Risks and Rewards in Hybrid pension plans

1. Risks and Rewards in Hybrid pension plans Mary Hardy Statistics and Actuarial Science

2. Outline • Background • Why not Defined Benefit? • Why not Defined Contribution? • Hybrid Pensions • Cash Balance • Target Benefit • Floor Offset (DB Underpin) • Concluding Comments

3. background

4. Employer Perspective - Benefits • Why do employers sponsor pension plans? • Recruitment • Retention • Facilitate turnover of older employees • Tax-efficient remuneration • Industrial relations • Altruism

5. Employer Perspective - Risks • Variable costs • Plan fails to meet recruitment/retention/retirement objectives • Regulatory risk • Industrial relations risk • Deficit induced crises • Surplus induced crises

6. Employee Perspective - Risks • Risks • Pension is too low at retirement age • Inflation erosion through deferment and/or retirement • Pension runs out • Employer defaults • Poor return on contributions • Bad investments • Intergenerational transfers

7. Government Perspective • Canadian pension assets total $1,240 bn (2013Q1) • $400 bn in stocks • ~ 20% of TSX capitalization • Preparing for social security and welfare costs of aging population. • Risk of move to personal pension provision?

8. Why not DB?

9. Why not DB? • Volatile employer contributions • Excessive cost to employer • Market consistent valuation • Low interest environment • Poor asset returns • Unwieldy • Fail to meet employer needs • Fail to meet employee needs • Conflicts of interest • plan sponsors, members and trustees.

13. US Private Sector DB membership

14. Why not DC?

15. Why not DC? • Levels of public confidence and understanding of DC are too low; • Individuals are unable or unwilling to choose appropriate funds; • Investment strategies offer little or no protection; • Funds are too volatile in the pre-retirement phase; • Decumulationoptions lack clarity and in many cases are not fit for purpose. Source: “Improving the design of retirement saving pension plans”. OECD

16. Why not DC? • Defined contribution pensions are not fit for 21st century lives. • The risk of buying at the wrong time, choosing the wrong annuity or failing to find the right rate could increase the number of poorer pensioners by many millions. • Pensioners taking on "the biggest gamble" of their lives when they buy an annuity • Require people "to be able to cope with risks that they do not really understand". • 72% of people would be more likely to save into a pension if it guaranteed a level of retirement income. Source: Pensions – Time for Change, Altmann

17. Illustration of DC Benefits • Assume 30 years in plan. • Salary fixed in real terms at $50,000 in 2011 • Median US salary • Invested 100% in S&P • 2% MER • Converted to 20-year annuity at long bond rates. • Retire at end year 1999-2011 • Target 65% replacement ratio

20. Hybrid Pensions

21. Cash Balance (CB) Pensions • 12 million in CB plans in USA • Looks like DC • contribution (% of salary) paid into participant’s account • account accumulates to retirement • lump sum retirement benefit • withdrawal benefit =account value (after vesting) • Regulated like DB • Participant accounts are nominal

22. Crediting Rates • Participant’s account accumulates at specified crediting rate. • For example • Yield on 30-year government bonds • Yield on 10-year government bonds • Yield on 5-year government bonds + 25bp • Yield on 1-year government bonds + 100bp • Fixed rate, eg 5% p.y. • CPI rate

23. Why CB? Promotional Literature, 1985: • The company's contribution is clear-cut and easily understood • A 5% of pay plan might require a contribution of only 4% of pay • Tangible, comprehensive benefits mirror DC plans Source: Kwasha Lipton, quoted in Gold (2001)

24. Framework, assumptions, notation • Participant with n years service at valuation date. • At valuation t=0. • Retires at T with n+T years • Ignore exits, annuitization. • Value future benefit arising from past contributions • Use market valuation methods • Valuation factor = Value per $1 of nominal contribution.

25. Framework, assumptions, notation • denotes the participant’s fund at • , denote the crediting rates at • denotes the -year spot rate at • denotes the short rate at • denotes the price at of a $1, -year zero coupon bond.

26. The Valuation Formula • We let That is • V(t,T) = market value at t of CB benefit at T • per $1 of nominal fund at t • No exits • No future contributions • With continuous compounding

27. Fixed crediting rate • Suppose is constant, =, say • Then • The T-year zcb price p(0,T), is known at t=0

28. Crediting with the short rate • Suppose the crediting rate is the short rate plus a fixed margin • That is , then

29. Crediting with k-year spot rates • Crediting with • We need a market model for • We use one-factor Hull-White / extVasicek model

30. Crediting with k-year spot rates

31. Crediting with spot rates, 2013 yield curveα=0.02, =0.006

32. V(0,20)

33. V(0,20)

34. V(0,20)

35. V(0,20)

36. V(0,20)

37. V(0,20)

38. T=10-years

39. T=5-years

40. CB Comments • The CB benefit isn’t as simple as we thought • The costs are not as cheap or stable as we thought • Long rates and constant rates produce more cost volatility than short rates. • Most common crediting rate is 30-year bond rate • Long rates are less volatile than short

41. CB Comments • High costs were not created by 2008 crisis • Funding methods allow liability valuation to be less than the aggregate accounts • Risk to benefit security • Inequities and perverse incentives • Managing the long rate guarantees is not easy • Easy (but costly) to manage fixed and short rates.

42. Target Benefit Pensions • A DC plan which looks like a DB plan • Details sketchy… • Er and Ee contribute based on cost of target benefit. • Er contribution fixed (per $ of payroll) • Ee contribution varies to meet target • Assets comingled • May maintain “surplus” or “deficit”  intergenerational issues. • May be regulated on surplus/ deficit

43. Target Benefit Pensions • Brown proposes 10% joint contribution for 65% RR target. • Cf DC example • Employer cost fixed • Employee cost varies • “Target benefit is expected, not guaranteed” • What do we mean here by “expected”?

44. Target Benefit Pension • Example 1: • 5% employer contribution; 5% target employee contribution • 20% max employee contribution (25% total) • Fixed interest rates • TRR 60% • 10000 simulations, lognormal returns (µ=0.07,=0.15) • Three year smoothing of asset returns and additional contributions.

45. TBP Example: Simulated total contributions

46. TBP Example:Distribution of Replacement Rates

47. TBP Example 2 (Sanders, 2010)

48. TBP Comments • With no smoothing: • Volatile ee contributions • Uncertain benefits • With smoothing • Aggregated intergenerational transfers • Uncertain benefits • Other issues • Comingled fund  risk management problems • Adjustment to pensions in payment

49. DB Underpin • Also called “Floor Offset” • Main benefit is DC • Guaranteed minimum DB benefit. • Example • 12% DC contributions invested in balanced fund • DB minimum = 1.5% FAS py of service • At retirement, compare annuitized DC with DB • Additional fund supports makeup benefit

50. Defined Benefit Underpin = Floor Offset • DC benefit with a DB guarantee • Wilfred Laurier University, Xerox (Bodie et al, 1988), York University • McGill (recently closed) Historically, only a very small percentage of retiring McGill Pension Plan members have required a supplement to bring their pension up to the minimum. However, this statistic could be quite different in the event of a prolonged market decline. From the McGill University Pension Guide for Members, 2007