For other still progressive organizations, implementing the three legs may mean using a variety of service
providers in ways that are both similar and different to how they are being used today. There will also undoubtedly be firms who
simply rely on their incumbent consultants without exploring alternatives. These organizations will likely find one or two of the stool’s
legs at some point as well. Finally, others may simply wait and hope to be bailed out by another asset bubble or perhaps protracted
rising interest rates.
In closing, it is my hope that pension plan stakeholders who read this paper will challenge themselves to think about the potential
value provided by the concepts on which the “three legged stool” is built, while contrasting this new approach with their current
process for managing pension programs.
About The Author
Jay Dinunzio is Vice President & Senior Consultant at Dietrich & Associates, Inc., a leading benefits consulting and brokerage firm
specializing in annuity funded solutions for terminating defined benefit plans, annuitization strategies for defined benefit plans and retiree
medical plans and annuities for 401k plans. He has over 12 years of experience working with institutional retirement plan sponsors of both
defined benefit and defined contribution programs. Much of his career has been spent providing risk management solutions to defined benefit
pension 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