When Pensions Met Vintage TV

Many of my readers are pretty familiar with pension plans. Those of you who have been around for a while may remember a time on the TV show 60 Minutes before the closing segment was occupied by Andy Rooney. Back in the late 70s, it was Shana Alexander on the left versus James J. Kilpatrick on the right on the Point-Counterpoint segment. In the early days of Saturday Night Live, this also led to the Jane Curtin-Dan Aykroyd segments famous among other things for their tag lines, "Jane, you ignorant slut," and "Dan, you pompous ass."

What does all this have to do with pensions? Not a thing, but today I'm going to tie them together anyway.

In any event, late last week, I read an article highlighting a Prudential study on the uptick in pension risk transfer (PRT). I thought that bringing back Shana and Jim (or Jane and Dan if you prefer) might be a good way to discuss it.

Point: 31% of respondents to the survey said that desire to reduce their pension plan's asset volatility was a key reason to engage in PRT.

Counterpoint: Jane, you ignorant slut, that means that 69% of plan sponsors didn't think that reducing asset volatility was a big deal. And, as I'll explain to you later, asset volatility can be dealt with.

Point: Dan, you pompous ass, another 25% said they wanted to focus on their core business rather than deal with a pension plan.

Counterpoint: But, Jane, you ignorant slut, a pension plan is part of their core business and 25% isn't very many anyway.

Point: Dan, you pompous ass, 25% said that they were tired of having to deal with small benefit amounts.

Counterpoint: Jane, you ignorant slut, if they didn't freeze their pensions, those companies wouldn't have to deal with small benefit amounts. Everyone would have wonderful pensions benefits.

We'll return to Point-Counterpoint after a short commercial break, but while that's airing, let's consider what each of our erudite commentators is pointing toward. Shana/Jane (actually likely taking the more conservative Jim/Dan role) are taking the position that managing pensions has just gotten out of hand in the US. With rising PBGC premiums and wild asset fluctuations, they want out of the pension business, at least to the extent possible.

At the same time, the other side is espousing that pensions can help with workforce engagement and management and that asset fluctuations need not cause angst for plan sponsors.

After hearing "Plop plop, fizz fizz, oh what a relief it is" and "Mr. Whipple, please don't squeeze the Charmin," we return to our regular programming.

Switching to our more traditional commentators ...

Point: Jim, so you are trying to tell me that companies should still maintain these blasted pensions and that the problems that a group of CFOs are worried about just don't matter?

Counterpoint: No, Shana, they matter. But, they are solvable. You've never had a creative mind, Shana.

Point: Jim, you're getting curmudgeony now. If you don't watch it, they'll replace you with that Rooney guy with the bushy eyebrows.

Counterpoint: Shana, I've heard you talk about LDI (liability driven investments), but how come you never talk about IDL.

Point: Jim, now you've lost it. Are you telling me that Interactive Data Language should be part of a pension discussion. Or, are you telling me that I should die laughing at your ignorance of real financial issues.

Counterpoint: Shana, IDL is investment driven liabilities. Since you clearly know nothing about this concept, you could choose to learn. Perhaps it doesn't resonate with you that if liabilities track to assets in a defined benefit plan, then all of these CFO issues would go away and companies would be able to keep their workers while keeping costs stable.

And, returning to our other cast of characters ...

Point: Dan, you pompous ass, that makes no sense at all. Everyone knows that assets don't drive liabilities.

Counterpoint: Jane, you ignorant slut, suppose they did.

Managing the Risk in Active Pension Liabilities

If you work with defined benefit (DB) pension plans at all, or if you happen to be among those responsible for them at a company that still sponsors an ongoing DB plan, you know that de-risking has been all the rage in recent years. And, this is not to say that this is not without good reason. With the inherent volatility in cash flow and accounting expense that has been added to the DB world by what some (including me) would consider poorly conceived funding and accounting rules, risk mitigation is often critically important.

So, let's consider what have been the trends in de-risking. There have been a mass of so-called lump sum windows in which former employees have been offered one-time opportunity to take a single sum distribution of the value of their remaining benefits thereby removing those liabilities from the plan's 'balance sheet' and thus eliminating the company's future liabilities with respect to them. And, there has been lots of liability driven investing (LDI). That is, companies look to invest assets in fixed income instruments of durations similar to the liabilities in the plan. By doing this, liabilities in the plan tend to move roughly in lockstep with the underlying assets intended to support those liabilities.

All this is great, especially for well-funded plans, but how about all the rest of those plans? And, these strategies tend to look at the liabilities that currently exist. How about the liabilities that will exist in the future (we used to consider those in actuarial valuations, but the law changes made them irrelevant in the annual valuations)? What do I mean by that? Consider an example.

The XYZ Pension Plan currently has its funding target (liability for accrued benefits). We can split that out among three groups of participants, two of which are composed of former employees. Suppose they are broken out as follows:

Retired participants: 100,000,000
Terminated Vested participants (former employees who are not yet in pay status, but are entitled to a benefit in the future): 30,000,000
Active participants: 70,000,000

for a total funding target of $200,000,000.

What do we know about the liabilities that compose this funding target? We know that the amount attributable to current retirees will generally decrease because for each year that a retiree lives, there are 12 months fewer of benefit payments that the retiree will receive in the future. This might tend to imply that this group represents a diminishing risk.

We know that the terminated vested group will become retirees. Generally, these are former employees with smaller benefits (they didn't work for the company until a retirement age). In the usual profile, they represent a far smaller liability than do retirees or actives. For a given vested term, the liability with respect to their benefit will generally increase as they approach retirement and then decrease. Lump sum windows were designed to target this group and have been quite successful. But, because their accrued benefits, and therefore attendant liabilities are smaller, the effect of having done this has not been as significant as it would be with a group of active employees.

The active employees currently accruing benefits are the most important group to de-risk. Why is this? There are several reasons:

• In our example, and typically, their accrued benefits represent a meaningful liability to the plan and plan sponsor.
• With each year that an active employee remains with the company, they are one year closer to retirement meaning that the discounting period until retirement has shortened.
• In an active plan, these employees continue to accrue benefits (more on this to follow).

Yes, active employees continue to accrue benefits. Suppose we consider a concept that used to be paramount to actuarial valuations of DB plans -- the actuarial present value of projected benefits under the plan (PVB). This is the actuarially determined amount that if it sat in a pool of assets today would be sufficient to eventually fund the benefits of that individual. 

For retirees and vested terms, the PVB and the accrued liability or funding target or accumulated benefit obligation (ABO in accounting parlance) are, save differences in actuarial assumptions, the same as each other and the same as the PVB.

For active participants, they are not. In fact, for a mid-career person, the PVB may be more than twice as large as the liabilities we are consider. And, if we are de-risking, isn't it really the eventual benefit liability that needs to be de-risked? 

If you agree, you're correct, and if you're a plan sponsor, we need to talk. 

If you disagree, you're likely not correct, and if you're a plan sponsor, we need to talk.

There is a really easy approach to this that many companies have taken and that is to freeze benefit accruals under the plan. But, not everyone wants to do that. Some companies actually philosophically like the concept of DB plans. But, the funding and accounting rules have made it more difficult to get comfortable with sponsoring them.

Suppose I told you that you could mitigate the risk in the active PVB. And, suppose I told you that you could do that without freezing accruals. 

You'd be interested, wouldn't you?

Let's talk. You won't regret it. Here is one way.

Does Your Plan Have Undue Risk?

An actuary friend of mine was complaining about upcoming end-of-year DB disclosures and the fact that his clients had funding calculations coming up that were going to be based on low interest rates and equity markets that have plummeted since the election. I further heard that the underfunded plans that he works with were overfunded as recently as September 1.

I asked him about de-risking, liability matching and things like that. He said that his clients give up too much upside return by doing that. I guess they would rather have underfunded plans.

In about 2002, I gave a speech to a bunch of pension investment professionals. In it, I espoused long duration fixed income investments in DB plans despite that everyone knew that interest rates couldn't go any lower. Of course, they also knew that this would take interest rate risk out of the equation, but people treated me as if I had some sort of strange disease.

I know of a few plan sponsors who did what I said. They are the ones with well-funded plans now. I don't know about you, but I'm not smart enough to know where interest rates are headed on any particular day. Frankly, I have expected them to be headed upward for that entire 10-year period, but that's not the point. The point is that there are a number of risks inherent in DB plans in the US. Some are outside of the sponsor's control, but others fall within it.

Shouldn't a sponsor consider controlling the ones that they can.

To LDI or not to LDI

I saw an interesting article today. It said that 63% of pension execs (whatever execs represents in this case) are now using an LDI approach for pension funding. I saw an article on the same site that asked the question, "If LDI is so great, how come more funds aren't doing it?"

"I see", said the blind man who knows that LDI stands for Liability Driven Investing. In a nutshell, pension funds that employ this technique seek to mitigate funded status volatility by having a portfolio of assets that varies with moving interest rates in essentially the same way as the plan obligations move.

I first discussed LDI with a client in (I think this is the correct year) 1998. At the time, this company's US pension funds had an overall funded status well in excess of 125% on any measure. The technique that I discussed with them didn't have such a catchy name though. I think we called it duration modeling (doesn't sound too catchy, does it). The good news -- that company adopted what came to be known as an LDI strategy and never fell into the morass of underfunding suffered my most US pension plans. The bad news (for participants anyway) -- the company eventually froze their plans to save money.

Back in the very late 90s and early 2000s, I gave some speeches on the topic. I always heard the same response from the naysayers -- roughly, do you mean to tell me that you think interest rates are going to go down? These naysayers were generally the absolute return people. Despite all the logic, they didn't seem to understand that even if you thought that interest rates would go up (they didn't over the next 10 years or so), probabilistic or stochastic analysis showed that for most plans, you would be doing a far better job of risk management by matching assets with liabilities.

Let's consider. Suppose that in 75% of all cases, you thought interest rates would go up and in 25%, they would go down (let's assume that in very few would they stay the same and we will just split them evenly between the two groups). Unfortunately, especially under the new PPA funding regimes, the worst possible scenarios for plan sponsors -- the ones that might put them out of business -- all occurred where interest rates fell and the plan sponsor chose to not match assets to liabilities. In the more positive (return) cases, the group that matched didn't do as well as the group that bet that interest rates would go up, but even so, they should have been able to sleep better.

You see, the matching, or immunizing, group, was coming close to ensuring that their required contributions would not be enough to cause corporate financial ruin. Yes, they were taking away some of their upside potential, but isn't that what risk management and insurance are all about? When you insure your home, for example, you know that you probably won't have a large claim. So, you are spending money on insurance that you probably won't recover (essentially decreasing your upside potential). On the other hand, if you do have that large claim, you'll be glad that you had that insurance, and that's what LDI is all about.

Sadly, so many companies that knew this was the correct approach for them resisted and many of them either had to reduce benefits, or in some particularly severe cases, were essentially put out of business by their pension plans.

It's not worth all that. If you still have a US defined benefit plan, at least consider your risks and see what you might do to mitigate them.

Top Concerns for Pension Plan Sponsors

An SEI 'Quick Poll' found that controlling funding status volatility is the number one priority for defined benefit plan sponsors. When I look at the Top 10, however, a common theme emerges: Managing Risk.

Here are the Top 10 (in traditional as compared to Letterman order):

1. Controlling funded status volatility
2. Providing senior management with long-term pension strategies
3. Improving plan's funded status
4. Conducting an asset-liability study
5. Effectively managing duration moving forward
6. Implementing a liability-driven investment (LDI) strategy using long bonds
7. Defining fiduciary responsibilities for trustees and investment consultants
8. Changing funding policies and timelines
9. Stress-testing the portfolio to gauge its ability to withstand extreme macroeconomic environments
10. Implementing a plan design change such as closing the plan to new entrants or freezing accruals in already closed plans

It's time to make a few comments on this list. First, who comes up with these choices? #9 was clearly the brainchild of someone with too much time on their hands trying to sound smart. Isn't that what you do as part of #4? Second, all ten of them address some element of risk management. Third, of the companies that chose #8, I wonder for how many of them, changing funding policies is the same thing as actually having a funding policy.

Managing Risk is Top Goal for DB Sponsors

I've been beating this into your head since I started this blog: risk management is the #1 priority for sponsors of defined benefit plans. According to the Towers Watson Forbes Insights 2010 Pension Risk Survey (you can read it for yourself here: http://www.towerswatson.com/united-states/research/3220 ), 63% of plan sponsors say they will focus on managing risk and 14% say they will focus on higher returns.

Here are some of the survey findings that I found interesting:

• 29% of plan sponsors are now making only the minimum required contribution to their DB plan(s) compared to 21% before the financial crisis.
• 8% of sponsors make ad hoc funding decisions. 15% did before the financial crisis.
• 36% (compared to 26% before the crisis) fund to explicit funding targets
• Accounting harmonization will cause 48% of plan sponsors to reconsider their commitment to DB plans, 52% to lower their equity exposure and 48% to adopt some sort of LDI strategy.
• Roughly 40% said that the financial crisis increased their employees' appreciation for DB plans.

If only Congress would recognize this and give us legislation that protects pensions instead of killing them.

Poll Shows Percentage of Pension Plans Using LDI Staying Relatively Steady

An SEI poll of 110 defined benefit plan sponsors says that 50% of 110 respondents (down from 54% in 2009, but up from 20% in 2007) are using liability-driven investing (LDI) in their plans. Just as interesting to me though is that the most prominent definition of LDI in the poll has changed from "matching duration of assets to duration of liabilities) to "a portfolio designed to be risk-managed with respect to liabilities."

"Hmm", says this writer. That first definition sounds like it has some structure to it. The second one sounds like wishful thinking. Perhaps there was no really good answer available in the survey and the most popular choice for 2010 was not necessarily the best answer, but it was the best choice among the answers available.

38% of respondents said that their primary benchmark was to improve funded status. 22% said that their primary benchmark was to minimize or control contributions. Funded status was #1 last year as well, but absolute return was the #2 benchmark in 2009.

This still seems backward to me. Perhaps I am wrong, but it strikes me that where a company has (at least from a mindset standpoint) committed to providing a pension to its employees, the goal should be to provide those benefits at the lowest cost possible (however that company measures cost), at the same time keeping its attendant risks low enough that the pension plan never interferes with the company's ability to run its business.

You can read more details on the survey here: http://www.plansponsor.com/LDI_adoption_steady_definition_fluid.aspx