Rate of Return Assumptions Hounded by Market Changes

In a recently released Issue Brief, the Academy of Actuaries discusses the interplay of the rate of return assumption and the investment mix. Focusing on the long-term return rate assumption for defined benefit pension plans, a familiar idiom comes to mind: “Don’t let the tail wag the dog.” It’s not that simple, however, as plan sponsors and service providers sometimes lose perspective on which of them is the dog. The comfortable role of actuaries is to act as the tail.

When performing valuations and projections, actuaries use assumptions related to the expected future rate of return for the defined benefit pension plan’s trust of assets. In doing so, they consult with the plan’s investment advisors to ascertain the trust’s investment policy and the portfolio’s current mix. Generally, plans that are heavily invested in fixed income securities will realize lower investment returns over time, but with lower volatility, compared to plans with more equity exposure. Plans with more equities will often experience higher investment returns over time, but also higher volatility. This information, along with consultation with the plan’s investment advisors, helps the actuary determine the appropriate rate of return assumption. 

Rate of Return Assumptions Hounded by Market Changes

Adjusting to Changing Markets

However, markets change over time and a reasonable assumption in one year may not be reasonable in a subsequent year. Also, as market conditions fluctuate, the financial implications of the actuarial projections also change.

In the current market cycle, many capital market projections are lowering future investment return expectations. As a result, actuaries are reducing the expected rate of return assumptions based on the revised capital market models. If portfolios are expected to produce fewer investment returns in the future, plans sponsors are concerned that they must either make additional contributions or reduce future benefits. Neither option is favorable, which often puts pressure back onto the financial advisors to look for additional returns.

Wagging the Dog

As we know, investment returns are a function of risk, and therefore, in order to generate additional returns sponsors may end up taking increased risk. Plan sponsors and financial advisors will often reach for higher returns based on the actuarial assumption that produces the desired result, in other words, letting the tail wag the dog.

This is a problematic option, as the sponsors may unsuspectingly take on more financial risk than is appropriate for the situation.   

Recognize Investment Risk

Actuaries should be reviewing the long-term rate of return assumptions at regular intervals and setting those assumptions based on the investment mix. This is especially true with multiemployer and public defined benefit pension plans, but it also has implications with corporate plans as well. Plan sponsors should be comfortable with the investment risk they are taking and asking their actuaries to perform sensitivity analysis as part of their projections so that investment risks can be better understood.

To view a list of tools that can help plan sponsors understand the impact of investment-related volatility, as well as the impact of favorable or unfavorable investment results, please contact Keith Nichols in the form below.

Published July 15, 2020

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Do Government Pension Plan Sponsors Know Their Risk?

It has been just over a year since the Actuarial Standards Board introduced Actuarial Standard of Practice No. 51 (ASOP 51) which requires actuaries to disclose certain risks to plan sponsors. ASOP 51 directs the actuary to assess and disclose risks to the pension plan, but it does not require a detailed analysis of each risk be performed. Instead, it requires an actuary to recommend a more detailed analysis of specific risks when they believe it would be significantly beneficial to the plan sponsor.

While ASOP 51 applies to all pension plans, governmental plans have their own unique risks to consider. Let’s discuss a few of those risks that impact governmental plan sponsors and where additional analysis may help you better understand the pension plan risks.

Do Government Pension Plan Sponsors Know Their Risk?

Contribution Risk

There have been several states that have enacted laws aimed at requiring governmental agencies to make a certain level of contribution to their pension plans, however, that is not the case in all states. Even with those laws, there may be a risk that contributions are not adequate to fund the pension plan if the law does not require appropriate actuarial consideration in setting the required contribution amounts. Making lower contributions than are actuarially sound increases the risk to the plan and plan sponsor. Inadequate contributions will increase future appropriate contributions, which may be hard or impossible to make. Negative press and possible intervention or solvency issues would be the worst result.

Plan sponsors should check their historical contributions relative to the Actuarially Determined Contribution (ADC). They should consider additional analysis for situations that may be possible. For example, a simple multi-year projection assuming that the plan funds a set percentage, like 80%, of the ADC to see how it impacts the plan. This can provide valuable information on how future contributions would increase.

Investment Risk

For governmental pension plans, the accounting rules allow for the discount rate to be set to the expected Long-term Rate of Return (LTRR) of the plan’s asset portfolio.

This can lead plan sponsors into choosing a more risky portfolio than is appropriate to increase the assumed discount rate; however, doing this adds market risk to the plan. If the assets have a large drop in a single year or do not perform as expected over time, then the ADC will increase.

While a stochastic study (randomly generated trials) of the assets will provide the best insight into the investment risk, government plan sponsors may not have the budget to pay for such a study. Instead, you could look at shocks to the portfolio. Scenarios can be either historical, like asking. “What if the Great Recession were to happen again?”, or simplistic, like asking, “What if we had a 20 percent loss on equities?”. Then you could see how those scenarios impact the plan.

Demographic Risk

Governmental pension plans may have provisions for Cost-of-Living Adjustments (COLAs) or unreduced early retirement benefits. In all plans, the assumptions used by the actuary are not going to exactly match participant behavior, but when the plan has an increasing benefit or additional subsidy like these provisions, these demographic differences have a more pronounced impact on the plan.

If your plan has COLAs, unreduced early retirement benefits, or other subsidies that may increase liabilities to the plan, you should consider additional analysis. Such analysis can be simple scenarios or more robust. However, frequent assumption analysis and appropriate revisions to the assumptions to the most recently available information is a good way to reduce demographic risk.

Questions? Do you need help in assessing risk to your public plan? Contact the Findley consultant you normally work with or reach out to Matthew Gilliland directly with the form below.

Published June 29, 2020

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