Employers are shying away from defined benefit plans because of volatility in the required contributions. Volatility can be managed provided care is taken in establishing an integrated investment, actuarial assumption and contribution policy.
A DB plan that pays meaningful retirement benefits provides valuable retirement income to its participants. However, such a plan also creates challenges for the plan sponsor, who must manage contribution volatility. By understanding investment returns and properly selecting actuarial assumptions and a prudent contribution policy, plan sponsors can manage funding volatility and create a mutually beneficial situation for both sponsor and plan participants.
A common DB plan benefit formula is: Y% x YOS x FAE, where Y is a fixed percentage normally between 1% and 2.5%, YOS is total years of service, and FAE is final average earnings. For private-sector companies, Y usually is at the lower end of the range, compared to 1.5% to 2.5% for public-sector organizations.
Ways to reduce contribution volatility
A comprehensive approach to manage contribution volatility begins with education at the plan sponsor level. Sponsors should understand that they ultimately are responsible for any funding shortfall. Further, sponsors should adopt prudent procedures for creating and maintaining a retirement committee to carry out general plan management responsibilities. The retirement committee should be educated on the potential sources of volatility in the plan and how to manage each source with concern for the big picture.
The three potential sources of volatility for a DB plan are: investment returns, the appropriate set of actuarial assumptions and a realistic contribution policy (see chart).
Since these three items are related, the retirement committee should pursue an integrated approach. The retirement committee first must understand the intricacies of these three key aspects, and subsequently hire the right investment adviser and actuary to help accomplish the task. It is important for the retirement committee to discuss their goals with the consultants and keep their minds open to the consultants' suggestions.
Investment strategy
Investing pension assets is very different from investing personal wealth. Whereas in personal investment there are no limitations, pension asset investment comes with fiduciary responsibility. Upon signature of a trust document, plan sponsors agree to enact a policy of prudent investment. We propose setting an investment policy based on a proven set of principles:
- Markets work. Capital markets do a good job of fairly pricing all available information and investor expectations about publicly traded securities.
- Diversification is key. Comprehensive, global asset allocation can neutralize the risks specific to individual securities.
- Risk and return are related. The compensation for taking on increased levels of risk is the potential to earn greater returns.
- Portfolio structure explains performance. The asset classes that comprise a portfolio and the risk levels of those asset classes are responsible for most of the variability of portfolio returns.
To define the relationship between risk and reward, there are three dimensions of risk: equity vs. fixed income, value vs. growth, and small vs. large. In all three cases, the argument simplifies to higher risk/higher return vs. lower risk/lower return. Plan sponsors should direct their investment adviser to take risks up to a defined comfort zone, with focus directed on the three dimensions of risk.
Studies have shown it is difficult for active managers to consistently produce investment returns in excess of market returns. In addition, active managers incur higher costs, thus reducing net investment return.
A well-structured, balanced and globally diversified portfolio of passively managed core asset classes, which are modeled to allow exploitation of the three dimensions of risk, allows a plan sponsor to capture the market returns without taking unnecessary risks. Index funds, by nature, have lower expense ratios as well. Decreased cost directly increases net investment return.
Creating the investment policy
It is important to have an explicit written investment policy statement prior to investing. The policy statement should be referred to when reviewing the investment performance on a quarterly basis.
Formulating investment policy for a pension fund that backs pension obligation requires careful analysis of the total plan benefit obligations. Further, adherence to an investment policy statement will keep the focus on financing the benefit obligation. The policy statement needs to reflect the plan's objectives, constraints, preferences and market expectations.
Benefit obligations are divided into three categories: short-, intermediate- and long-term. The first step is to determine the amount of fixed income investments to cover the short and intermediate benefit obligations based on risk preference. This provides an indication of the ratio of bonds to equity to be held. The next step is to select the right asset mix to achieve a globally diversified portfolio.
The portfolio should match the financial characteristics of the plan's benefit obligations. The investment policy statement should include quarterly performance review, and rebalancing. The investment policy statement should be reviewed periodically for any significant changes in the benefit obligations.
Among the common mistakes sponsors make when forming an investment policy statement:
- Taking risks that don't reward.
- Formulating an investment policy without taking into account the plan's benefit obligations.
- Allowing too much leeway in the investment policy statement to allow investment advisers to take unnecessary risks.
Actuarial assumptions and funding method
In calculating the pension plan's benefit obligation, an actuary would first calculate a stream of expected benefit payments for each employee. The second step is to determine the present value of these payment streams using the selected actuarial assumptions. Also, this process involves incorporating the selected actuarial funding method.
The key actuarial assumptions that affect the value of a plan's benefit obligation are interest rate assumption, salary increase assumption, turnover and retirement rates, and mortality rates table.
Actuarial assumptions are needed in order to calculate the plan's liability and the normal cost each year. These two key numbers are used to calculate the annual contribution. Because we do not know what will actually happen in the future, we encourage plan sponsors and actuaries to select each assumption carefully to provide a margin of safety.
The funding method is used to allocate total plan liability due to past service and future service. Without getting into too many details, entry age normal is appropriate in most cases for large pension plans. This funding method provides a margin of safety in determining plan contribution.
Interest rate assumption usually is the most important assumption. The interest rate assumption is used to value the benefit obligation in today's present value. For example, a one-time $100 benefit payable 30 years from now is worth $11.42 today, based on an interest rate assumption of 7.5%.
In other words, if we have $11.42 today, and if we know it can earn 7.5% investment earnings per year, we will have an accumulated value of $100 in thirty years.
The interest rate assumption is based on the expected return, as developed in the investment strategy, and other market factors.
For example, if the expected return of the investment portfolio put together is 8.35%, then an appropriate interest rate assumption is 7.5%. We recommend a margin of safety of 50 -100 basis points. Other factors we take into considerations are what were the past investment returns, and what other investment expects are saying and their justifications.
Some common missteps:
- Setting the investment policy based on the actuarial assumption; it should be the other way around.
- Not providing a margin of safety.
The second most important assumption if the plan's benefit formula is based on final average earnings is the salary increase assumption. Again, this assumption needs to reflect the best estimate of future salary increases with a margin of safety.
The remaining key assumptions should be selected to closely reflect the best estimates of future trends.
Contribution policy
The final step in reducing volatility in contributions is to carefully develop a good long-term contribution policy.
In general, the annual contribution is the normal cost, plus an amortization of the unfunded liability. Normal cost is the cost of funding the benefit earned by the active participants in a given year. If the plan has unfunded liability, then there will be an amortization payment to pay off this unfunded amount in a certain number of years.
Some funding methods combine the amortization payment into the normal cost calculation. The first step is to determine the contribution range for the year.
In a plan that utilizes the EAN funding method, the minimum is usually the normal cost plus a 30-year amortization of the unfunded liability. The maximum is the normal cost plus a shorter amortization of the same liability.
A good contribution policy is to establish a conservative contribution level that will not only pay off the unfunded liability in less than 30 years, but will also maintain the same contribution level even when actual experience is worse than assumed for most years. For example, an organization has 1,000 active employees (for simplicity, let us assume that none are retirees or terminated with vested benefits) with $50M in payroll. Let us assume the interest rate is 7.5%, the normal cost is $5M, the plan liability is $100M, the plan assets, $80M, and that the unfunded liability is $20M. The 30-year amortization payment of the unfunded liability is $1,693,423.
The minimum contribution is calculated as follows:
Normal cost - $5,000,000
30-year amortization - 1,693,423 payment
Total - $6,693,423
Percent of payroll - 13.4%
The maximum contribution is calculated as follows:
Normal cost $5,000,000
10-year amortization 2,913,719 payment
Total $7,913,709
Percent of payroll 15.8%
In this scenario, we recommend the client contribute $7.5M, or 15% of payroll. This contribution policy should suffice for a few years, barring extreme or unforeseen circumstances like the current economic crisis.
Common mistakes include:
- Most investment advisers are too eager to earn business and will agree with the plan sponsor's request to achieve an arbitrary target of investment return.
- Many actuaries are afraid to challenge clients when the assumptions used are not realistic.
- No margin of safety is built into each level.
Kien Liew, FCA, is an investment adviser and actuary at PensionAsset. Bill Schroeder is a consulting actuary at PensionBenefits.
