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Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Kelly Coffing, EA, FSA, MAAA Principal and Consulting Actuary Milliman, Seattle, Washington
Grant Camp, EA, FSA, MAAA, Consulting ActuaryMillimanSeattle, Washington
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IntroductionDB Plan Sponsors:
» Do you have pension volatility blues?
DC Plan Sponsors: » Are you struggling with the difficulties of 401(k)
plans?
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Introduction Senator Harkin reports on America’s retirement readiness:
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
$6.6 TrillionRetirement Deficit
DB Plan
>50%
<$10,000
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Introduction 2012 Aon Hewitt Survey of HR Professionals:
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
4%
Employees Will Have Sufficient Retirement
Assets
10%
Employees Will Take Accountability for
Retirement Success
18%
Employees Will Be Able to Manage
Income in Retirement
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Today’s Agenda Retirement risksVariable Annuity Pension Plan (VAPP) Basics
» Benefit examples» Pros and cons» Funding, FASB, PBGC premiums» Inflation protection
VAPPs with benefit stabilizationPlan feature comparison Transition considerations
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Retirement Risks Retirement is a risky business: promising retirement security in a future
we can’t predict» Investment markets have been more volatile than predicted» Bond yields are at near historic lows» People are living longer than anticipated» What’s next?
Four main retirement risks: these are timeless» Investment Risk» Interest Rate Risk» Longevity Risk» Inflation Risk
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Retirement Risks
The risk that assets will decline due to losses in the investment markets Example
Results» Large volatility in asset balances from year to year» DB benefit promises that are difficult to fund» DC balances that reduce retirement security
Investment Risk
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Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
-40%
0%
40%
1926 1955 1984 2013
Returns for Portfolio of 60% Large Cap Equities / 40% Long BondsMajor Market Events in Blue
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Retirement Risks
The risk that the price of bond type instruments will change (because interest rates change) Example
Results» Annuity purchase prices are very high now» Bond rates and bond purchase prices vary from year to year
Interest Rate Risk
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Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
0%
5%
10%
15%
2000 2002 2004 2006 2008 2010 2012 2014
Long Term Corporate Bond Yields
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Retirement Risks
The risk associated with not knowing how long you will live Example
» This risk is borne alone for a participant with a 401(k)» A pension plan pools this risk across all plan participants
• Pooled longevity risk is relatively easy to manage
Longevity Risk
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Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
0%
25%
50%
75%
100%
65 85 91 98
Probability of Living to Very Old Age
50%
25%
5%
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Retirement Risks
The risk associated with loss of purchasing power over timeExample
» Over the last 86 years, inflation has averaged 3%
Inflation Risk
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Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
$1,000
$412
Purchasing Power
Year of Retirement30 Years into Retirement
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Retirement Risks
Plan Sponsor bears most of the risks
Traditional Defined Benefit Plan
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Investment riskInterest rate riskLongevity risk
Inflation risk
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Retirement Risks
Plan Sponsor bears none of the risks Participants bear all of the risks
Defined Contribution Plan
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Investment riskInterest rate riskLongevity riskInflation risk
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Retirement Risks
Risks are shared
Variable Annuity Pension Plan (VAPP)
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Longevity risk
Investment risk
Inflation and interest rate risks(significantly reduced)
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Traditional Plan Strengths
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Traditional DB
Longevity pooling
Lifelong income
Bigger benefits to long service employees
Professional asset management
Increased preference by younger workers
Traditional DC
Portable benefits
Predictable employer cost
Participants enjoy the market upside
Provides vehicle for employee savings
No concern with plan maturity
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Variable Annuity Pension Plan
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
VAPPProfessional Asset
Management
Lifelong Income
Longevity Pooling
Predictable Employer
Cost
Expected Inflation
Protection
Eliminate Maturity Concern
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VAPP Basics
VAPP—Variable Annuity Pension Plan Currently legal, has been legal since 1953 Plans with this design
» Major League Baseball has a plan that is part VAPP and part more traditional DB
» Aerospace Employees’ Retirement Plan» There are others, they are hard to track (no flag on Schedule SB)» Most are single employer plans
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Variable annuity pension plans (VAPPs) have controllable employer costs, like DC plans AND provide employees lifelong retirement income, like DB plans.
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VAPP Basics Career average or flat dollar type
accumulation “Hurdle Rate”, usually set between 3% - 5%
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Earned benefits fluctuate annually based on actual investment return of the plan Keeps assets and liabilities in
balance by adjusting liabilities
If the return = hurdle rate, there is no change to the monthly accrued benefit.
When return < hurdle rate,Underlying benefit decreases,BUT reserve prevents benefit decrease
When return > hurdle rate,Benefit increases
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VAPP Basics
2% career average VAPP 2014 Pay: $60,000
» $3,000 per year pay increases
2014 accrual: 2% x $60,000/12 = $100 per month 2015 accrual: 2% x $63,000/12 = $105 per month “Hurdle Rate” = 4%
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Active Benefit Example
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VAPP Basics
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Plan Year 2015 2016 2017 2018
Investment Return (I) 10.2% 2.9% -8.7% 14.3%
Hurdle Rate (H) 4.0% 4.0% 4.0% 4.0%
Benefit Increase (Decrease)* 6.0% -1.1% -12.2% 9.9%
Monthly Benefit
Plan Year Pay 12/31/2014 12/31/2015 12/31/2016 12/31/2017 12/31/2018
2014 $60,000 $100.00 $106.00 $104.83 $92.04 $101.16
2015 $63,000 $105.00 $103.85 $91.18 $100.20
2016 $66,000 $110.00 $96.58 $106.14
2017 $69,000 $115.00 $126.39
2018 $72,000 $120.00
Total Accrued Benefit $100.00 $211.00 $318.68 $394.80 $553.89
Sum of Accruals $100.00 $205.00 $315.00 $430.00 $550.00
*Calculated as (1+I)/(1+H) - 1
Active Benefit Example
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VAPP Pros
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Plan maintains 100% funding » Funding not subject to investment risk» Liabilities not subject to interest rate risk
Predictable employer costs» Funding: Minimum = Normal Cost» PBGC: No Variable Rate Premium» FASB
• Dampened balance sheet volatility• If pay related, currently have to use salary
scale projection which may cause some underfunding
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VAPP Pros
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Longevity pooling» Easier for a group to manage
• Difficult for an individual» Mortality
• Need small funding reserve for experience not matching assumptions
• Periodically update assumption
Expected inflation protection» Return in excess of the hurdle increases benefits
resulting in expected COLA» Professional asset management» Maintain balanced, diversified portfolio
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VAPP Pros
4% hurdle rate, 70% Stocks / 30% bonds from 1926 to 1955
Inflation Protection Expected—Retiree Benefit Example
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'26 '28 '30 '32 '34 '36 '38 '40 '42 '44 '46 '48 '50 '52 '54
Mont
hly B
enef
it Ov
er T
ime
Flat $1,000
$1,000 Adjusted for Inflation
4% Hurdle VAPP ($1,000 Initial Benefit)
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VAPP Pros
4% hurdle rate, 70% Stocks/30% bonds from 1955 to 1984
Inflation Protection Expected—Retiree Benefit Example
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'55 '57 '59 '61 '63 '65 '67 '69 '71 '73 '75 '77 '79 '81 '83
Mont
hly B
enef
it Ov
er T
ime
Flat $1,000
$1,000 Adjusted for Inflation
4% Hurdle VAPP ($1,000 Initial Benefit)
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VAPP Pros
4% hurdle rate, 70% Stocks/30% bonds from 1984 to 2013
Inflation Protection Expected—Retiree Benefit Example
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12
Mont
hly B
enef
it Ov
er T
ime
Flat $1,000
$1,000 Adjusted for Inflation
4% Hurdle VAPP ($1,000 Initial Benefit)
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VAPP Cons
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Benefits are volatile (see stabilization)» Get the good returns with the bad» Long term expected growth» Potential for short term pain
Communication difficulties» 1990s—easy» 2008—hard» Can be overcome
Not common but increasing in number Contribution each year like DC—no
holiday
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Benefit Stabilization
Asset allocation changes Plan modifications
» Floor benefit» Fixing retiree benefits» Caps on returns to shore benefits up in a down market by protecting
high water mark
There remain questions on how IRS and FASB could treat modifications
Possible Strategies
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Benefit Stabilization
One time contribution or a policy» More difficult as plan matures
Limit benefit increases» Cap increases at 10% a year (so returns above 14.4% build reserve)» Build reserve to desired level» Can build reserve in any maturity
Plan could get overfunded—to reduce overfunding:» Increase all benefits» Reduce employer contributions
Reserve Building
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Benefit Stabilization
Protect High Water Mark Determined on year by year basis
» Poor returns in the prior year» Reserve used to keep benefit from dropping» Only paid if reserve is sufficient» Plan not to drop below 100% funded
Underlying VAPP not changed» Paid if reserve runs out» Paid if increases above prior high water mark
Reserve Spending
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Benefit Stabilization: Cap and Shore-up Cap increases at 10%, limit funded status to 125%, 4% hurdle
» 70% Stocks / 30% bonds from 1926 to 1955; 115% funded at 1926
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Methods
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'26 '28 '30 '32 '34 '36 '38 '40 '42 '44 '46 '48 '50 '52 '54
Mon
thly
Ben
efit
Over
Tim
e
Flat $1,000$1,000 Adjusted for Inflation4% Hurdle VAPP ($1,000 Initial Benefit)Stabilized VAPP Benefit
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Benefit Stabilization: Cap and Shore-up Cap increases at 10%, limit funded status to 125%, 4% hurdle
» 70% Stocks / 30% bonds from 1955 to 1984; 115% funded at 1955
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Methods
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'55 '57 '59 '61 '63 '65 '67 '69 '71 '73 '75 '77 '79 '81 '83
Mont
hly B
enef
it Ov
er T
ime
Flat $1,000$1,000 Adjusted for Inflation4% Hurdle VAPP ($1,000 Initial Benefit)Stabilized VAPP Benefit
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Benefit Stabilization: Cap and Shore-up Cap increases at 10%, limit funded status to 125%, 4% hurdle
» 70% Stocks / 30% bonds from 1984 to 2013; 115% funded at 1984
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Methods
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12
Mont
hly B
enef
it Ov
er T
ime
Flat $1,000$1,000 Adjusted for Inflation4% Hurdle VAPP ($1,000 Initial Benefit)Stabilized VAPP Benefit
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Plan Feature Comparison
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
Defined Benefit
Cash Balance
Defined Contributio
n
Variable Annuity
Guaranteed benefit never decreases Yes Yes
Lifelong income (if no lump sum) Yes Yes Yes
Professional investment management and longevity pooling provide larger benefits Yes Yes Yes
Supports retention and orderly retirement Yes Yes Yes
Allocates contributions to long service Yes Yes
Plan design protects older employees Yes Yes
Stable cost Yes Yes
Prevents investment losses and interest rate changes from creating contribution volatility
Yes Yes
Designed to provide post-retirement inflation protection Yes
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Transition Considerations Current plan liabilities
» May have legacy underfunded liabilities» Still need to manage that risk» De-risking options
Could convert the current plan to a VAPP» From DC Plans» From Traditional DB Plans
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Questions?
September 10, 2014Variable Annuity Pension Plans: A Balanced Approach to Retirement Risk
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Resources “Variable Annuities: A retirement plan design with less contribution volatility”, by Mark
Olleman, Ladd Preppernau and Kelly Coffing, Milliman White Paper, September 2012 “Asset Driven Liabilities: The Variable Annuity Plan”, Donald Fuerst, Enrolled Actuaries
Meeting, Session 103, April 7-10, 2013. “The Retirement Crisis and a Plan to Solve It”, by Senator Tom Harkin, July 2012. “2012 Hot Topics in Retirement: Waning Confidence and the Need for Continued
Innovation”, Survey Highlights, Aon Hewitt, 2011. “Attraction and Retention: What Employees Value Most”, by Steve Nyce, Towers
Watson Insider, March 2012. “Defined Benefit vs. 401(k) Investment Returns: The 2006 2008 Update”, Towers
Watson Insider, December 2009.
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