Longevity and Defined Benefit Plans - The Good and The Bad By: Nathan ZahmCFA

Imagine all the medical advances that have been made since the start of the new millennium and how they’ve helped us live longer and healthier lives. Now ask: When was the last time mortality data was changed? The answer: The start of the millennium.

Defined benefit (DB) plan sponsors are guided by mortality and projection tables  developed and issued by the Society of Actuaries (SOA) to calculate their plan’s funded status, contributions, lump sums, liabilities, and other key metrics. In October 2014, the SOA released new tables based on data collected from 2004 through 2008. These will replace tables that were based on 20-year- old data (from 1990 to 1994). The new tables reflect that people are living significantly  longer (about two to three years, and thanks in part to those medical advances) and are  continuing to live longer at a faster rate. This, in turn, means that DB plan liabilities—or benefits expected to be paid—will increase.

DB plans pay the cost of benefits when they are due, and fund—or save—for future benefits, generally through a combination of investment return and plan contributions. While the updated mortality tables provide a more realistic picture of those future liabilities, they’ll have some serious ramifications on a DB plan sponsor’s investment strategy and other decisions about the plan, as shown below.

Here, we’ll identify a number of factors that DB plan sponsors will need to address when considering how the updated mortality tables could affect their plan decisions going forward.

Gauging the impact on the plan

As evident from the table on the prior page, there’s a lot changing for DB plan sponsors. Dealing with these changes will require a proactive approach to manage these higher costs and increased liability.
Given the significance of the new mortality tables’ effects, plan sponsors would be well-served to:
• Meet with their actuary to gain an understanding of how large an impact the tables will have on their plan’s liability; depending on the mortality assumptions currently being used, liabilities could increase by 5% to 10%.
• Decide the best direction to take to begin accommodating any expected increase in their plan’s liabilities and duration.

Timing is critical

The new mortality tables will likely impact plans sponsors at different times, depending on the reporting function.
Balance-sheet accounting and reporting purposes. For accounting purposes, actuaries, accountants, and auditors are required to use all available information in calculating liabilities for reporting. This includes the new mortality tables and—while auditors may or may not require the use of the new tables for year-end 2014 disclosure—it’s likely that actuaries and plan sponsors will at least be asked to analyze the impact of their usage and comment on their current assumptions relative to these new tables. Others may actually require the usage of the new tables for year-end 2014 disclosure.

Minimum funding, lump-sum calculation, and plan termination purposes. The timing ofregulations that govern these is prescribed by law for IRS and PBGC purposes. It’s expected that the updated tables would be effective for plan years beginning in 2016 or 2017. At that point, lump-sum benefits and their portion of a plan  termination cost will likely increase as will minimum required contributions.
 
Determining the best approach: Investment strategy

Today, the investment objectives for most DB plans are to achieve and maintain their targeted funded status, and to reduce pension risk and its volatile effects on the organization’s balance sheets. Many plan sponsors have implemented liability-driven investing (LDI) and other derisking strategies to help accomplish these goals. In broad terms, as funded status improves, a pension portfolio’s fixed income allocations should increase while return-seeking assets decrease, following a preordained glide path as contained in the plan’s dynamic investment policy statement, as illustrated in the sample glide path on the following page.

Pension risk focuses on asset return in relation to the liability, which has significant interest rate sensitivity. Thus, an effective way to reduce—or hedge—some of this risk is through a portfolio that contains fixed income of appropriate quality and duration relative to the plan’s liabilities—in other words, with plan assets that can come close to mimicking the plan liability.

A fully hedged (or immunized) portfolio will consist, then, entirely of fixed income. But if plan liabilities rise and funded status drops with the updated mortality tables, sponsors will need to determine how the change will impact the pension fund’s investment strategy. To begin this process, sponsors should ask themselves:
1. Does the optimal hedging portfolio change?
2. How will the increase in plan liabilities be addressed?

Actions to consider: Investment  strategy

Answering these questions requires that plan sponsors begin a process to help determine the best action to take for their circumstances.
Calculate duration impact. As noted, it’s likely that implementation of the new tables will not only decrease funded status, but also lengthen the liability duration. This is because more payments will occur further into the future.

Review the plan’s optimal hedging portfolio and modify allocations accordingly. The investment strategy for many DB plans is laid out in a glide path contained in the plan’s dynamic investment policy statement adopted by the plan’s investment committee. As illustrated below, the glide path guides changes in asset allocation as trigger points are reached when funded status improves. The example below shows a glide path that has not been adjusted to take into account the impact of the new mortality tables.

This glide path may need to be altered to accommodate the longer duration of the plan’s liabilities. For instance, this might include increasing the percentage of the long Treasury STRIPS fixed income allocation, or decreasing the fixed income allocation to intermediate bonds and increasing the long bond holdings. 

Sample glide path, frozen plan, assuming current mortality  assumptions

Source: Vanguard

The question to ask: Investment  strategy

Once plan sponsors and their actuaries determine how increased longevity is likely to affect their plans, they’ll need to grapple with how to keep their plan on its path to full funding by overcoming the hurdle posed by the drop in funded status. Essentially, it boils down to this: Do we want to make a plan contribution to fund the liability increase?

If the answer is yes: There’s no need to alter a plan’s current glide path, since the funded status will stay the same.

If the answer is no: Then there’s another question: Will we rerisk? Rerisking means moving backward along the glide path to allocate greater percentages to return-seeking assets in the hopes that equity returns can make up some of the loss in funded status. Of course, this also means taking on greater risk. If sponsors are comfortable doing so, there’s no need to alter the plan’s current glide path as they are simply following the asset allocation for their new funded status. But if they prefer to shy away from more risk, the current glide path should be modified to acknowledge their reduced risk preference and a more conservative approach by using the same asset allocation at a now-lower funded status.

The effect on other plan decisions

Lump-sum windows. The IRS governs how lump sums must be calculated. The new mortality tables are expected to become effective for IRS purposes in 2016 or 2017. When that happens, lump-sum payments are likely to be costlier. Sponsors  who have been thinking about making a window available to certain participants may want to consider their timing. It will be important, though, to consider the fiduciary and disclosure responsibilities to participants as well, particularly for windows offered before the new tables are implemented.

Group annuities. Essentially, there should be little or no effect on the cost of purchasing annuities because annuity providers continuously update their mortality assumptions and have already priced in the cost of longer lives for pension plan participants. Of course, there are other cost considerations that plan sponsors need to take into account beyond those of the plan’s liabilities, such as administrative and other expenses when analyzing a group annuity purchase.
 
Plan termination. Plans that have already been terminated won’t be affected by the updated tables. Once the tables are adopted by the PBGC and IRS, however, the cost of plan termination is expected to increase because of the increase in lump-sum costs.

Frozen plans. Even these plans will be affected, since the frozen pension benefits can be expected to be paid for a longer period of time.

Dynamic investment policy statements. Investment committees should regularly  revisit these statements in the normal course of  events, but it’s especially important for them to do so in light of the new mortality tables. If a plan’s risk preference and profile are expected to change in response to the effects of the new tables, this must be reflected in the document that governs how plan assets are invested to help accomplish its stated goals and objectives.

Going forward

DB plan sponsors, their actuaries, and investment advisors will likely spend a lot of time addressing how the updated mortality tables will affect their plans. Part of their discussions should focus on the importance of developing or revising an investment strategy that can adapt to an ever-changing pension liability.
It’s worth noting that the SOA’s Retirement Plan Experience Committee, which leads the research efforts for the periodic mortality table updates, has set a goal to update the tables at least every three years.1 By comparison with significant changes every decade, a move to steadier, more manageable change will  be a good thing indeed.
 
1   NewsDash, by Plan Sponsor, November 5, 2014

A quick guide to the updated SOA mortality tables

The SOA published reports for a new mortality table and a new projection table—RP-2014 and MP-2014, respectively—in October 2014.

RP-2014 contains the “base” mortality table.
In addition to the general mortality tables for RP-2014, the exposure draft includes those that reflect mortal- ity tables for white-collar versus blue-collar, active versus retired, female versus male, higher- versus lower- income. These versions may be helpful for plans with a distinct population where such fine-tuning might make sense.
MP-2014 is the new mortality projection scale (replacing Scales AA and BB under current tables) that projects mortality improvements—meaning that people are not only living longer, but they’re improving their longevity faster than expected. MP-2014 will be used to project the RP-2014 table into the future to reflect improving life expectancies over time. For example, a 65-year-old in 2035 is likely to have a longer life expectancy than a 65-year-old in 2015.
Predicting mortality with a projection scale such as MP-2014 is called generational mortality because it reflects mortality changes for future generations. When just the RP-2014 table is used in isolation, this is referred to as static mortality. The SOA recommends that plans use generational mortality rather than static mortality in their assumptions.
Greater detail is available at soa.org
 
For more information
The following Vanguard research and commentary provide in-depth information that can help plan sponsors determine the best approach to accommodate the impact of the improved mortality tables. They’re available at institutional.vanguard.com, by calling your Vanguard representative, or by calling 800-310-8876.
Pension derisking: Start with the end in mind Pension derisking: Diversify or hedge?
 
Pension risk: How much are you really taking?
Glide path ALM: A dynamic asset allocation approach to derisking
Pension plan immunization strategies: How close can you get?
DB investing essentials
Frozen pension plans: Is immunization or termination the right choice?

Connect with Vanguard®    >  www.vanguard.com
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© The Vanguard Group, Inc., used with permission.

 

 

 

Nathan Zahm

Nathan Zahm is a senior investment strategist in Vanguard Investment Strategy

Group. He is part of the team responsible for establishing and overseeing the

investment philosophy, methodology, and portfolio construction strategies supporting

Vanguard’s products, strategies, and advisory services. Mr....

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