SilverLink - Spring/Summer 2008 - (Page 21)

EMPLOYEE BENEFITS Defined Benefits Keep Your Eye on the Pension Prize Controlling Risk for Your DB Plan by Glen Gahan, FSA It’s not your father’s pension plan anymore. The 21st century is here. Baby Boomers are beginning to retire and Deﬁned Beneﬁt (DB) pension plans are facing new challenges. This article will identify a process to measure and minimize volatility risks of DB plans in accordance with the plan sponsor’s objectives. Pension plan assets have traditionally been allocated with 60-70 percent in equities and the remainder in ﬁxed income or bonds. This allocation is consistent with modern portfolio theory, which seeks an efﬁcient frontier based on the investor’s risk tolerances. On a long-term basis, this allocation is appealing because it provides the highest expected return on assets for the given long-term level of risk. The higher the investment return, the lower the amount of employer contributions and accounting costs. However, this traditional type of risk analysis considers only investment risk, while ignoring liability risk. determine employers’ required contributions are based exclusively on corporate bond rates. Previously, they were based primarily on the employers’ expected long-term rate of return on plan assets. For 2008, plan liabilities are based on an average interest rate of approximately six percent. For the same plan, liabilities were based on an interest rate of eight percent in prior years. This change results in an increase in plan liabilities, as well as an increased exposure to annual volatility in liability. The amount of the 2008 required contribution for most plans, however, is not signiﬁcantly different under the new funding rules, due to offsetting changes in methods. The difference may become more signiﬁcant in future years depending on the plan’s investment return. Bonds or Equities? Some plan sponsors are developing a more holistic approach to asset allocation by considering the impact of changing interest rates on plan liabilities. To minimize a plan’s volatility, plan sponsors could invest 100 percent in bonds of varying durations, matched to the durations of the plan’s liabilities. Thus, as interest rates decrease, the plan’s liability increases, but the value of the matched bonds increases by the same amount. This results in a more stable funded status for the plan. However, since bond returns are expected to be less than equities over the long term, employer contributions and accounting costs will be higher under a 100 percent bond strategy. The other extreme—investing 100 percent in equities— generally produces the lowest expected long-term employer contributions and accounting costs, but the amount of annual volatility is often unbearable for the prudent investor. Liability Risk This type of risk refers to the volatility of liabilities resulting from ﬂuctuating interest rates. Other predictions or assumptions of the pension plan will contribute some liability volatility, such as longevity, pay increases and incidence of early retirement. However, these other assumptions generally do not result in signiﬁcant variances in plan liability from year to year. Interest rate risk has been a factor for many years under U.S. accounting standards through the selection of the annual discount rate. The discount rate is the rate used to determine the present value of beneﬁts expected to be paid by the plan based on the current service of its participants. As discount rates decrease, the present value of beneﬁts (liability) increases, creating volatility which may be signiﬁcant on an annual basis. For example, a mere one percent change in the discount rate may affect the plan’s liability by ten percent. Interest rate risk is now more prominent in the funding rules and is similar to the discount rate concept used under accounting rules. Beginning in 2008, the plan liabilities used to Asset-Liability Modeling Plan sponsors have begun utilizing Asset-Liability Modeling (ALM) to evaluate the risk/reward outcomes of numerous asset allocations under a variety of simulated economic scenarios. This analysis forecasts the investment return while simultaneously calculating the impact of these same economic factors on the plan’s liability. With this information, plan sponsors can view the whole picture of what a plan’s 21 SILVERLINK — SPRING / SUMMER 2008

Table of Contents Feed for the Digital Edition of SilverLink - Spring/Summer 2008

SilverLink - Spring/Summer 2008 Contents Risk Management: Mitigate & Educate Disastrous Distractions Accounts Receivable BoomerCare Risk Reduction, What’s Your Function? Time Out! Double Down Employee Benefits: Who’s Paying Whom for What? Time to Reconcile Keep Your Eye on the Pension Prize Show Me the Money Private Client Services: A Generous Strategy Is There Any Good News Left? Special Insurance for Special Times Client Spotlight: Omaha Performing Arts Internal Happenings: SilverStone Group Wellness Activities Group

SilverLink - Spring/Summer 2008

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