Theopinionsexpressedinthispresentationarethoseofthespeaker.TheInternationalFoundation disclaimsresponsibilityforviewsexpressedandstatementsmadebytheprogramspeakers. Alternative Pension Strategies (Part 1) Mark Olleman EA, FSA, MAAA Consulting Actuary and Principal Milliman, Inc. Seattle, Washington P06-1
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Alternative Pension Strategies (Part 1) - IFEBP · Alice and the Cheshire Cat from Lewis Carroll’s Alice’s Adventure in Wonderland “Would you tell me, please, which way I ought
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The opinions expressed in this presentation are those of the speaker. The International Foundationdisclaims responsibility for views expressed and statements made by the program speakers.
Alternative Pension Strategies (Part 1)
Mark Olleman EA, FSA, MAAAConsulting Actuary and PrincipalMilliman, Inc.Seattle, Washington
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Outline
• Values• Risk• Adequacy• Alternative Strategies
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The Journey of Plan Design
GoalsValues
Perceived NeedEducation
FocusCosts
DecisionsImplementation
AdequacyCompetitiveness
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ValuesAlice and the Cheshire Cat from Lewis Carroll’s Alice’s Adventure in Wonderland
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to.” said the Cat.
“I don’t much care where.” said Alice“Then it doesn’t matter which way you go.” said the Cat.
• If you don’t know where you are going, any road will take you there.
• Values should direct your journey.
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Cost Related Values
• Cost Level– Any plan design can be cheap or expensive.
• Efficiency– What is important is the value provided for
each dollar of contribution.– Efficiency = the cost of adequacy
• Contribution Stability– Do you want predictable costs or predictable
• 65 year old man:– 50% chance of living to 86– 5% chance of living to 99
• 65 year old husband and wife– 50% chance one will live to 93– 5% chance one will live to 103
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Inflation Risk
% of Original Purchasing Power2 % Inflation 3% Inflation
10 years 82% 74%20 years 67% 55%30 years 55% 41%40 years 45% 31%
Inflation has averaged 2.2% over the last 20 years and 2.9% over the last 90 years.
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Portability Risk
• Portability risk is the risk that retirement benefits will be smaller due to changes in employment.
• Defined Benefit: inflation, eligibility• Defined Contribution: “leakage”• Non vested participants can lose employer
provided benefits in any retirement plan
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Interest Rate Risk
• Risk of low interest rates– Strategies that remove risk from retiree
payments by investing in bonds or insurance contracts
• Will be expensive when interest rates are low• Interest rate changes create cost volatility
– All strategies are sensitive to the extent low interest rates may create a “low return environment.”
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Adequacy
• Why do you have a retirement plan?To provide retirement income.
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Adequacy—Replacement Ratio
How much is enough?• Replacement ratio: The percent of
pre-retirement income neededpost-retirement to sustain standard of living.
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Adequacy Replacement Ratio
How much is enough?• Studies suggest people need a
replacement ratio of approximately 78% at age 65.(much more before Medicare eligibility at 65)
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Sources of Adequacy
• Traditional concept:three-legged stool– Social Security– Pension– Personal savings
• Fourth leg? Income from working
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Funding of Adequacy
How do you fund retirement?Benefits + Expenses are funded by Contributions + Investment Earnings
investments$ $ $
$
$ $
$
$
$$
$ $ $$
$
$ $$
Assets$
$
$ $$
$
$
$
$ $
PENSIONFUND
$ $
benefits
expenses
employer contributions
employee contributions
C + I = B + E
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There Are Two Funding Stages:
1. Accumulation (C + I)2. Distribution (B + E)
investments$ $ $
$
$ $
$
$
$$
$ $ $$
$
$ $$
Assets$
$
$ $$
$
$
$
$ $
PENSIONFUND
$ $
benefits
expenses
employer contributions
employee contributions
C + I = B + E
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Planning for Adequacy—Accumulation
When an individual plans for their own adequacy they need to decide:• Pre-retirement (accumulation)
– How much money will I need every month when I retire?
– How much does that mean I need to have accumulated at retirement?
– How much do I need to save to accumulate that amount?
– How should I invest those savings?
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Planning for Adequacy—Distribution
When an individual plans for their own adequacy they need to decide:• Post-retirement (distribution)
– How much can I spend in retirement?– How do I invest in retirement?
• Risk—How do I plan for risk?
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Adequacy Cost Factors “Efficiency”
Many things influence the cost of providing an adequate benefit:• Investment return• Longevity• Longevity pooling• Retirement age• Risk tolerance• Risk
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Cost of Adequacy (Value = Efficiency) Investment Earnings
Let’s say, Kris is hired at 25, retires at 65, dies at 86• Contribute for 40 years (e.g. 25 to 65)• Annual contribution and benefit growth: 3%• Contribution in year before age 65: $10,000
$5,600 = 137% of $4,080 -OR- 132% of 4,240 -OR- 189% of 2,970
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Retirement Strategies
What matches your values?
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Traditional Defined Benefit
• DB defines a specific benefit at retirement. Many options, examples:– 1% of contributions made for participant– $50 per month for each year of service– 1% of final pay for each year of service
• Contributions vary• Guaranteed monthly benefit is paid for the
*Tend to benefit younger participants.(+)/(-) shaded cells are the changes from DB
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Hybrid Plans/Alternative Strategies
Wide variety:1. Defined Benefit + Defined Contribution2. Spillover plans3. Annuity plans4. Cash balance plans5. Composite plans6. Variable annuity plans
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1.“Combined” or “DB + DC” Hybrid
• Combines reduced Defined Benefit with a Defined Contribution plan
• When discussing public plans some people will assume this is what you mean when you say “hybrid plan.”
• Proportionately reflects values of DB and DC – Smaller defined benefit means more contribution
stability and less guaranteed benefit
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2. “Spillover” Plans
• Special type of “combined” or “DB + DC” hybrid• Contributions not needed for traditional DB plan
“spillover” into DC.– DC contributions vary– Total contributions are stable (value)– DB accruals are stable (value)– Relies on strong active contribution base
• Again, proportionately reflects DB and DC values
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3. Annuity Plans
• Defined Contribution Plan• Accumulation phase
– Trustees manage the assets. Like a DB trust there is no participant investment selection.
– Generally only employer contributions
• Distribution phase– May purchase insurance company annuities at
retirement to pay monthly benefits– May pay lump sums
(2) Depends on relationship between interest credit and investments.(+)/(-) shaded cells are changes from Traditional DB
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5. Composite Plans
• Can pay benefits in same form as a “Traditional Defined Benefit Plan.”
• No withdrawal liability• No PBGC premiums or PBGC protection• Must maintain 15 year projection of 120% funded• Recent events
– 9/9/2016: Rep. John Kline unveiled “discussion draft” of legislation
– 9/22/2016: Health, Education, Labor and Pensions subcommittee held hearing to collect feedback on the discussion draft.
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Composite Plans—Discussion Draft
• If 15 year projection of funded ratio is less than 120% trustees are required to adopt a “realignment program” with the following hierarchy:
• Tier 1– Contribution increases by bargaining parties– Reductions in future benefit accruals by trustees, but not below
1% of contributions.– “Adjustable benefits” such as early retirement provisions can be
reduced for participants not in pay status.
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Composite Plans—Discussion Draft
• Tier 2– Reductions in accrued benefits for participants not yet in pay
status. – Reductions in post-retirement benefit increases for retirees.
• Tier 3– Future benefit accruals may be reduced below 1%.– Core benefits for retirees in pay status may be reduced.– Until either:
• Plan’s projected funded ratio is 120%.• Plan’s projected funded ratio is at least 100% and plan’s current
funded ratio is at least 90%.
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Composite Plans—Early Intervention
• Early intervention and responsible funding will:– Minimize required adjustments, and– Reduce the likelihood of reductions in benefits earned
in the past. Note that if other plan’s go to the PBGC, earned benefits including retiree benefits are reduced.
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Composite Plans—Observations
• The remedies are similar in substance and order to those already available under PPA and MPRA: – Contribution increases, future accrual decreases, adjustable
benefit decreases, and if a plan is critical and declining then core benefit decreases.
– However, the remedies are made sooner.– Not really a new plan design, stricter funding rules with
increased ability to adjust earned benefits
• The remedies start by protecting benefits earned in the past using the sacrifice of current members and employers.
• The adjustments are not automatic. The trustees and bargaining parties must decide.
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Composite Plan Values
Yes Maybe No
Guaranteed Benefits Equity* Inflation Protection
Lifelong Income Simple to Communicate (-) Contribution Stability(+)
Efficiency Portability
Workforce Mgmt. Inheritance
Attraction / Retention EE Responsibility
Works w/o Participant EE Freedom
Understanding Flexibility (e.g. Lump sums, loans)
Cost/Risk Sharing (+)
*Tend to benefit older participants.(+)/(-) shaded cells are changes from Traditional DB
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6. Variable Annuity Plans (VAPs)
Established in 1953:Revenue Ruling 185, 1953-2 says a plan “which provides benefits that vary with the increase or decrease in the market value of assets from which such benefits are payable” satisfies the Internal Revenue Code requirement for “definitely determinable benefits.”
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Variable Annuity Plans
• Monthly benefits are earned like traditional DB, but go up or down by the % plan returns are larger or smaller than a “hurdle rate.”
• Shifts investment risk from employers and active participants to all participants including retirees.– All participants share in gains and losses– Sustainable, robust funding in all markets
• Jack is retired in a “pure” VAP with a 4% “hurdle rate.” His benefit is $1,000/month
• Year 1: Investment return = 1%– Jack’s benefit changes to
$1,000 x 1.01 ÷ 1.04 = $971
• Year 2: Investment return = 11%– Jack’s benefit changes to
$971 x 1.11 ÷ 1.04 = $1,036
• Investment return averaged 6% and benefit went up 3.6% over two years.
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Variable Annuity Plansthe Promise Is Changed
Fundamental shift in paradigm • When assets supporting benefits earned in the past go down:
– Traditional DBs charge future generations of members and employers with contribution increases and reductions to benefits earned in the future.
– VAPs charge participants who earned those benefits in the past by adjusting those benefits to be consistent with the current value of the contributions made for those benefits.
– Someone has to pay. Who will it be? What is fair?What is your value?
• VAP provides “lifelong” benefit with some expected inflation protection over the long term instead of a “guaranteed” dollar benefit.
• Your strategy should reflect your values. If you don’t know where you are going, any road will take you there.
• When assets supporting benefits earned in the past go down, do you want to fund those benefits by:– Charging future generations with higher
contributions and lower benefit accruals?
– Charging the participants who earned those benefits by adjusting those benefits?
– Is there a win-win? What is your value?
• How will you manage the risk of growing liabilities and an increasing retiree population?
• How is adequacy reflected in your values?(Is your strategy “efficient?”)
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2017 Educational ProgramsPensions
63rd Annual Employee Benefits Conference October 22-25, 2017 Las Vegas, Nevadawww.ifebp.org/usannual
Trustees and Administrators InstitutesFebruary 20-22, 2017 Lake Buena Vista (Orlando), FloridaJune 26-28, 2017 San Diego, Californiawww.ifebp.org/trusteesadministrators
Certificate of Achievement in Public Plan Policy (CAPPP®)Part I and Part II, June 13-16, 2017 San Jose, CaliforniaPart II Only, October 21-22, 2017 Las Vegas, Nevadawww.ifebp.org/cappp
Related ReadingVisit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books.