CASH BALANCE PENSION PLANS: VALUATION, FUNDING AND OTHER INTERESTING ISSUES Mary Hardy, University of Waterloo IAA Webcast 6 May 2014 IAA Webcast May

Outline 1. Introductory comments 2. Market valuation method and results 3. Funding 4. Concluding comments and questions IAA Webcast May

CASH BALANCE PLANS ARE NEWSWORTHY... IAA Webcast May

A way out of Pa. pension mess This year, Simpson proposed a “cash balance” pension compromise, in which new employees would be offered an investment plan with a guaranteed 2 percent earning rate. Sources: Kravitz 2012 National Cash Balance Research Report; Lancaster Newspapers, April ; MarcoNews.com April5,

Cash Balance Pensions  Look like DC  contribution (% of salary) paid into participant’s account  account accumulates to retirement  lump sum retirement benefit  withdrawal benefit = account value (after vesting)  Regulated like DB  Participant accounts are nominal IAA Webcast May

Crediting rates  Participant’s account accumulates at specified crediting rate.  IRS safe harbor rates:  Yield on 30-year government bonds  Yield on 10-year government bonds  Yield on 5-year government bonds + 25bp  Yield on 1-year government bonds + 100bp  Fixed rate, eg 5% p.y.  CPI rate IAA Webcast May

Cash Balance plans outside the US  In the UK  “Relatively rare” – but gaining traction  “Investment risk remains with employer”  Treated as money purchase for tax; DB for auto- enrolment  In Japan  Credited interest – flat; bond, bond average, combination  Introduced 2002 IAA Webcast May

Market Valuation: Framework, assumptions, notation  Participant with n years service at valuation date.  At valuation t=0.  Retires at T with n+T years  Ignore exits, annuitization.  Value future benefit arising from past contributions  Use market valuation methods  Generates the cost of transferring the pension liability to capital markets IAA Webcast May

Framework, assumptions, notation IAA Webcast May

Framework, assumptions, notation IAA Webcast May

The Valuation Formula IAA Webcast May

The Valuation Formula  We let That is  V(t,T) = market value at t of CB benefit at T  per $1 of nominal fund at t  No exits  No future contributions  With continuous compounding IAA Webcast May

Fixed crediting rate IAA Webcast May

Fixed crediting rate IAA Webcast May

Crediting with the short rate IAA Webcast May

Crediting with the short rate IAA Webcast May

Crediting with k-year spot rates IAA Webcast May

Crediting with k-year spot rates: 4/2013 YC IAA Webcast May 2014 V(0,T) Crediting RateT=5T=10T=20 30-yr yr yr yr+0.25% yr+1.0% ½-yr+1.5% short+1.75% % fixed

Impact of the starting YC  Repeat the valuation for yield curves  1998 → 2013 IAA Webcast May

V, 20 years to retirement IAA Webcast May

V, 20 years to retirement IAA Webcast May

V, 20 years to retirement IAA Webcast May

V, 20 years to retirement IAA Webcast May

V, 20 years to retirement IAA Webcast May

V, 20 years to retirement IAA Webcast May

T=10-years IAA Webcast May

T=5-years IAA Webcast May

Comments  What is the most stable choice for r c ?  Long rates are more stable than short rates  Constant rates are even more stable  But long rates and constant rates produce more volatility than short rates.  What about withdrawals?  Par yields not spot rates? IAA Webcast May

Questions  Are market values of pension obligations relevant?  Is the volatility surprising?  Can the liability be hedged? IAA Webcast May

VALUATION AND FUNDING IAA Webcast May

Actuarial valuations  Principles and notation:  AL t = actuarial liability = target asset requirement  NC t = Normal Contribution = contribution needed to fund the expected increase in AL, t to t+1  i t = valuation interest rate  Under valuation assumptions, ignoring exits IAA Webcast May

Actuarial valuation for traditional DB  Accruals based  past service earned benefits are included in the valuation  Accruals methods are PUC and CUC/TUC  Projected accrued  benefits from past service indexed to retirement by salary scale.  Current accrued  benefits from past service valued assuming no further salary increases. IAA Webcast May

Actuarial valuation for Cash Balance  Accruals based  past service accued contributions are included in the valuation  Accruals methods are PUC and CUC/TUC  Projected accrued  benefits from past service indexed to retirement by credited interest.  Current accrued  benefits from past service valued assuming no further interest credits. IAA Webcast May

CB Valuation 1: Past service, projected credited interest  Past service  no allowance for future contributions to participant’s fund  This is the method used above, with market rates and models IAA Webcast May

CB Valuation 2: Past service, current credited interest  Past service  no allowance for future contributions to participant’s fund  Current credited interest  no allowance for future credited interest  v i (s) denotes the valuation discount factor for s-yrs ahead IAA Webcast May

CB Valuation 3: Full service, projected credited interest, pro-rata accrual IAA Webcast May

Example Employee A 1 year service 19 years to retirement S= ; F= c=6% Employee B 10 years service 10 years to retirement S=60 000; F= c=6% Employee C 19 years service 1 year to retirement S=75 000; F= c=6% IAA Webcast May /40

Example  Assume (i) risk free rate (ii) Corporate Bond rates  Crediting rate = (30-year rate)  Future crediting rate assumption (for method 3) i c (s)=  Future salary growth assumption 2% p.y. (method 3) IAA Webcast May

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Method 3: The ‘traditional’ valuation approach  Non-accrual based CB valuation + high discount rate  AL may be considerably less than fund values  Every exiting participant diminishes the security of the remainder Even for a fund which is 100% funded  Valuation factors should have floor of 1.0  We should eliminate ‘traditional’ valuation for CB  Move to true accruals aproach IAA Webcast May

Conclusions  The CB benefit isn’t as simple as we thought  This benefit isn’t as cheap as we thought/think  DB valuation methods do not adapt to CB  Design is important  Short rates are more stable for crediting  Short rates are easier to hedge  Misinformation abounds  Within and outside the actuarial community IAA Webcast May

Final questions  Does the Cash Balance Pension really meet the objectives of sponsors or participants?  Costs are volatile.  Hedging is complex.  Commonly used funding methods obfuscate costs.  Benefit security may be significantly compromised, even for “100% Funded” plan. IAA Webcast May

Acknowledgements  Co-authors David Saunders and Mike Xiaobai Zhu  Society of Actuaries Pension Section Research Committee  Society of Actuaries: Center of Actuarial Excellence Grant  Global Risk Institute Research Project: Long horizon and Longevity Risks  Natural Science and Engineering Research Council of Canada  Report available from SOA website. IAA Webcast May