November 2012

Volatility Management in Pension and Retiree Health Plan Actuarial Valuations

By Richard Joss

Volatility in pension fund investments creates a significant problem for plan sponsors. The investment volatility can lead to unacceptable levels of contribution volatility and to relatively wide swings in the plan’s perceived funded status. In addition, specific issues related to retiree health plans also create significant volatility concerns for plan sponsors. To address this topic, the Society of Actuaries (SOA) issued a call for papers that afforded practitioners the opportunity to share various perspectives on this important facet of pension or retiree health plan management. These papers have now been gathered into a single monograph titled “Volatility Management Monograph.” Below is a brief summary of the content of each of the seven published papers. Actuaries are encouraged to visit the website for more details. The seven papers are:

  1. “Analyzing the Impact of Pension Plan Management on Corporate Profitability,” by Doug Andrews, Ph.D., CFA, FCIA, FSA, FIA
  2. “TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans,” by Michael Ashton, CFA
  3. “Plan Design Approaches to Volatility Management in Retirement Plans,” by Richard Joss, Ph.D., FSA
  4. “Modeling Defined-Benefit Pension Plans: Basic Dynamics,” by Robert McCrory, FSA
  5. “Modeling Defined-Benefit Pension Plans: Basic Metrics,” by Robert McCrory, FSA
  6. “Volatility Management in Defined-Benefit Pension Plans: Basic Optimization,” by Robert McCrory, FSA
  7. “Mitigating Volatility of Retiree Health Valuation Results,” by Jeff Petertil, ASA, FCA, MAAA and Justin Petertil

“Analyzing the Impact of Pension Plan Management on Corporate Profitability”

This paper establishes a framework to analyze the volatility of corporate profits as a result of variability in accounting for pension plans. Under current accounting practice, a variety of asset-smoothing techniques are permitted. These techniques have been criticized because they make adjustments to market values, and may give the users of financial statements an incorrect impression of a plan’s true funded status. In the interests of greater accounting transparency, there is a move to adopt mark-to-market results and to remove most, if not all, asset-smoothing techniques.

One concern with the removal of the smoothing techniques is that volatility will be introduced into the corporation’s income statement. Since the variable component of many executives’ compensation is dependent upon results in the income statement, volatility, especially volatility that reduces income, would be considered undesirable. This paper creates a model Canadian corporation to study the impact that various smoothing techniques would have on corporate accounting, and the potential resulting impact on executive pay.

The paper considers different investment policies, different levels of funding, and modest variations in the plan design to study the potential resulting volatility in corporate income statements. The approach of the paper is to create an income statement for a hypothetical corporation which is similar to a large Canadian corporation with a significant defined-benefit pension plan and a relatively mature workforce, assume that the smoothing techniques currently used by the accounting regulations are removed, and examine the impact on corporate income statements.

The results of the exercise show that various smoothing techniques do affect corporate income, and that this issue should be studied carefully before all smoothing techniques are removed. The author concludes the paper by suggesting that actuaries and accountants involved in setting accounting standards discuss the impact of any proposed changes on both funding and accounting practices to make sure that any difference is justifiable.

“TIPS, the Triple Duration, and the OPEB Liability: Hedging Medical Care Inflation in OPEB Plans”

This paper notes that the adoption of FAS 158 forces sponsors of post-employment health benefit plans to consider how to manage the volatility that changes in medical care inflation create in the other post-employment benefits (OPEB) liability. By choosing carefully how the nominal discount rate is decomposed into real return and inflation, the author illustrates that the true exposure to an OPEB plan is the spread of medical care inflation above (or below) the overall inflation rate. The implication is that an effective immunization strategy exists that can eliminate most of the volatility in the OPEB account.

The paper discusses medical care inflation generally and how it affects the OPEB liability. The author then offers some notional approaches to addressing the problem of open-ended medical care inflation exposure. The paper offers some practical steps that can be taken to ameliorate this particular risk. An OPEB liability often has a natural offset to a large part of the perceived medical care inflation risk.

The key point is to recognize that the positive duration of the OPEB liability with respect to medical care inflation partly offsets the negative duration of the OPEB liability with respect to overall inflation. When looked at in detail, it turns out that the salient risk is not medical care inflation, but the spread between medical care inflation and overall inflation. This suggests the use of a reasonable and basic portfolio which, when combined with a defensible strategy for valuing the spread, defeases the major risks of the OPEB liability and virtually eliminates the balance sheet and income statement volatility caused by changes in medical care inflation expectations over time.

“Plan Design Approaches to Volatility Management in Retirement Plans”

This paper approaches the volatility management question from purely a plan design perspective. The goals of the approach are to allow the plan sponsor and plan participants to remain exposed to the possible benefits of equity investing while sharing the potential downsides. Under traditional defined-benefit plan designs, the sponsor is the one who reaps all the risks and reward, whereas under traditional defined-contribution plans, it is the employee participant who gains any rewards but suffers any losses. This paper suggests alternative plan designs where the risks and rewards can be shared, offering that this may be a more preferable solution to one where the exposure to equity investments is eliminated altogether.

The paper offers two different basic plan designs for consideration. But given that each approach can be weighted and combined with more traditional plan designs, the potential range of options is limitless. The two basic designs are a floor plan and a variable annuity plan.

Under the floor plan concept, the participant for the most part earns benefits under a defined-contribution scheme. There is a wraparound defined-benefit component that guarantees the participant a minimum annuity benefit. The approach brings the full investment responsibility back under the control of the employer, hence exposes all pension investment decisions to full-time professional investment advisors.

Under a variable annuity approach, participants receive a portion of their standard defined-benefit annuity in terms of variable annuity units. As markets rise, the participants’ actual monthly payments will rise. However, should equity markets fall short of targeted levels, the participants’ monthly payments will be reduced. This plan design represents a true sharing of the risks associated with equity investing.

With these types of designs it is possible to retain the highest level of professional money manager involvement, continue to maintain a relatively high exposure to potentially higher-returning equity investments, yet pool some important key retirement risks such as the longevity risk.

“Modeling Defined-Benefit Pension Plans: Basic Dynamics”

This paper explores the dynamics of a pension plan over time in an uncertain environment. The paper adopts the technique of simulating the behavior of a model plan in a stochastically varying economic environment. While both the model plan and the model environment are simplified, the model plan displays interesting behavior suggesting policy considerations that should be included in the design and funding of defined-benefit pension plans. The goal is to answer the question of how a pension plan is likely to behave in a stochastic environment, with randomly fluctuating asset values and inflation.

The dynamic behavior of a pension plan is most important in the area of governance. For example, the model plan exercise shows that there could be enormous uncertainty in the amount required to pay for guaranteed benefits. Given the amount of uncertainty, a conservative approach to setting of benefit levels seems warranted.

As an example of an observation gained from studying the model plan, it was noticed that average cost of the model plan stays relatively stable for about 10 years, but then gradually decreases. The author suggests a likely source of this dynamic is the exclusive benefit rule, which precludes the return of funds from an overfunded plan to the plan sponsor. This dynamic creates an asymmetric contribution environment. Contributions are required to be increased in times of poor returns and underfunding, but in times of good returns and overfunding, assets cannot be withdrawn. The result is that the overfunding is compounded rather than corrected during times when there is a series of favorable returns. Overfunding will continue to grow until the actuarial cost becomes zero, and then it is often compounded after that. On average, this asymmetry pulls the mean and median plan costs down over time.

The author also uses the model plan approach to study investment risks and funding risks. With regard to investment risks, the model plan approach is helpful in seeing the risk/reward trade-off of different investment strategies. With regard to funding risk and volatility, it is noted that the contribution volatility is highest for the plans that are the best funded.

The author concludes by noting that defined-benefit pension plans are complex dynamic systems. They often display complicated and counterintuitive behavior. He points out that the actuarial cost of the model plan is neither level nor stable (even when the actuarial assumptions turn out to be right overall), that the level of funding can vary over a wide range, that riskier investments bring more cost volatility, and that cost variability increases to a maximum when the plan is roughly 100 percent funded.

“Modeling Defined-Benefit Pension Plans: Basic Metrics”

This is the second of three papers submitted by Robert McCrory. The purpose of this paper is to explore pension plan metrics by measuring the behavior of a defined-benefit pension plan in an uncertain environment with the eventual goal of evaluating the quantitative impact of competing policy choices. By creating a model plan, and testing it under a variety of simulated environments, the paper identifies the metrics that are particularly useful in evaluating pension policy choices.

As noted in the paper, defined-benefit plans are sponsored by employers to provide retirement security to their employees. One administrator posed a simple question to the paper’s author: “What do we manage to?” The paper answers that question by presenting a set of potential measurements, or metrics, of pension plan performance, and then testing these various metrics in simulated actual economic environments.

The competing policy choices include plan design, investment strategy and actuarial funding methodology. Various policy choices are compared using different metrics that are specifically selected for their ability to differentiate amongst the policy choices. If the metric yields roughly the same value for all policy choices, then the metric would be of little value.

For example, one of the policy decisions to be evaluated might be the corridor around market value of assets for selecting an asset-smoothing algorithm. Corridors might range from 0 percent, meaning that assets are always valued at market, to a relatively high value such as 30 percent or 40 percent, meaning that during times of market upheaval, the actuarial value of assets could be allowed to differ significantly from the market value of assets.

Once a particular policy is selected, it is then evaluated by the use of metrics. The key metrics are the level of cost, predictability of cost, variation of cost, intergenerational equity, and minimum and maximum funded levels. The paper concludes that many of the usual metrics—mean and standard deviation in particular—may not be particularly helpful due to instability over time and a relative insensitivity to policy changes. The paper introduces other measures that may be more useful in evaluating policy decisions, at least under certain circumstances. There are always trade-offs in any policy decision, and plan managers and sponsors need to compare the potential impacts of various choices. This paper lays out a framework for making such policy decisions.

“Volatility Management in Defined Benefit Pension Plans: Basic Optimization”

This is the third paper submitted by Robert McCrory. In this paper, the author notes that a traditional method for managing contribution volatility in defined-benefit pension plans has been the use of an actuarial value (or smoothed value) of pension plan assets for the purpose of determining plan contributions. This approach has been based on the assumption that asset gains and asset losses will tend to offset one another over time. The goal of this paper is to develop a methodology for measuring and evaluating the quantitative impact of competing asset smoothing techniques. The ultimate goal, quite naturally, is to determine if it is possible to identify an optimal smoothing policy.

The paper meticulously compares the impact of various smoothing strategies by looking at incremental changes in the gain/loss smoothing period and the corridor around market value. Different strategies are then tested using a model plan and model economy to see which strategies appear to develop the most desirable results in terms of stable contributions, predictable contributions and funded ratios.

The key conclusions based on the research are that, after longer time periods, asset smoothing tends to increase plan costs, but that smoothing provides a much higher level of predictability to plan costs. Furthermore, by weighing each of the various metrics, it is possible to design an asset-smoothing policy that could optimize the specific desires of a given plan sponsor recognizing the trade-offs involved between contribution stability, funded ratio, difference between market value of assets and actuarial value of assets, or other metric.

The paper concludes by noting that real pension plans differ radically from one another and involve a variety of factors that can affect the decision as to which smoothing policy is the “best” one for the plan. When this concern is added to the labor/management or other political realities surrounding the plan, the selection of an appropriate smoothing method can be difficult. But by introducing quantitative metrics to the process, the paper adds a new element to the decision-making process.

“Mitigating Volatility of Retiree Health Valuation Results”

This paper deals specifically with volatility in retiree health valuations. While at times retiree health accounts have volatility problems that are similar to those in pension plans, retiree health plans also have volatility concerns related to changes in the benefit level, fluctuations in benefit cost level, and alterations in eligibility for or duration of the benefit. This paper focuses primarily on these causes and offers specific suggestions for mitigating the volatility concerns.

The first key difference between volatility issues for pension plans and for retiree health plans is that the benefit level (cost-sharing arrangements between the retiree and the plan sponsor) may change from year to year. For example, the retiree may face new levels of deductibles or copayments, be subject to new plan benefit maximums or out-of-pocket payments, or be subject to new lifetime reimbursement limitations. A second key difference between pension and health volatility is the volatility related to the variation in claim payment. The health care cost trend becomes a critical assumption that is not present in most pension valuations. Finally, the plan sponsor may have the right to limit coverage either by requiring increased service to qualify for benefits, by limiting the duration for which benefits may be paid, or in some cases precluding new hires from receiving any benefits at all.

The paper then proceeds to illustrate various methods to mitigate volatility concerns. It compares the impact on claim cost by considering the number of experience periods included in the claim history, and several different weighting schemes to account for changes in the claim cost experience. In addition, the paper outlines the differences that various different accounting rules will have on retiree health valuations.

But the biggest impact included in the paper is the suggestion that health actuaries specifically reflect a plan sponsor’s right to rescind benefits. Especially in those situations where a sponsor has demonstrated a clear pattern of benefit scale-backs or increased employee cost participation, a direct reflection of possible future changes can have a material impact on the volatility from one valuation to the next. The specific reflection of the employer’s right to rescind is illustrated with a variety of examples.

In summary, to aid in mitigating the year-to-year volatility in retiree health valuations, the authors target two specific sources of that volatility. For claim cost problems, the authors recommend a weighted average of historical experience along with realistic projections for health care trends. For right-to-rescind-type changes, the authors propose an uncertainty premium operating by way of a higher discount rate. This technique offers sponsors the ability to gain a more realistic and predictable expense pattern for their retiree health plans.

Dick Joss, FSA, is retired. He can be contacted at