Session 100 PD - Pension De-risking Through Glide Paths

Moderator:

Kathleen Patrice Brolly, FSA

Presenters: Brett Brooks Dutton, FSA, EA, FCA James Michael Gannon Jr., FSA, EA

Alexander Pekker, ASA

SOA Antitrust Compliance Guidelines SOA Presentation Disclaimer

2017 SOA Annual Meeting & ExhibitMODERATOR: KATHLEEN BROLLY, FSA

SPEAKERS: JAMES GANNON, FSA, CFA, EAALEXANDER PEKKER, ASA, CFA, PhDBRETT DUTTON, FSA, CFA, EA, FCASession 100, Pension De-risking Through Glide PathsOctober 17, 2017

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Presentations are intended for educational purposes only and do not replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of the Society of Actuaries, its cosponsors or its committees. The Society of Actuaries does not endorse or approve, and assumes no responsibility for, the content, accuracy or completeness of the information presented. Attendees should note that the sessions are audio-recorded and may be published in various media, including print, audio and video formats without further notice.

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4

Agenda• History and fundamentals• Implementation considerations• Do funded status glide paths make sense?• Q&A

History and fundamentals

Pension system and asset allocation – pre 2009

• Plan design –10% of pension plans hard frozen and heavily biased by size of plan.

• Asset allocation – long term proposition to meet long term liabilities• Fixed weights to specific asset classes • Asset only capital market assumptions• Important in supporting and managing pension expense• Plans NOT using LDI• Derisking often meant: lower expected return, higher pension expense,

higher contributions, worse asset results relative to peer, etc. Focus was rarely on plan liability and how to manage surplus volatility

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2008 Pension Crisis

• S&P 500 loses 37 percent during 2008• Discount rate falls from 6.5% to 5.75%, increasing liabilities by ~17.6%

based on Citigroup Pension Liability Index

• Milliman’s 100 largest pension plans• Funded status drops from 106% to 80%• Assets lose ~19%• Fixed income investments typically core bonds (short duration)

• Perfect storm – equity market crash + falling discount rates + unmatched liabilities => takes overfunded plans to very underfunded plans

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What plan sponsors were saying at the time• Fool me once – early 2000 “tech crisis” reduces funded status, but most plans

had recovered by 2008

• Fool me twice – 2008 Global Financial Crisis again reducing funded status

• We can’t afford to have this happen next time – “when we get back to a fully funded position again, we will need to derisk and lock it in, especially as we are now freezing our pension plans”

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The response from consultants and asset managers• “Liability responsive asset allocation”- Russell Investments

• “Dynamic Investment Policy Series: Parts 1 to 3” – Hewitt Associates

• “Journey Management – Part 1 and 2” – Blackrock Solutions • “How a pension plan’s funded level should influence its investment strategy”

– Vanguard

• “Dynamic Derisking Solutions” – Mercer

• All those and many others published in 2009 and since• In general all link equity allocation with funded status

• the lower the funded status the higher the equity allocation and the higher the funded status the lower the equity allocation and the higher the LDI allocation to better match plan liabilities

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Utility function and frozen pension plans

• A utility function measures an investor’s preference for wealth and the amount of risk they are willing to undertake to gain more wealth

• Most investors are “risk averse” meaning they value more wealth than less but they have a diminishing marginal utility for each unit of wealth relative to the risk needed to achieve that wealth

• Pension plans are no different and maybe even more impacted by this principle—especially closed or frozen pension plans, who have a fixed level of wealth necessary to fund the plan and all promised benefits

• General principle of risk and reward when investing – if there is no (or limited) reward then why take the risk. Well funded frozen pension plans have very little incentive to take more risk to be better funded.

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Why “glide paths” replace static allocations• A maturing pension system • The availability, sophistication and acceptance of LDI instruments and

risk transfer strategies• Trapped capital, especially for frozen or closed pension plans, is a

concern. • Glide paths are a dynamic asset allocation in response to financial

conditions of the plan and its sponsor rather than in response to views of the market

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Risk/Reward trade off for frozen pension plan• Risk and reward are measured by

the ability to manage the level and volatility of contributions, a true representation of the way assets and liabilities interact

• For the 70% funded plan a sponsor may logically choose any point that reflects their desired risk level because the graph is downward sloping (typical efficient frontier)

• As the lines “flattens” (yellow –90% funded) or even “inverts” (dark blue – 110% funded) at higher funded statuses the case for return seeking assets weakens because the company is no longer compensated with lower contributions

• Contributions have asymmetric risk as they can by very high but can never go below zero (asset reversion) except under special circumstances

Rew

ard

–av

erag

e co

ntrib

utio

ns

Risk – VAR for contributions

70% funded plan

90% funded plan

110% funded plan

Increasing contributions (more risk)

Decr

easin

g co

ntrib

utio

ns (m

ore

rew

ard) Low level of

return seeking assets

High level of return seeking

assets

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Glide Path Illustration1. Funded status is typically based on

marked to market set of assets andliabilities

2. Initial asset allocation policy

3. End goal funded status objective(i.e. full funding or annuitypurchase level)

4. End goal asset allocation

Additional pieces – one way vs. two way, established in IPS, tactical ranges, managing the return seeking portfolio (illiquid assets), managing the LDI portfolio (level of interest rate hedging), interaction to discount rates or based on time

Equi

ty A

lloca

tion

Funded status (PBO or PVFB)1

2

3

4

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Glide path adoption• 2016 CIO Magazine survey of frozen corporate pension plans states 70% of frozen

pension plans have a glide path in place with an additional 16% planning to do so.

• Vanguard Survey of Defined Benefit Plan Sponsors, October 2016 – Incidence of glide path adoption increased among respondents to 62% from 50% in a similar study performed 3 years earlier

• United Technologies Corp., Form 10-K filed 2/9/2017 – “ … the interest rate hedge is dynamically increased as funded status improves”

• Verizon Communications Inc., Form 10-K filed 2/21/2017 – “ … ,this allocation will shift as funded status improves to a higher allocation of liability hedging assets.

• Ford Motor Company, Form 10-K filed 2/9/2017) – “We employ a broad global de-risking strategy which increases the matching characteristics of our assets relative to our obligation as funded status improves.

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Implementation considerations

ALEX PEKKER, ASA, CFA, PhDSENIOR INVESTMENT DIRECTOR

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A systematic way to adjust asset allocation to reduce funded status risk (volatility) as funded status increases

WHAT IS A DE-RISKING GLIDEPATH?

0%

20%

40%

60%

80%

100%

60% 70% 80% 90% 100% 110% 120%

LIAB

ILIT

Y-H

EDG

ING

ASS

ETS

FUNDED STATUS

SAMPLE GLIDEPATH

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A systematic way to adjust asset allocation to reduce funded status risk (volatility) as funded status increases

WHAT IS A DE-RISKING GLIDEPATH?

Usually expressed in terms of asset allocation, particularly the breakdown between growth assets and liability-hedging assets

Can be based on other factors besides funded status (such as level of interest rates)

Can also target funded status risk, hedge ratios, or other metrics

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BUT NO GLIDEPATH IS THIS SIMPLE

CONSIDERATIONS

DESIGN

Frequency of triggers (e.g., every 5%)

Ranges around target weights

Re-risking (one-way or two-way)

Changes within growth and liability-hedging assets

Committee dynamics/governance

EXECUTION

Frequency of monitoring

Governance: how is the decision to rebalance made

Implementation: how is the rebalance actually executed20

DESIGN ISSUES ABOUND

0%

20%

40%

60%

80%

100%

60% 70% 80% 90% 100% 110% 120%

LIAB

ILIT

Y-H

EDG

ING

AS

SETS

FUNDED STATUS

ONE-WAY OR TWO-WAY GLIDEPATH?

0%

20%

40%

60%

80%

100%

60% 70% 80% 90% 100% 110% 120%

LIAB

ILIT

Y-H

EDG

ING

AS

SETS

FUNDED STATUS

SAMPLE GLIDEPATH WITH 5% TRIGGERS

0%

20%

40%

60%

80%

100%

60% 70% 80% 90% 100% 110% 120%

LIAB

ILIT

Y-H

EDG

ING

AS

SETS

FUNDED STATUS

RANGES AROUND TARGET WEIGHTS (SAMPLE)

ALWAYSDE-RISK

RE-RISK?

0%

20%

40%

60%

80%

100%

70% 75% 80% 85% 90% 95% 100%105%110%

ASSE

T W

EIG

HT

FUNDED STATUS

(MORE) DETAILED ASSET ALLOCATION

CUSTOM LDILONG TREASURY

LONG CREDIT

HEDGEFUNDS

PRIVATEEQUITY

GLOBAL EQUITIES

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THE REBALANCING PROCESS IS COMPLEX

LIQUIDATEGROWTH ASSETS

Select funds or managers for liquidationSell funds or notify managers to raise cashPotentially wait until next liquidity period (e.g., hedge funds)

TRANSFERTO CASH

Wait for cash to settle

INVEST INTOLIABILITY-HEDGING ASSETS

Select funds or managers to add toBuy funds or transfer cash to managers to investAdjust strategy if needed (e.g., duration, credit allocation, completion)

Manage cash for benefit payments, contributions, administrative expenses, etc.

Manage overall portfolio risk

Adjust benchmark

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3-30 DAYS, MAYBE LONGER 1-3 DAYS 1-30 DAYS, MAYBE LONGER

Actually Derisked

LIQUIDITY AND TRANSACTION COSTS MATTER

All times and transaction costs are estimated for common investments in normal market conditions; transaction cost is the bid-ask spread plus a transactioncharge (if any) charged by the manager plus any trading charge charged by the custodian.[1] Time to liquidate or fully invest depends on the liquidity of the instruments, account size, and market conditions. Most mutual fund trades settle the next day.[2] For hedge funds and collective investment trusts, there may be a notice period prior to liquidation or investment.[3] Private investments cannot be easily liquidated and fully investing may require an extended period of time depending on the size of the investment.[4] For Treasuries and corporate bonds, the longer the duration, the higher the transaction cost.

ASSET CLASS / VEHICLETIME TO

LIQUIDATETIME TO

FULLY INVESTTRANSACTION

COSTCash Immediate Immediate None

Mutual funds (various asset classes) 1 day[1] 1 day Varies, low

Treasury bonds 1 day 1 day 0.01%-0.50%[4]

Exchange traded funds (ETFs) 3 days 1 day Varies

Portfolio of US stocks 3-30 days[1] 3-30 days[1] Varies

Portfolio of non-US stocks 3-30 days[1] 3-30 days[1] Varies

Portfolio of corporate bonds 3-30 days[1] 2-6 weeks[1] 0.5%-1.0%[4]

Portfolio of high yield bonds and/or bank loans 3-30+ days[1] 3-30+ days[1] At least 0.5%

Collective investment trusts (various asset classes) 1-30 days[2] 1-30 days[2] Varies

Hedge funds 1 week to 3 years[2] 1 day to 3 months[2] N/A

Private investments Potentially years[3] Varies[3] N/A

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DAILY MONITORING IS FEASIBLE, BUT IS IT MEANINGFUL?

DAILY MONTHLY OR QUARTERLY

MEANINGFUL? Debatable Yes

FEASIBLE? Yes, but.... Yes

ACTIONABLE? Possibly Yes

PROS “Lock in” funded status

improvements quickly Less costly to monitor

Lower transaction costs

CONS

Monitoring may be costly and involve approximations

Higher transaction costs

Time to rebalance could offset benefits

Can miss “locking in” improved funded status

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-4%

-2%

0%

2%

4%

DEC-10 DEC-11 DEC-12 DEC-13 DEC-14 DEC-15 DEC-16

MONTHLY RETURN

MONTHLY MONITORING IS USUALLY SUFFICIENT

-8%

-4%

0%

4%

8%

DEC-10 DEC-11 DEC-12 DEC-13 DEC-14 DEC-15 DEC-16

MONTHLY RETURN

-4%

-2%

0%

2%

4%

DEC-10 DEC-11 DEC-12 DEC-13 DEC-14 DEC-15 DEC-16

DAILY RETURN

-8%

-4%

0%

4%

8%

DEC-10 DEC-11 DEC-12 DEC-13 DEC-14 DEC-15 DEC-16

DAILY RETURN

Source: Bloomberg, MSCI.

GLOBAL EQUITIES (MSCI ACWI (NET)) BLOOMBERG BARCLAYS LONG CREDIT

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DECISION-MAKING:DELIBERATIVE VS. AUTOMATED

DELIBERATIVE AUTOMATEDCommittee makes a decision

whenever a trigger is hitRebalancing is automatic whenever a trigger is hit

PROS

Greater sense of ownership

Opportunity for tactical moves

Decision reflects committee’s thought process at time of IPS adoption; no second-guessing

Timely

CONS

Could be indecisive, defeating the purpose of a glidepath

May not be timely

Could result in higher transaction costs

PRACTICAL? Yes Yes, but…

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PORTFOLIO CONSTRUCTION WOULD DRIVE EXECUTION PROCESS

SIMPLIFYING COMPLICATED

ASSETS & MANAGERS Liquid stocks and bonds only Illiquid assets

(e.g., private equity)

NUMBER OF MANAGERS Small Large

TRANSACTION COSTS Low High

CASH FLOWS Relatively small or predictable

Large or unpredictable

EXECUTIONStaff or

outsourced/discretionary manager

Committee or Treasurer

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Actually Derisked

USING DERIVATIVES CAN ADDRESS SOME OF THE EXECUTION CHALLENGES

Manage cash for benefit payments, contributions, administrative expenses, etc.

Manage overall portfolio risk

Adjust benchmark

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3-30 DAYS, MAYBE LONGER 1-3 DAYS 1-30 DAYS, MAYBE LONGER

LIQUIDATEGROWTH ASSETS

TRANSFERTO CASH

INVEST INTOLIABILITY-HEDGING ASSETS

Put on liability-hedging futures

Liquidate liability-hedging futures once invested

30%40%

70%85% 90%

70%60%

30%15% 10%

70% 80% 90% 100% 110%FUNDED STATUS

SAMPLE GLIDEPATH (10% TRIGGERS)

PRACTICAL EXAMPLE 1:SIMPLE PORTFOLIO

Glidepath is written into the Investment Policy Statement

Investment advisor/consultant monitors funded status monthly (3-day delay)

Committee reviews glidepath position quarterly and votes to rebalance if a trigger is hit

Corporate treasurer executes rebalancing (with no futures overlay)

MARKETFIXEDINCOME

GLOBALEQUITIES

1 fixed income manager(Fund, then separate account)

4 equity managers (Funds only)

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10%

35% 40%30%

40%

50%

50%50%

10%

15%

15%

5% 3%

15%

10%

45%35%

25%10% 8%

70% 80% 90% 100% 110%FUNDED STATUS

SAMPLE GLIDEPATH (10% TRIGGERS)

PRACTICAL EXAMPLE 2:COMPLEX PORTFOLIO

Glidepath is written into the Investment Policy Statement

Discretionary manager/OCIO monitors funded status monthly (3-day delay)

Discretionary manager/OCIO executes rebalancing whenever a trigger is hit– Selects managers to liquidate and add to, ensures liquidity

for benefit payments and transactions– Manages futures exposure via the completion or overlay

manger

– Process is set up pre-trade

Committee monitors discretionary manager/OCIO

MARKETFIXEDINCOME

GLOBALEQUITIESHEDGE FUNDS

CUSTOMFIXEDINCOME

1-4 fixed income managers

20+ growth assets managers, including illiquid private equity investments

Completion/overlay manager

PRIVATEINVESTMENTS

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CONCLUSIONS

It’s a long way from theory to practice

Keep design and execution considerations in mind

Understand the liquidity, transaction costs, and investment horizons of different asset classes — and how they play into glidepath construction and execution

Decide if daily (or even monthly) monitoring is both feasible and actionable

Set up effective processes to make andexecute glidepath decisions Consider using staff or discretionary manager (OCIO) Futures can help ensure more effective and timely rebalancing

Be realistic

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Do funded status based glide paths make sense?

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Before We Begin …

• Thanks to Evan Inglis for supplying the modeling and much of the other thinking behind these presentation slides.

• Disclaimer: The views I express are my own; they may or may not reflect the views of my employer, or Society of Actuaries, or anyone else.

Funded Status-Based Glide Paths: Yes or No?

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• Pension investment (asset-liability) risk should be minimized for the following situation:• Plan sponsor is a for-profit corporation or other taxable entity• Plan is closed or frozen• Assets are within 5% of providing full termination cost for all future benefits

Agreed:

The questions:• Should sponsors of underfunded plans take on more asset-liability risk, then gradually

reduce risk as funded status improves?

• Is the answer to the question above based on behavioral adaptations or financial theory?

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Funded Status-Based Glide Paths: Yes or No?Behavioral perspectives are important

Makes plan sponsors comfortable committing

to reduce risk later

Makes plan sponsors comfortable taking risk

nowand

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Comparing ApproachesFunded status glide path expectations are similar to high risk portfolio

LHA ratio <80% 80% 85% 90% 95% 100% 105% 110%

F.S. Based 0.4 0.5 0.6 0.7 0.8 0.9 0.95 1.0

Low Risk 0.8 0.8 0.8 0.8 0.8 0.9 0.95 1.0

High Risk 0.4 0.4 0.4 0.4 0.4 0.4 0.7 1.0

F.S. Based Low Risk High RiskPV10 – average $18.9 $23.4 $18.7PV10 – 99th percentile $48.4 $35.8 $51.5Contribution volatility $1.38 $1.22 $1.41

Assumptions for 1,500 trials:

• 10 years, 70% funded, 7-year PPA amortization

• RSA expected return = 7.0%, volatility = 14%

• Expected rate = 4.35%, volatility = 0.40%

• LHA are perfect liability hedge

• Re-risking upon drop in funded status

10 years of contributions

Source: Nuveen Asset Management

• Lock in gains – buy low, sell high• Take more risk when asset value is lower• Greater potential to be successful when contribution

level is higher (cash flow is more positive)• Gradual change reduces regret risk

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The Good

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The Good: Buy low, sell high

• Risky return-seeking assets have only short time frame to pay off

• There’s still a lot of risk at the beginning of the glide path

• Sponsors lament in 2025: Where Have All the Long Bonds Gone?

• Interest rate risk is uncompensated • It hasn’t worked so far

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The Bad

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The Bad: Glide paths haven’t worked so far

• Why not reduce risk at lower levels of funding?• Consequences of a downturn are more severe (benefit restrictions, risk of ruin)• Unfunded liability is a concentrated bet on the debt of the plan sponsor• Dutch pensions & insurance companies reduce risk at lower levels of funding• Cost of capital increases

• Why take any risk?• No corporate value is created by investing in equities• Shareholders can get all the equity exposure they want more effectively by

investing directly• Uncertain costs create challenges with corporate planning and decrease the

value of expected future profit (increase discount rate)

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The Ugly

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Sequencing Risk for Glide PathsDespite lower asset base, early loss is more harmful

10-year scenarios starting with assets = $75, liability = $100All scenarios have 5.0% geometric average for RSABenefit payments increase from $3.5 to $6.0 over 10 years

Source: Nuveen Asset Management

• F.S.-based glide paths make sense as a way to gradually adapt portfolios to a new risk perspective and they minimize regret risk

• F.S.-based glide paths lock in gains and reduce risk as asset base increases

• F.S.-based glide paths are not clearly aligned with fundamental principles of finance and investment theory

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Funded Status-Based Glide Path Summary

Q&A