1. Variable Annuity Plans Allocation of Risks in Hybrid Pension Plans Florida GFOA Webinar Series June 19, 2014 Donald E Fuerst, Senior Pension Fellow American Academy of Actuaries James J. Rizzo, Senior Consultant and Actuary Gabriel, Roeder, Smith & Company 1

2. There has been a debate swirling around corporate and governmental employers for decades as to which is better: – Defined benefit (DB) retirement plans, or – Defined contribution (DC) retirement plans A hybrid plan is a good alternative resolution to the DC - DB debate But let’s defined the terms first by examining their characteristics DB Plans and DC Plans 2

3. Traditional Defined Benefit (DB) plans – Benefits paid are defined by formulas and rules – Contributions by the employer are actuarially determined – Pension plans usually pay monthly pensions for life – Like the pension part of FRS – Like local police and fire pension plans – Like Social Security Traditional Defined Contribution (DC) plans – Employer contributions are defined by a formula – Account balance plans that credit interest equal to the actual earnings of underlying investment assets – Like the Investment Plan part of FRS – Like 401(k) plans in the private sector – Like so-called 401(a) plans and 457 plans in the government sector DB vs. DC Debate 3

4. 1.Individual Account Balances 2.Account Interest Credited 3.Investment Risk and Reward* 4.Predictability of Contributions* 5.Unfunded Actuarial Accrued Liability* 6.Retirement Planning* 7.Longevity and Other Risks* 8.Benefit Skew* 9.Form of Benefit* 10.Portability 11.Vesting 12.Funded Status 13.Operational Expenses* 14.Education and Communication * Most important distinctions Distinguishing Features 4

5. DB vs. DC Comparison 5

6. 6

7. Consider a hybrid plan as: – An alternative to traditional DC and DB plans – A creative solution – Out-of-the-box thinking Hybrid Plans 7

8. A hybrid plan is a single plan that has some features of a DB plan and some features of a DC plan An arrangement with side-by-side DB and DC plans – Two separate plans – This arrangement is not really a hybrid plan – Although some people use the term “hybrid” when describing a side- by-side DB and DC – But consider a Toyota Prius – gasoline and electric in one car Two broad types of hybrid plans 1.Cash Balance Plans 2.Variable Annuity or Variable Benefit Plans Hybrid Plans 8

9. 2.Variable Annuity or Variable Benefit – “Looks” a lot like a DB plan Lifetime pensions paid Rewards long-service employees – Monthly benefit amount varies (up and down) depending on certain trigger points built into the plan design Investment Trigger -- Benefits change or vary (up and down) depending on level of investment returns, OR Employer Contribution Trigger – Benefits change or vary (up and down) depending on the level of employer contributions otherwise required Hybrid Plans 9

10. 2.Variable Annuity or Variable Benefit (continued) – Investment Return Trigger – Some designs (e.g., Variable Annuity Plan) index the benefit earned for the year to retirement date using unit values based on investment returns – higher indexing for higher returns; lower indexing for lower returns. Other designs can change the multiplier for the current year depending on investment returns for the year - higher multipliers for higher returns; lower multipliers or zero for lower returns. Still other plan designs pay additional “dividends” on benefits for higher returns. Hybrid Plans 10

11. 2.Variable Annuity or Variable Benefit (continued) – Employer Contribution Trigger – The multiplier changes in order to keep the employer contribution predictably within a pre-set corridor – higher multiplier if employer contribution would be low; lower multiplier if employer contribution would be high Some designs can change the multiplier only for that year of trigger, while others change it retroactive to plan start date Some designs can retain the final average earnings concept instead of a career average (or career accumulation) earnings found in most investment trigger variable annuity hybrids or all cash balance hybrids Hybrids Plans 11

12. Hybrid Features 12

13. Hybrid Features 13

14. Hybrid Features 14

15. Hybrid Features 15

16. Primary motivations for moving from DB to DC plans 1.“The corporate world has moved from DB to DC plans.” 2.“ We got rid of our DB plan where I work(ed).” 3.“I never had a DB plan; neither should they.” 4.“ The conservative think-tanks and legislatively active organizations say we should move to a DC plan.” 5.“My political party leaders say DB plans are bad.” 6.“DB plans are more dangerous than DC plans in the hands of politicians.” 7.“I don’t trust elected officials to stand up against the unions; they often grant retroactive benefit improvements in DBs.” 8.“Employer contributions to our DB plans have become unbearably and unreasonably high.” 9.“Employer contributions need to be more predictable.” 10.“Employer (taxpayers) should not bear the investment risk.” Hybrids Plans 16

17. Management and elected officials sometimes START with the “position” of advocating DC plans over DB plans Consider moving the dialogue from “positions” to “interests” or “principles” Identify the underlying interests of the parties and resolve the matter with solutions and proposals: – That appeal to their “interests”, rather than – Fight their positions Positions vs. Interests 17

18. Variable Annuity Plan (VAP) A pension plan where the annual pension benefit fluctuates (both before and after retirement) with the performance of investment funds Advantages for the employer: – Financial predictability: stable cost, little or no unfunded liabilities – Retention: allocates benefits to long-service employees Advantages for the employee: – Provides lifetime income – employee can’t outlive assets – Portable benefit, potential inflation protection 18

19. Career accumulation plan Benefit credit is converted to variable annuity units at year- end purchase price of the units Units accumulate throughout an employee’s career – Each year employee participates in the plan, more benefit credits are earned that are converted to “variable units” at the end of the year At NRD employee receives an annual retirement income based on number of “variable units” accumulated Annual income in retirement for each unit is the unit value at the end of the previous year Variable Annuity Plan 19

20. Variable Annuity Plan Basic benefit formula is a traditional career average formula – Example: 1% of pay – Formula is applied to actual pay each year – Benefit is annual annuity at normal retirement age Participant earns $50,000 Participant accrues a benefit = $500/year payable at 65 The benefit is used to “buy” variable units at year-end unit value – Example: Variable unit value = $10 – $500 benefit buys 50 variable units 20

21. Variable Annuity Plan A variable unit is the right to an annual pension benefit equal to the unit value beginning at NRD Participant’s 50 units would generate $500/year at retirement if the unit value remains $10 – If unit value increases to $11, 50 units would generate $550/year at retirement – If unit value decreases to $9, 50 units would generate $450/year at retirement If unit value increases by average 2%/ year for 25 years – Unit value is $16.41 when Participant retires at age 65 – 50 variable units earned when age 40 then generate $820.50 annual pension income Unit value can continue to fluctuate during retirement – If the value falls 1% to $16.25 during first year of retirement, benefit in year 2 will decline to $812.50 21

22. Units earned5045484345 Accumulated units5095143186231 End-of-year unit value$10.00$11.00$10.50$11.50$11.00 Year-end pension income $500$1,045$1,502$2,139$2,541 Example 22

23. Variable Annuity Plan Unit Value Determination Initial unit value can be any value Unit value fluctuates annually based on the actual return of the pension fund (for the previous year) relative to a benchmark rate called the hurdle rate If assets earn more than hurdle rate, unit values are increased If assets earn less than hurdle rate, unit values are decreased For example, if hurdle is 5% and assets earn 8% (or 2%), unit values increase (or decrease) approximately 3% VAP is equivalent to the plan sponsor funding a fixed annuity determined at an interest rate equal to the hurdle rate – Investment experience above or below the hurdle rate is passed through to the participant through a change in the unit value 23

24. Variable Annuity Plan Unit Value Changes Formula for Unit Value to pass all investment gains or losses to participant is: UV t = UV t-1 x (1 + i t ) / (1 + h) where i t is the actual return during the period t-1 to t and h is the hurdle rate 24

25. Variable Annuity Plan Hurdle Rate The hurdle rate is a plan provision, not an actuarial assumption, although sometimes referred to as assumed interest rate or AIR Hurdle rate is a critical component of plan design – Higher rate lowers plan costs, but increases the likelihood that participants’ benefits will decrease – Lower rate increases plan costs, but increases the likelihood that participants’ benefits will increase – Setting the hurdle rate at (or a little above) a reasonable risk-free rate of return enhances certain features Minimum permissible hurdle rate is 3% Plans with hurdle rate < 5% are subject to statutory hybrid rules (private sector concern) 25

26. Service Cost Changes with Hurdle Rate 26

27. Can Retirees Handle Volatility? Most common objection to VAP is that “retirees need guaranteed benefits, cannot accept declines” Actual experience of VAPs tells a different story Consider actual VAP experience for 50+ years 27

28. Variable Annuity Unit Value (1961-2013) Back to back declines three times in 50 years: 1973-74: 32% Recovered 92% in 2 years, 100% in 6 2000-01: 18% Recovered 100% in 2 years 2008-09: 17% Recovered fully in 2013 28

29. Variable Annuity Unit Value Effect of Changing AIR Back to back declines three times in 50 years: 1973-74: 34% Recovered 88% in 2 years, 100% in 8 2000-01: 20% Recovered 100% in 3 years 2008-09: 19% Still 4% under peak value 29

30. Variable Annuity Plan VAPs compare favorably to traditional DB plans in several respects: Benefits are comparable to Final Average Pay plans Benefits are more portable than Final Average Pay plans Benefits provide potential inflation protection Variations of VAP offer participant ability to manage risk exposure 30

31. Comparison to Final Pay Plan FAP Benefit Formula = 1% of Final Average Pay for each year of service RSP Benefit Formula = 1% of Annual Pay, Assumed Interest Rate = 4% Average pay increases over career = 3% Retire at 65 with 30 years Service Benefit expressed as Percent of Final Average Pay Average Investment ReturnFAP BenefitVariable Benefit 5%30%24.3% 6%30%27.7% 7%30%31.8% 8%30%36.7% 31

32. Variable Annuity Plan Portability Variable units continue to appreciate for terminated vested participants Benefits continue to grow with investment experience, unlike traditional pension benefits Participants are not harmed by changing employment as in a final pay plan Benefits are not paid in lump sum or rollover, thus preventing leakage EBRI study indicates as much as 60% of early distributions are not rolled over 32

33. Variable Annuity Plan Portability 33

34. Purchasing Power of Level Benefit of $1000 Per Month with 2.5% Inflation 34

35. Variable Benefit versus Purchasing Power (1961-2012) Purchasing power based on CPI-U from BLS 35

36. Other Design Issues Adjustments for early retirement or optional forms of payment can be made by adjusting the number of units – Similar to adjustments made to traditional plan benefits for these items – Can subsidize early retirement, if desired 36

37. Conflict in Variable Benefit Plan Young participants want to see growth in benefit values, temporary volatility is of no concern Retired participants may want stability of current income Trustees are fiduciaries, investing assets on behalf of all participants But participants have conflicting interests What are fiduciaries to do? 37

38. Variable Annuity Plan Investments Each unit represents a sub-account of the pension trust Stable Units: High-quality short- to-intermediate term fixed income securities. Diversified Units: Generally, an actively managed fund where plan sponsor selects the investment managers and asset allocation. Higher potential return than Stable Shares but more volatile. 38

39. Variable Annuity Plan Participant choice is possible Each unit fund represents a sub-account of the pension trust Stable units: High-quality short-to-intermediate term fixed income securities. Equity units: 100% equity investment, actively managed or an index fund. Diversified units: Generally, an actively managed fund where plan sponsor selects the investment managers and asset allocation. Less risky than Equity units. Other variations are possible: - More/less classes of shares - Different classes of shares (e.g. Lifecycle shares) 39

40. Participant Choice Employees can structure the risk/reward of their retirement portfolio based on their own circumstances and tolerance levels Participants elect once per year which class(es) of shares they wish to purchase at year-end Could purchase just one type of share or all three share classes Also can exchange or reallocate any shares previously earned Statement sent in first quarter of following year shows the results of the share purchase and/or exchanges 40

41. How Do You Get There? Conversion from existing DB Plan – Simplest approach is to freeze current plan benefits VAP unit balance begins at zero and grows Ultimate retirement benefit is: frozen old-plan benefit plus benefit from RSP Risk due to the old frozen plan benefits still exists under this approach – Other approaches, including converting accrued benefits, are possible Can significantly reduce the risk associated with prior accrued benefits quickly and cost effectively Integrating VAP into existing DC Plans as payment form 41

42. Conversion Less Harmful to Older Workers 42

43. Variable Annuity Plan Asset Driven Liabilities In traditional DB plans, matching assets and liabilities requires continual rebalancing of portfolio In VAP, assets and liabilities are always matched Benefits are portable Design can mimic final pay benefits Potential for purchasing power protection in retirement Unfunded liabilities (surpluses) are less likely – Arise from demographic experience – Usually smaller in magnitude 43

44. Driving principles/interests from City Council – Roll back future benefits to bend the cost curve soon – Future benefit levels should be adequate and competitive – Share risks between employees and employer – Make employer contributions more predictable Case Study: City of Ocala GE 44

45. Bend the expected cost curve – Changing benefits for new hires alone will take a very long time to bend the expected cost curve So putting in a DC plan for new hires alone won’t do much soon enough Putting in a new DB formula for new hires alone won’t do much either – Must change benefits for all employees (current and new) in order to bend the expected cost curve in a reasonably short time Either all in a DC or All in a less generous benefit structure for future service Case Study 45

46. Bend the expected cost curve (continued) – Not permitted to roll back future benefits earned by current active employees eligible for normal retirement – Not permitted to roll back benefits retroactively, i.e.: Not permitted to cut benefits for current retirees and beneficiaries Not permitted to cut accrued benefits below what active employee have earned so far Case Study 46

47. Bending the expected cost curve (continued) – Freeze the benefits for current actives at what they earned as of the transition date; call it Part A – Start the new and less generous benefit structure for future service; call it part B – Final benefit is Part A plus Part B – Grandfather current active employees within five years of Normal Retirement Date Case Study 47

48. Make the employer contribution more predictable... By sharing the risk with employees. – Moving to a DC plan for new hires alone will take a very long time to share the risk – Not permitted to share the risk with current retirees or with current active employees eligible for normal retirement – Not permitted to share the risk on benefits earned at transition Part B benefit structure is the hybrid plan design – Part B monthly projected benefit can go up or down, depending on the trigger mechanism (total contributions), thereby sharing the risk and reward – Part A monthly benefit is fixed and frozen at the transition date Case Study 48

49. Case Study 49

50. Case Study Without a VBH feature in the legacy DB plan -- It will take over 40 years to reach a 50-50 risk-sharing with employees; in 20 years City/taxpayers still bear 85% of investment risk 50 City/taxpayers Bear 100% Risk Employees Bear 100% Risk

51. Consider DC, cash balance, variable annuity plans – Implemented for benefits earned in the future – Even if covering current employees’ future service and new hires Most do nothing about the massive legacy obligations of Part A – No risk sharing – Costs still unpredictable Ocala’s variable benefit hybrid design did – The employer and employee share the risks (for the legacy Part A) – The total costs (for Part A and Part B combined) are more predictable Case Study 51

52. Part B starts out with a 1.6% multiplier, like FRS Regular Class – Multiplier can go up, but not above a cap of 2.55% and – Multiplier can go down, but not below a floor of 1.0% -- – Depending on the level of the actuarially required contribution. – As long as the actuarially determined contribution (ADC) stays within a pre-set employer contribution budget, the multiplier remains unchanged; improves predictability – Makes the employer contribution more predictable Case Study 52

53. If the ADC were to go above the top of the budget corridor: – The multiplier is reduced in order to keep the ADC inside the corridor – Employee bears the risk above the corridor. If the ADC were to go below the bottom of the budget corridor: – The multiplier is increased in order to keep the ADC inside the corridor – Employee reaps the reward below the corridor Makes the employer contribution more predictable by sharing the risk (and reward) with the employee Case Study 53

54. Case Study With a VBH Feature: Budget Corridor 54

55. Circular 230 Notice: Pursuant to regulations issued by the IRS, to the extent this presentation concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual’s circumstances from an independent tax advisor. This presentation shall not be construed to provide tax advice, legal advice or investment advice. Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation. This presentation is not an expression of the views of FGFOA, or Gabriel, Roeder, Smith & Company, or the American Academy of Actuaries and may not even express the views of the speakers. Disclaimers 55

56. Contact Information Donald E Fuerst, Senior Pension Fellow American Academy of Actuaries 202-785-7871 fuerst@actuary.org James J. Rizzo, Senior Consultant and Actuary Gabriel, Roeder, Smith & Company 954-527-1616 Jim.Rizzo@gabrielroeder.com 56

57. Questions and Answers ? 57