4.3 Pension funds

Question 1

Pension plans invest financial assets on behalf of employees to provide the latter with ______. A pension plan is essentially ________ earned over time through employee service.

Answer 1

Pension plans invest financial assets on behalf of employees to provide the latter with future retirement income. A pension plan is essentially deferred compensation earned over time through employee service.

Question 2

What did WTW 2020 study show was the combined value of the 15 largest pension funds?

Answer 2

Pension assets in the 15 largest pension plans totaled over $21.7 trillion.

Question 3

The World Bank has found that in high-income countries, about XXX% of the labor force will receive benefits from either a private or a government pension plan

Answer 3

90%

Question 4

Why are pension plans good for employers / employees:
For employer - (attract)
For employee - saving need, tax

Answer 4

For employer - hiring and retention of key talent is the primary reason for offering some form of employer-sponsored retirement savings plan

For employee - decrease the need for the employees to directly save themselves, and tax benefits: taxed in retirement and not in the year in which the contribution is deposited, so leads to higher accumulation potential and typically be subject to a lower marginal tax rate during retirement than during their accumulation years

Question 5

Benefit of pooled pension funds vs individual:
1. EOS - manager, fee, classes
2. liquidity
3. LR

Answer 5

1. economies of scale - so access to better managers, lower fees and alternative asset classes
2. more ability to invest in illiquid assets (to gain illiquidity premium) as there is a longer time horizon due to the pooling of mortality risk over a large number of employees (the time horizon considers the average age of the pool of employees and the mortality estimates become much more certain because of the high number of employees, whereas for the individual plan must be gradually more conservative as there is less time to recoup potential losses)
3. longevity risk reduced - risk of a retiree running out of money during their lifetime. Individual investors bear the risk alone when they have their own pension assets, but pooled pension assets spread longevity risk across all plan participants.

Question 6

Three US examples of DC plan

Answer 6

401(k), a 403(b), and a profit-sharing plan

Question 7

Who bears the risk in a DB plan?

Answer 7

Because DB plans contain an inherent guarantee that a prespecified benefit will be paid upon retirement, they shift investment risk from the employee/participant to the plan sponsor (employer).

Question 8

What is a hybrid plan? (CBP - advantage)

Answer 8

Combine elements of the DB and DC plan types. Example is a cash balance plan which is a hybrid DB plan that maintains individual account records for plan participants, showing their current value of accrued benefits. The advantage here is the ability to transfer the benefit to a new plan if the employee changes employers

Question 9

What is the retirement replacement ratio?

Answer 9

The percentage of preretirement income replaced by an income source during retirement.

Question 10

Three approaches to risk for a DB plan:
1. AF
2. AL (vol of surp, correlation)
3. IAL

Answer 10

1. Asset focused - considers only the volatility of the rate of return on the plan’s assets i.e. try to maximize expected return
2. Asset liability - considers funded status (difference between assets and liabilities: positive difference is called a pension surplus (overfunded), while a negative difference is called a shortfall/deficit (underfunded). In this approach, risk of DB plan assets is measured as the volatility of its surplus. the higher (lower) the correlation between assets and liabilities, the lower (higher) the risk. For example, an asset that has low volatility (on a stand-alone basis) but is negatively correlated with plan liabilities would have higher risk. In that regard, cash will not always be a low-risk asset.
3. Integrated asset liability - considers the plan’s funded status with the plan sponsor’s operating profits simultaneously - Because a funding shortfall will necessitate higher cash inflows from the sponsor, it is better that such a shortfall occurs when the sponsor is more profitable (there would ideally be a negative correlation between the funded status and the plan sponsor’s operating profits). Therefore, an asset with low correlation to plan liabilities might not be considered as risky if it is negatively correlated with the plan sponsor’s operating profits

Question 11

In the three approaches to risk management for DB plans (AF, AL, IAL) - how does correlation and risk tie in?

Answer 11

For asset focused, only care about volatility of the return on assets.

For asset liability, looking at the vol of the surplus, so higher (lower) the correlation between assets and liabilities, the lower (higher) the risk.

For integrated asset liability, you are looking at the plan’s funded status with the plan sponsor’s operating profits simultaneously. So an asset that has low correlation with liabilities (while in AL approach would be higher risk), would be low risk if it was negatively correlated with the plan sponsor’s operating profits

Question 12

Formula for value of a firms equity when considering the DB integrated asset-liability approach.

Answer 12

Et = OAt – OLt + (At – Lt)

i.e. operating assets less operating liabilities, with At - Lt representing the funding status of the DB plan.

Question 13

What correlation is preferable between DB plan funded status and the plan sponsor’s operating profits?

Answer 13

Would prefer to see negative correlations between the funded status and the plan sponsor’s operating profits. All else equal, plan assets that have low (high) correlations with plan sponsor operating assets and high (low) correlations with plan sponsor operating liabilities are the lowest (highest) risk for the plan.

Question 14

What four key factors that most affect the risk of plan liabilities?
1. IR
2. I
3. RC
4. MR

Answer 14

1. interest rate - interest rates directly impact the discount rate used to compute the projected benefit obligation, so this is the biggest concern. A fall in interest rates will result in a rise in future liabilities.
2. inflation - future benefits are linked to inflation, so if inflation increases, then so would future benefit payments
3. retirement cycle - trend of when participants retire and become benefit recipients, given large sample size, it is often reasonably predictable, but possibility for uncertainty such as early retirement due to business cycle declines
4. mortality rate - reasonably predictable in the short term, although concern could be declining mortality, which means increasing longevity and longer pension payouts

Question 15

What five key factors does plan sponsor need to consider when addressing its risk tolerance? (two are related to plan, two sponsor, one beneficiaries)
1. FS
2. FS
3. FC
4. FP
5. PD

Answer 15

1. funded status - under/overfunded - underfunded typically means take less risk (although may also take more if needing to make up the difference)
2. fund size (size of assets v liabilities, effectively size of surplus - higher surplus can take more risk)
3. future contributions (relative to sponsors cash flows) - if the sponsor’s future free cash flow is expected to be high (low), then the plan sponsor can tolerate more (less) risk
4. financial position e.g. as measured by expected future free cash flows and the debt-to-equity (D/E) ratio (e.g. better can take more risk)
5. participant demographics - if the pool is younger can take more risk, a. have longer time horizon to make up losses, and b. with older employees, increased liquidity requirements

Question 16

What two buckets can be used for SAA for a DB plan?
1. HB - track and minimise, what correlation with IR, inflation and population longevity? 3 instruments for this? what correlation if linked to sponsors financial position?

2. GB - allocate to, goal is to outperform the _____ and reduce need for _____.

Answer 16

1. hedging bucket - intended to track the plan’s liabilities and to minimize volatility of the fund’s surplus.
   - should have negative correlation with interest rates, positive with inflation and positive with longevity. May use long-duration bonds, inflation-index bonds, longevity derivatives. If IPS links to sponsor’s operating results, want HB to have low correlation with sponsor’s expected free cash flow.
2. growth bucket - designed to allocate surplus assets to riskier investments in hopes of enjoying more substantial returns
   goal of the growth bucket is to outperform the growth rate in plan liabilities and reduce the need for future contributions into the plan by the sponsor

Question 17

What are three hedging bucket approaches for DB plan.
1. DM
2. CFM
3. OA

Answer 17

1. duration matching - match the duration of the hedging bucket with that of the liabilities, designed to address IR risk, requires rebalancing as the duration of the hedging bucket will change over time
2. cash flow matching - matching the planned future cash inflows of the plan assets with the planned outflows of the plan liabilities (e.g. maturities line up), but difficulty may be to find assets that match the exact cash flow timing
3. overlay approach - using derivatives to create the required hedges, e.g. interest rate swaps, may be able to also increase leverage. An advantage is that plan sponsor can manage the hedging bucket without having to sell assets from the growth bucket

Question 18

What is a key negative of DB plans for employees?

Answer 18

They are not portable—they cease to accumulate upon termination of employment and may not be transferred to a new employer.
Some employers are more generous and offer vesting of pension benefits subject to specified vesting periods. An employee who leaves an employer before becoming fully vested (e.g., five years) receives fewer or no benefits.

Question 19

What about participants does plan sponsor need to consider to predict liabilities?
1. ET
2. YoS
3. ASaR
4. AAoM
5. NoE

Answer 19

1. employee turnover
2. years of service by employees
3. average salary at retirement (i.e. current salary, salary inflation and years to retirement)
4. average age of mortality
5. number of employees (and future employees and ages)

Question 20

What is ABO vs PBO?

Answer 20

The accumulated benefit obligation (ABO) is the present value of all benefits currently accrued by existing participants (active and retired). Simple calculation, although needs some assumptions (such as salary increases and average employee life expectancy).

The projected benefit obligation (PBO) is the present value of all estimated future benefits to be paid to retirees. This is ABO plus assumed future benefit accruals - much more difficult to calculate. This is used when calculating pension surplus.

Question 21

The FTSE Pension Liability Index tracks…
At end of 2009 the index was at ___%, with estimated duration of PBO liabilities at ___. At end of 2018, the yield had decreased to ____%. Compute the estimated change in liabilities.

Answer 21

The FTSE Pension Liability Index tracks corporate bond yields whose rates are used to discount future pension liabilities into the PBO calculation. At the end of 2009, the index stood at 5.98% with an estimated duration of PBO liabilities at an average 16.2. At the end of 2018, the index had decreased to 4.22%. Computing the estimated change in liabilities is done like with any fixed-income investment:

% change in liabilities = –modified duration × change in yield

Therefore, from 2009 to 2018, a PBO with a duration of liabilities of 16.2 and unchanged assumptions would have seen its liabilities increase 28.5% = –16.2 × (0.0422 – 0.0598).

Question 22

Why is DB plan now less popular in the US?
1. increased… (reporting, disclose, 7y)
2. younger

Answer 22

1. increased regulations - publicly traded corporations are now required to report the funded status on their balance sheets, requirement that funded status of DB plans must be disclosed to employees, underfunded plans must be fully funded within seven years.
2. younger workers tend to move jobs more often, which makes nonportable DB plans less attractive to them

Question 23

What are two options if sponsor of a DB plan decides to stop offering their plan:
1. f
2. t

Answer 23

1. freeze plan - no longer accrues benefits past the date of freezing, but all previously accrued benefits will still provide income in retirement
2. terminate plan - sponsor is no longer responsible for pension obligations, previously accrued benefits are either paid out to employees directly or rolled over into other financial products

Question 24

Why does a DB plan’s sponsor have conflicting objectives in allocating plan assets (risk return)

Answer 24

Sponsors want to earn the highest possible return to minimize future contributions. At same time, seek to minimize the risk of being underfunded.

Large allocations to equities and alternative asset classes may have high long-term returns but cause excessive short-term volatility for plan assets. Sponsors who truly desire to reduce volatility will increase allocations to fixed income, but the offset is lower returns, which may result in higher contributions required from the plan sponsor.

Question 25

What is LDI? (aim, example of, in practice)

Answer 25

Liability-driven investing. Example of duration matching - attempts to lower surplus risk by constructing a portfolio of assets that is highly correlated with plan liabilities.
Uses corporate bonds to form a portfolio with a duration that matches the duration of plan liabilities (same can be done with derivatives).

Question 26

What is COLA? How might sponsors hedge associated key risk?

Answer 26

Cost-of-living adjustment (COLA) - annual inflation-indexed increase in benefits during retirement.

The risk here is inflation risk, so should consider hedging that inflation risk with inflation-protected bonds, such as Treasury Inflation-Protected Securities (TIPS).

Although such bonds earn a set coupon and the principal increases with inflation, the key drawback is that their overall returns have historically been low. Therefore, an alternative inflation hedge is real assets, such as real estate and commodities, whose values typically rise with inflation over time.

Question 27

What is a key benefit of governmental social security plans? (2)

Answer 27

They are portable for the employee. They also provide benefits to an employee’s dependents in the event of death or disability during the career years

Question 28

What may be imposed by a governmental social security plan? Also what is different to employer plans (correlation/progressive).

Answer 28

A cap on benefits earned. Known as a progressive system because higher-salary employees receive benefits that are a smaller percentage of their salary compared to lower-salary employees.

In the United States, the retirement income–replacement ratio is designed to be higher for those who have lower earnings and lower for those with higher earnings. As such, the system is designed to provide more of a retirement savings cushion for those with lesser means. That differs from DB plans where income levels are positively correlated with benefits size

Question 29

In 2016, what was the global split of pension plan types?

Answer 29

49% DB, 48% DC, 3% other.
Within individual countries, some countries hold their pension assets almost exclusively in DB or in DC plans.

Question 30

Split of DB and DC in the US?

Answer 30

65% DC, 35% DB.

Question 31

With a DC plan, the employer is not subject to what?

Answer 31

The employer is not subject to surplus risk with DC plans, as the terminal value of the participant’s account is not guaranteed

Question 32

What is the name for when employer matches employees contribution to DC plan?

Answer 32

Matching contribution (up to a certain %).

Question 33

Both DB and DC plans have vesting schedules for the sponsor’s contributions - what is the key difference?
(move / die)

Answer 33

The key difference is that once fully vested, assets in a DC plan are portable for an employee who leaves the employer; they can go into the DC plan of the new employer or into a separate retirement account.
Also, because a DC account is the employee’s property, it can be passed on to the employee’s heirs (not the case with most DB plans, although some DB plans may contain provisions to pay some of the pension up to the death of the surviving spouse)

Question 34

Who bears the longevity risk with a DC/DB plan?

Answer 34

With a DC plan, investment risk and the longevity risk are borne by the employee - they may outlive the money. In a DB plan, those risks are borne by the employer.

Question 35

Who chooses the asset allocations in DB / DC plan?

Answer 35

In a DB plan, the sponsor typically chooses all the asset allocations, while in a DC plan, the sponsor provides a series of investment options from which the participant chooses all the asset allocations.

Question 36

For DC plans, what is an easy allocation solution instead of asset allocation (aligns to date of retirement)?

Answer 36

target-date fund
the process of moving from more risk to less risk follows a glide path