Reading 4.3 Flashcards
Pension plans are also referred to as
pension schemes or superannuation plans
World’s 15 Largest Pension Plan Sponsors (2022)
Pension funds offer 4 main advantages over individual investor retirement savings in self directed plans:
- Monitoring - Pension funds can hire trained staff and external managers to monitor the investment portfolios.
- Economies of scale - large pension funds to more easily meet minimum investment requirements of alternative investments and to negotiate preferential terms
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Pooling longevity risk
* Individual investors and pension plans face longevity risk (i.e., risk of individuals living longer than expected), which may result in individuals outliving their resources and thus needing retirement benefits to last for longer than expected. However, pension plans can base future benefits on the average of their pool of beneficiaries. Pooling longevity risk enables pension plans to allocate more to illiquid assets to earn an illiquidity premium. - More predictable longevity risk (more predictable when averaged over a large number of employees)
- Pension plans can make long-term investments, often with asset allocations based on the average company employee’s age. However, when individual investors make retirement investments, their asset allocations become more conservative over time as the investors near retirement and are less able to endure and recover from investment losses. This provides an advantage to pension funds.
There are 3+1 basic types of pension plans:
1) defined benefit (DB),
2) governmental social security plans
3) defined contribution (DC).
4) hybrid plan = cash balance plan
What is a cash balance retirement plan?
The employer still takes on some risk by determining a formula for benefits (like DB), but employees have more visibility into their projected retirement savings through the hypothetical individual account tracking (like DC).
3 APPROACHES TO MANAGING ASSETS IN DEFINED BENEFIT PLANS
1) Asset focused risk management
- Measures risk as volatility of asset returns only.
- Aims for maximum expected return within risk tolerance and liquidity needs.
- Treats cash as riskless.
2) Asset-liability risk management
- Measures risk as volatility of the plan surplus (assets minus liabilities).
- Prefers assets positively correlated with liabilities (reduces surplus volatility).
- Cash is not necessarily risk-minimizing.
3) Integrated asset-liability risk management
- Considers both plan funding and firm operations.
- Prefers assets with negative correlation between (surplus volatility) and firm profitability.
- Analyzes risk through firm’s market value and operating assets/liabilities.
There are 4 key factors that affect the value of a plan’s liabilities:
- Interest rates - most important factor that affect liability values: changes in interest rates affect the discount rate used to determine the present value of future obligations.
- Inflation - depends on how much inflation affects benefits. For instance, pension benefits are indirectly tied to inflation via salaries (since salaries, to which benefits are tied, tend to increase with inflation) or may be directly tied to inflation through cost of living adjustments.
- Retirement cycle - requires modelling of data to include the ages of a firm’s employees, its retirement policy, and the number of employees likely to retire in the future. However, some factors may be difficult to predict, such as changes in the economic environment, the number of future employees and their tenure at the firm, if the firm reduces staff in a recession, or if employees leave for other employment in strong economic periods.
- Mortality rate
Five key factors that affect the risk tolerance level of pension plan sponsors:
- Funding status
* Plan sponsors with underfunded DB plans with large deficits tend to have less risk tolerance.
* Despite this, underfunded plans are not always less risky. A plan’s risk level depends on the sponsor’s risk tolerance and objective. For instance, the sponsor of a slightly underfunded plan with low risk tolerance has to assume some risk if its objective is to improve the plan’s funded status by earning a return greater than the liabilities’ growth rate. - Plan size
* Sponsors with large plan liabilities relative to the size of their assets have high risk tolerance. - Expected future contributions relative to employer’s free cash flows
* Sponsors with large expected future free cash flows compared to projected contributions needed to cover obligations have higher risk tolerance, while those with relatively small future free cash flows have less risk tolerance. - Sponsor’s financial position
* Sponsors with little debt tend to have more tolerance for risk, even considering it beneficial to issue debt to contribute to the fund. In contrast, sponsors with high debt-to-equity ratios have less risk tolerance due to exposure to business fluctuations and being unable to issue debt. - Employees’ characteristics
* Sponsors with younger employees tend to have more tolerance for risk (e.g., surplus risk), since they have more time to overcome shortfalls in fund assets. In contrast, employers with aging employees tend to have less tolerance for surplus risk and for liquidity risk (where the latter is due to sponsors with aging employees needing more liquidity).
Many DB plans use a simple strategic asset allocation approach that divides the portfolio into two buckets:
1) hedging bucket - constructed to simulate the liabilities’ growth and aims to
reduce the volatility of the fund’s surplus.
- It involves allocating to assets with returns that are negatively correlated with interest rates, positively correlated with the inflation rate, and positively correlated with increased longevity in the population.
2) growth bucket - composed of investments that are expected to outperform the plan’s liabilities, thus reducing the sponsor’s future contributions to the fund. The allocation size depends on the sponsor’s propensity to assume surplus risk
In the asset-liability framework, the hedging bucket may be constructed in three ways
i. Duration matching approach - constructed such that its duration matches that of the liabilities.
► This approach is easy to implement. However, the portfolio must be monitored and rebalanced since changes in the yield curve and credit spreads affect the duration of assets.
ii. Cash flow matching approach - constructed such that its expected future cash inflows match its expected liability cash outflows at each future time.
► This approach is more difficult to implement than duration matching since
instruments to match cash flows at each future point in time may not be available. For instance, extremely long-term zero-coupon bonds needed to match long-term liabilities may be unavailable or expensive to create using strips (i.e., principal only securities created by separating a bond’s principal and interest).
iii. Overlay approach - constructed using financial derivatives. Use of derivatives may result in leveraged positions, which increase the risk of the portfolio.
► A potential advantage of the overlay approach is that the hedging bucket may be created without having to sell some of the growth bucket. For instance, the fund can enter into an interest rate swap to receive a fixed interest rate in exchange for a variable rate, and will benefit if interest rates decrease (since this increases the value of the liabilities). If the plan sponsor can maintain its allocation to the growth bucket, it may benefit from outperformance of the growth portfolio.
With greater risk tolerance, sponsors may have two options.
i. Allocate more of the portfolio to the growth bucket.
► In this case, the growth bucket’s risk is held constant.
ii. Allocate more of the growth bucket to less liquid, riskier assets (e.g., private equity or hedge funds with long lock-ups) to capture higher return.
► In this case, the relative sizes of the hedging and growth buckets are maintained.
What is the retirement income-replacement ratio?
The employee’s pension benefit relative to final salary
Example: it is 60% (= $60,000 - benefit /$100,000 - last salary).
What is a Defined benefit (DB) plan?
Employer-sponsored retirement plan in which employee benefits are determined using a formula based on factors such as salary and years of employment.
Non Portable benefit plan definition and 3 implications
Def: that benefits earned at one company cannot accrue at another company.
Implications:
1) Individuals who spend their entire careers with one employer are rewarded with more DB retirement benefits than those who exercise job mobility and work for multiple employers with DB plans
2) Heirs of employees who die before retirement receive no benefit payments from DB plans.
3) Many firms have vesting periods of 5-10 years before employees can earn retirement benefits, which means that employees must work for the entire vesting period before they qualify for retirement benefits. This exacerbates the issue with lack of portability of DB plans.
In planning for future benefit payments to employees, employers need to reserve assets on a yearly basis. Therefore, employers with DB plans need to estimate the value of their liabilities.
This involves making a number of assumptions about the 4 following factors:
1) Employee turnover and length of service at date of separation
2) Average wages at retirement (which requires current wage, estimated retirement age, and annual wage inflation until retirement)
3) Assumed age of death (since benefits are paid from retirement age to the age of death)
4) Number of current employees, future employees, and their ages
Pension fund liabilities may be categorized as 2 types:
1) Accumulated benefit obligation (ABO) - This is the present value of benefits accumulated by employees and retirees. For a young company, the ABO may be small and relatively easy to calculate, since the number of employees, their tenure, and average salary are all known.
Future wage increases and average employee lifespan are estimated.
2) Projected benefit obligation (PBO) - This is the present value of benefits assumed to be paid to all future retirees. The PBO is more challenging to calculate since the number of future employees, employee turnover, future wage levels, and years of service are unknown.
► The PBO also changes over time: as corporate bond yields (used to determine the present value of benefits) increase, the PBO declines; as bond yields decrease, the PBO increases.
The primary differences between the ABO and PBO are based on 2 things:
- If the firm has current employees, the ___ is always less than ___.
- In a new firm and with young employees, the ___ may be much smaller than the .
- In a mature firm with older employees and numerous retirees, the ___ will have similar magnitude to the ___.
1) current versus future salaries
2) years of employee service
ABO & PBO
ABO & PBO
ABO & PBO
The change in PBO value may be approximated as (formula):
(similar to a short position in corporate bonds)
% Change in liabilities = - Modified duration x Change in yield
A pension plan’s funded status is a measure of its …
assets compared to its PBO or ABO (expressed in terms of currency or percentages)
What is a pension surplus?
Fully-funded plans are ___% funded.
1) (i.e., assets in excess of PBO liabilities).
For instance, an overfunded plan may be described as being 2 million euros overfunded or as having assets that are 110% of its PBO.
* Underfunded plans have assets that are less than their liabilities. For instance, a plan may be $3 million underfunded; or if its assets are 80% of its PBO, it is 80% funded or 20% underfunded.
2) 100%
Distribution of Investment Return Assumptions (table) in 2022
Average Assets Allocated to Alternative Investments by Institutional Investors (2021)
Retirees can estimate their exposure to longevity risk using data on their retirement funds, the cost of living, and mortality tables. A retirement fund’s expected economic life EL (in years) may be approximated by (formula):
The present value of a growth annuity may be expressed as (formula):
