1. 1/59 RISKS AND REWARDS IN HYBRID PENSION PLANS Mary Hardy Statistics and Actuarial Science Université Laval March 2014

2. 2/59 Outline 1. Background 2. Why not Defined Benefit? 3. Why not Defined Contribution? 4. Hybrid Pensions a) Cash Balance b) Target Benefit c) Floor Offset (DB Underpin) 5. Concluding Comments Université Laval March 2014

3. BACKGROUND Université Laval March 2014 3/40

4. 4/59 Employer Perspective - Benefits  Why do employers sponsor pension plans?  Recruitment  Retention  Facilitate turnover of older employees  Tax-efficient remuneration  Industrial relations  Altruism Université Laval March 2014

5. 5/59 Employer Perspective - Risks  Variable costs  Plan fails to meet recruitment/retention/retirement objectives  Regulatory risk  Industrial relations risk  Deficit induced crises  Surplus induced crises Université Laval March 2014

6. 6/59 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 Université Laval March 2014

7. 7/59 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? Université Laval March 2014

8. WHY NOT DB? Université Laval March 2014 8/40

9. 9/59 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. Université Laval March 2014

10. 10/59 Université Laval March 2014

11. 11/59 Université Laval March 2014

12. 12/59 Université Laval March 2014

13. 13/59 US Private Sector DB membership Université Laval March 2014

14. WHY NOT DC? Université Laval March 2014 14/40

15. 15/59 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;  Decumulation options lack clarity and in many cases are not fit for purpose. Source: “Improving the design of retirement saving pension plans”. OECD Université Laval March 2014

16. 16/59 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. Université Laval March 2014 Source: Pensions – Time for Change, Altmann

17. 17/59 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 Université Laval March 2014

18. 18/59 Université Laval March 2014

19. 19/59 Université Laval March 2014

20. HYBRID PENSIONS Université Laval March 2014 20/40

21. 21/59 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 Université Laval March 2014

22. 22/59 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 Université Laval March 2014

23. 23/59 Why CB? Promotional Literature, 1985: o The company's contribution is clear-cut and easily understood o A 5% of pay plan might require a contribution of only 4% of pay o Tangible, comprehensive benefits mirror DC plans Source: Kwasha Lipton, quoted in Gold (2001) Université Laval March 2014

24. 24/59 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. Université Laval March 2014

25. 25/59 Framework, assumptions, notation Université Laval March 2014

26. 26/59 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 Université Laval March 2014

27. 27/59 Fixed crediting rate Université Laval March 2014

28. 28/59 Crediting with the short rate Université Laval March 2014

29. 29/59 Crediting with k-year spot rates Université Laval March 2014

30. 30/59 Crediting with k-year spot rates Université Laval March 2014

31. 31/59 Crediting with spot rates, 2013 yield curve α=0.02,  =0.006 Université Laval March 2014 V(0,T); 2013 YC Crediting RateT=5T=10T=20 30-yr1.1681.2351.380 20-yr1.1301.1891.361 10-yr1.0951.1061.230 5-yr+0.25%1.0731.0911.177 1-yr+1.0%1.0621.1201.250 ½-yr+1.5%1.0831.1701.366 short+1.75%1.0911.1911.419 5% fixed1.2291.3401.562

32. 32/59 V(0,20) Université Laval March 2014

33. 33/59 V(0,20) Université Laval March 2014

34. 34/59 V(0,20) Université Laval March 2014

35. 35/59 V(0,20) Université Laval March 2014

36. 36/59 V(0,20) Université Laval March 2014

37. 37/59 V(0,20) Université Laval March 2014

38. 38/59 T=10-years Université Laval March 2014

39. 39/59 T=5-years Université Laval March 2014

40. 40/59 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 Université Laval March 2014

41. 41/59 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. Université Laval March 2014

42. 42/59 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 Université Laval March 2014

43. 43/59 Target Benefit Pensions  Brown proposes 10% joint contribution for 65% RR target.  Cf DC exampleexample  Employer cost fixed  Employee cost varies  “Target benefit is expected, not guaranteed”  What do we mean here by “expected”? Université Laval March 2014

44. 44/59 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. Université Laval March 2014

45. 45/59 TBP Example: Simulated total contributions Université Laval March 2014

46. 46/59 TBP Example: Distribution of Replacement Rates Université Laval March 2014 Quantiles 5%10%50%90%95% 30.8%35.4%57.1%98.9%117.9%

47. 47/59 TBP Example 2 (Sanders, 2010) Université Laval March 2014

48. 48/59 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 Université Laval March 2014

49. 49/59 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 Université Laval March 2014

50. 50/59 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 Université Laval March 2014

51. 51/59 Value of Accrued DB Underpin  Accrued benefit value at t, retire at T  Past service  Current salary  A T is the only random term at t  This is a European put option – use Black Scholes Université Laval March 2014

52. 52/59 Hedging the Accrued DB Underpin  Use Black Scholes  Long position in T-year zero coupon bonds  Short in DC fund assets  No allowance here for interest rate risk  Contributions pay for  Additional service  Salary increase  Discrete hedging errors  Model errors Université Laval March 2014

53. 53/59 DB Underpin Contribution rates: Entry age 35, varying accrual rates, 12% DC plan Université Laval March 2014

54. 54/59 DB Underpin Comments  Average additional contribution ~ 2% with 12% DC plan  Risk management is feasible, but challenge from  Basis risk  Interest rate risk  Annuity cost risk  True hybrid plan  Manages downside without funding excessive upside Université Laval March 2014

55. 55/59 Summary  DB is not working for large part of private sector  Volatile contributions  Cannot rely on equity premium  Volatile solvency valuations  Small benefit in recruitment  DC is not working for large numbers of workers  Volatile and uncertain benefits  Individuals lack expertise  Lump sum payouts Université Laval March 2014

56. 56/59 Summary  Cash Balance is not the solution for employers or employees  Volatile employer contributions  Uncertain future benefit  Based on flawed premise  Relying on equity premium to fund fixed type benefits  No pooling of longevity  Tricky risk management (in some cases) Université Laval March 2014

57. 57/59 Summary  Target benefit plans are not the solution for employees (and maybe not employers)  Volatile contributions  Uncertain benefits  Surplus /deficit rules create employer risk  And intergenerational inequity  Risk management compromised by comingled funds. Université Laval March 2014

58. 58/59 Summary  DB-underpin may be a solution  Focus on safety net  Risk management is well understood from option theory  Cost is manageable (but sensitive to salary)  Intergenerational transfer appropriate  But  Basis risk, interest rate, longevity risk remain  Constrains DC investment options Université Laval March 2014

59. 59/59 Acknowledgements  Global Risk Institute  Society of Actuaries Pension Section  Natural Sciences and Engineering Council  Co-authors: David Saunders Mike Zhu Kai Chen Université Laval March 2014