Point of View - Global Investment Solutions from Northern Trust

The Evolving Plan Structure Landscape
Plan sponsors around the world are combining the best features of defined benefit and defined contribution retirement plans to address new regulations and market trends.

Government and corporate policymakers face a double-edge sword when mapping out retirement plans. Not only do they need to develop a system that factors in rising longevity without incurring unattractively steep contributions, but pension policies also must acknowledge the trend toward more individual control of investments without introducing a significant amount of risk. Longevity poses a significant risk to the majority of defined benefit plans in the United Kingdom and United States. It has been calculated that an extra year on longevity assumptions adds an additional 4% in liabilities. Faced with this, it is no wonder plan sponsors are increasingly seeking to transition into hybrid plan structures and pure defined contribution arrangements.

In fact, U.S. corporate 401(k) plan assets already outweigh defined benefit assets, according to Clint Cary, investment strategist at Northern Trust. Cary sees cash balance plans as one of the hottest trends in retirement benefits today, in part because the longevity risk is borne by individual participants rather than the corporate plan sponsor.

The sponsor is freed of longevity risk within a cash balance plan structure because the defined benefit does not extend into retirement. Instead, plan participants receive a lump sum at retirement for selecting an annuity or another type of investment.

Cary explains that cash balance plans offer employees a specific defined benefit, which is typically the value of contributions compounded annually at a specified rate — normally the 10-year or 30-year Treasury yield. While this is not an ambitious investment goal, it forms a reliable foundation on top of which plan participants can layer other savings, he says.

“Plan sponsors in the United States increasingly view themselves as enablers rather than paternalistic providers,” Cary says. “Cash balance is an anchor, but there are multiple other sources of retirement income to consider, including individual savings.”

New Rules,
New Strategies
The monetary value of transferring longevity risk — as well as the burden on those institutions that will bear financial responsibility for participants beyond retirement — is about to become more evident. That is because new accounting standards require employers to report retirement plan valuations based on market rates. Several European countries already have introduced accounting standards to address large-scale, defined benefit liabilities in the private sector. Based on the experiences of these countries, the overall funding problems of U.S. defined benefit plans have two ramifications for plan sponsors: The first is an increasing shift into liability driven investing (LDI) strategies; the second is a growing reliance on cash balance plans and different variations of defined contribution plans. (See “Integration of Plan Management Policies,” below.)

The LDI trend is the first of these consequences, according to Simon Cohen, senior pensions analyst at Northern Trust in London. “These strategies provide a framework for measuring, managing and monitoring the inherent risk/return trade-offs of the plan’s assets relative to the liabilities,” he says. “There is more emphasis on risk budgeting and how that budget is spent relative to liabilities.”

Cohen sees two aspects to this shift, the first of which is a probable increase in the use of derivative instruments such as interest rate and inflation swaps to hedge duration and inflation risks. “Mitigating these risks reduces the volatility of the pension plan and frees up the risk budget for return-enhanced strategies,” he says. “Although the use of swaps does not preclude the use of bonds, buying bonds alone does not solve the problem because their cash flows are not particularly tailored to the nature of plan liabilities.”

Cohen says the second aspect of the LDI trend is that it promises greater refinement of purely return-seeking investment strategies. He expects this to lead to diversified portfolios with greater emphasis on alternative assets and strategies (e.g., private equity, hedge funds, currency management, portable alpha and credit portfolios).

The Financial Times estimates that roughly £70 billion in U.K. pension assets — almost all in the private sector and roughly 10% of the overall corporate pension total — are now in LDI strategies. Cardano Risk Management, a Rotterdam-based risk management consulting company, estimates that up to €50 billion in Dutch pension assets are covered by swap variants, and that figure doesn’t include the country’s three largest plans: ABP, PGGM and PME. Given that this trio comprises half the Dutch pension market, and all three plans have entered into swaps either directly or indirectly, it is estimated that LDI covers about one-eighth of the overall Dutch market. It is worth noting that in both the U.K. and Dutch markets, the LDI development is only as old as the introduction of new accounting standards — the International Accounting Standards Board’s IAS 19, which took effect in 1999, and other subsequent national rules that govern valuation methods for liabilities.

The second ramification of new accounting standards is that cash balance plans and variants of defined contribution plans are growing in importance. Closing a traditional defined benefit plan to new participants does not halt its costs, as existing participants continue to accrue future benefits. LDI is evidence that new methods for dealing with these present liabilities are necessary.

Canadian academic and investment consultant, Keith Ambachtsheer, suggests a convergence between defined benefit and defined contribution plans. First, to avoid the risk of employees making poor investment decisions, he sees auto-enrollment and auto-pilot investing for individuals. With an eye on longevity risk, Ambachtsheer also advocates post-employment variable annuities, which promise efficient allocation of capital that can help avoid disputes concerning surpluses. Instead, participants receive an income stream that is aligned to their age and financial status.

Leading the Way
Beyond North America, several plan sponsors have developed creative hybrid structures by combining the best characteristics of defined benefit and defined contribution plans. In Denmark — the first country in the world to introduce LDI to pension fund management — the vast majority of employees participate in industry-wide arrangements. Some of these plans cover a number of professions, such as Hellerup-based Pensionskassernes Administration (PKA), which is responsible for 210,000 participants in a variety of health professions. PKA promises a defined benefit, related to interest rates, much like a U.S. cash balance plan. But there is also the possibility within PKA’s structure to pay out a bonus if sufficient surplus exists.

PKA’s investment strategy includes complicated derivatives, beginning with a constant maturity swap, a structure established six years ago that helps the plan sponsor ensure it can pay defined benefits. This rather new structure pays any excess when the long-term euro swap rates exceed 4.25%. In addition, when employers define benefits, they are more likely to use insurance techniques such as structured derivatives rather than traditional, long-only securities.

Under the Danish plan’s setup, labor agreements influence the potential bonus allocation. This leaves PKA’s constituent plan sponsors open to the issue of wrangling, which could be avoided with a defined contribution component.

But there are other examples of how labor agreements have facilitated rather than hindered change. From 2000 through 2004, plan sponsors in the Netherlands moved from predominantly final salary to career average benefits with the help of unions. Final salary plans accounted for 60% of pensions in 2000, while just under a third of the country’s plan participants were in career average plans. By 2004, however, only 13% of Dutch workers remained in final salary schemes while 77% had agreed to shift to career average pensions.

Liabilities currently pose one of the largest dilemmas for defined benefit pension funds. To deal with the issue, plan sponsors are increasingly shifting assets into liability driven investing (LDI) strategies and relying more heavily on defined contribution features.

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“Both final salary and career average are pure defined benefit calculations,” Cohen says. “But the latter typically works by offering a percentage of median salary across a worker’s entire career, rather than the median of the last three years of employment — as is the case with final salary plan structures.”

While the Dutch have preserved defined benefit plans, the change from final salary to career average has required some noteworthy tolerance of reduced income. Zeist-based PGGM, the €82 billion scheme that covers 1.9 million current and former health care workers, acknowledges that its higher-paid consultants and managers will receive lower pensions as a result of career averaging. The opposite is true for some of the lowest-paid workers, especially manual-labor staff.

Defined contribution plans are rare in the Netherlands. Where they do exist, benefits tend to be predetermined to equal 70% of final salary. In other words, contributions are set with an ultimate purpose in mind, rather than benchmarking against peer businesses or a human resources guide to contribution levels. For the few employers that have taken the defined contribution route — such as Heerlen-based chemicals manufacturer DSM — total contributions are more than 20% of salary for each employee. Typically, legal agreements give the plan sponsor little room for reducing contribution levels from year to year.

But while this seems to promise a defined benefit, there is ultimately no guarantee to participants — and this is communicated clearly at the outset. In other words, if participants do not eventually receive 70% of their final salaries, they have no legal recourse to the employer or the actuary that calculated the contribution rate 40 or 50 years earlier. Seventy percent is a well-planned expectation — but not a promise.

Conclusion
An entirely new company with no pension liabilities has several possibilities at its disposal when creating a retirement plan. “That plan, however, is likely to include at least some features of a defined contribution plan because of the current economic and regulatory climate,” explains Cary.

But for employers with existing pension liabilities, retirement plan costs are likely only to grow in the near future, as plan sponsors deal with the rising burden of accrued benefits and the added expense of retirement programs for new employees. “Evolving strategies and structures can provide a plan sponsor with alternatives to selling bulk pension liabilities to a third-party firm,” Cohen adds, “which might not be in the best long-term interest of the plan and its participants.”

LDI strategies provide alternatives for plan sponsors mulling structural change, but seeking to preserve some defined benefit features. “By helping plan sponsors nullify a portion of their risk and allowing them to allocate more assets toward return-enhanced strategies, employers can also navigate new regulations,” Cary notes. Similarly, hybrid structures and cash balance plans can assist employers looking to maintain certain defined benefit aspects by shifting to plan participants a portion of the risks and costs associated with increased longevity.