Variable Annuity Pension Plans: A Balanced Approach to ... · PDF fileIntroduction Senator...

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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:


$6.6 TrillionRetirement Deficit

DB Plan

>50%

<$10,000

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Introduction 2012 Aon Hewitt Survey of HR Professionals:


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


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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


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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

September 10, 2014


-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

September 10, 2014


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

September 10, 2014


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

September 10, 2014


$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


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


Investment riskInterest rate riskLongevity riskInflation risk

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Retirement Risks

Risks are shared

Variable Annuity Pension Plan (VAPP)


Longevity risk

Investment risk

Inflation and interest rate risks(significantly reduced)

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Traditional Plan Strengths


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


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


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%


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%


Active Benefit Example

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VAPP Basics


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


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


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


$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



$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



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VAPP Pros

4% hurdle rate, 70% Stocks/30% bonds from 1984 to 2013



$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



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VAPP Cons


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


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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


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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


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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


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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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


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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


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Plan Feature Comparison


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


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Questions?


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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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