Governor of California, Edmund G Brown Jr, has announced proposed legislation that outlines sweeping reforms to the state’s pension system, but appears to have stepped back from a proposal to create a hybrid pension plan.

The hybrid defined-contribution/defined-benefit plan was proposed last year when Brown launched a 12-point reform package.

It was widely opposed by the state’s Democrat-led legislature after pressure from public sector unions and has been seemingly sidelined since Brown announced the key components of the Public Employee Pension Reform Act of 2012.

The governor claims he has reached agreement with the legislature, a point some Democrats have contested, but the plan – as it currently stands – stipulates all current and future state employees are to contribute at least 50 per cent of their pensions.

The reforms also eliminate state-imposed barriers that have prevented local governments from increasing employee contributions.

While the hybrid scheme is seemingly mothballed, it could be potentially revived via a provision that permits employers to “develop plans that are lower cost and lower risk if certified by the system’s actuary and approved by the legislature”.

According to the National Association of State Retirement Administrators there are 10 US states that currently adopt some form of hybrid pension scheme.

At the end of last year CalPERS released a working paper analysing the reforms that found if the hybrid scheme included closing off the current DB scheme to new members, it would result in lower investment returns and increase contribution to fund existing pensions.

By stopping the flow of any future new member contributions, a hybrid system would also further worsen the current 75 per cent funded ratio of CalPERS’ current DB scheme.

Governor Brown originally proposed that all new public employees would be required to join a hybrid pension plan that would target a 75 per cent income replacement ratio after 30 to 35 years of service.

The retirement benefits would be provided equally by the DB and DC component and social security. If a member did not access social security their benefit would consist of two-thirds DB and one-third DC components.

“It should be noted that if the design of the Hybrid Plan results in the closing of the current DB plan there would be a significant cost impact to the employer due to the changes in asset allocation and amortization methods,” CalPERS noted in its analysis of the effect of the proposed reform package.

In separate issue briefing released earlier in 2011, CalPERS said that closing off the current DB scheme would mean that investments would gradually shifted into lower risk, more liquid assets such as fixed income to ensure benefit payments for existing members.

Governor Brown’s reforms also include:

  • Increasing the retirement age by two years or more for all new public employees
  • Ending so-called spiking, calculating end-benefits over three years of final compensation
  • Rolling back retirement-benefit increases granted in 1999 and reducing benefits below current levels
  • Prohibiting retroactive pension increases and pension holidays where employers and employees agree to halt contributions for a specified period of time.
  • Establishing consistent formulas for calculating the future benefits of new employees.

Senior Democrats involved in negotiations have been reported as predicting that the raft of changes will save the state tens of billions of dollars over the next 20 to 30 years.

Brown says that the reforms will involve considerable sacrifice from public employees and predicts reforms will slash what some regard as bloated retirement benefits relative to the private sector.

“If the legislature approves these reforms, public retirement benefits will be lower than when I took office in 1975,” he says.

Some of the proposed changes will require a referendum before they can be enacted, according to the Governor.

Democrats in the legislature predict the final package of legislation will be passed by the end of the week.

CalPERS will hold a special board meeting today to consider the implications of the legislation.

The funded status of US defined-benefit corporate-pension plans continued to worsen last year, despite plan sponsors increasing contributions by $70 billion, a new Mercer study reveals.

Mercer found funding levels have slipped to 2009 levels, with the outlook for 2012 likely to extend the bleak news for plan sponsors.

The funded status of pension plans sponsored by companies in the S&P 1500 declined from 81 per cent at the end of 2010 to 75 per cent by the end of 2011. Funded status continued to decline in 2012 as these plans hit a record low of 70 per cent as of July 31, representing a shortfall of $689 billion.

 

Low growth, high volatility

Eric Veletzos, principal and consulting actuary with Mercer’s retirement, risk and finance business, puts the blame for the continuing slide in funded status on the low-returns environment coupled with record-low interest rates.

“Liability growth exceeded asset returns for the fourth consecutive year, offsetting these contributions,” Veletzos says.

The median asset return for 2011 was 2.9 per cent, down from 12.1 per cent in 2010 and 18.5 per cent in 2009.

Meanwhile, the median pension liability grew by 13.7 per cent in 2011, the third consecutive year with liability growth in excess of 10 per cent.

The high liability rate of growth is driven by decreasing interest rates.

 

Stacking up risk

Mercer’s research paper, How Does Your Retirement Program Stack Up, bases analysis on information contained in the 10-K reports filed by companies in the S&P 1500 for the 2011 fiscal year.

The figures reveal that the prevalence of what Mercer describes as “risky” plans in the S&P 1500 increased from 4.7 per cent during 2001, an increase of nearly 70 per cent.

“These plans are poorly funded and more material compared to the size of the corporations, so pension risk is a major issue for these organisations,” he says.

The tough environment is reflected in the expectations of plan sponsors, with Mercer noting median expected return had declined marginally from 7.92 per cent to 7.73 per cent by the end of 2011.

Part of this can be explained by a general trend among corporate defined-benefit plans to gradually de-risk their investments away from high-risk assets, such as equities, to fixed-income investments.

Mercer is seeing a range of strategies from funds aimed at controlling the volatility of their funded status. These include liability-driven investing and other risk-management strategies.

The consultant is also seeing increased interest in risk-transfer strategies such as lump-sum cash-outs and annuitisation.

Ford and General Motors are two recent high profile examples of corporate-pension plans that have looked to transfer risk to a third party. This trend is expected to gather pace in the coming years.

 

Australian superannuation funds are now required to disclose a measurement of risk to fund members, with trustees encouraged to use a standardised measurement backed by regulators and industry peak bodies.

The Standard Risk Measure will provide a rating of a fund’s investment option based on the likely number of negative returns this option is predicted to experience over a 20-year period.

The push to require funds to disclose the risk profile of their investment options comes as part of sweeping reforms to Australia’s superannuation system, which include bolstering the governance standards of funds to bring them in line with the banking and insurance industries.

 

World leader?

Two industry organisations, the Association of Superannuation Funds of Australia (ASFA) and the Financial Services Council (FSC) released a standard risk measurement that will be included in funds’ product-disclosure statements.

ASFA claims no other jurisdiction in the world requires funds to disclose a measurement of risk to superannuation members, boasting Australia is leading the world in this type of risk disclosure.

The standard risk measurement was formulated after regulators demanded the industry improve the way it discloses risk to members of Australia’s $1.3-trillion superannuation-fund industry.

The government has agreed to lift the superannuation guarantee from 9 per cent to 12 per cent, but has instigated a series of tough new reforms for the industry.

The increased compulsory contributions are predicted to treble the size of the industry, bringing total assets to more than $3.2 trillion by 2035.

 

The power of comparison

ASFA says the purpose of the risk measurement will be to provide fund members with a way of comparing investment options both within a fund and across other superannuation funds.

Super funds can use another risk measurement, but must explain to regulators why they have chosen to not adopt the industry standard.

In a statement, ASFA says the move to an industry standard for risk measurement was an important indication to government and regulators that the industry could self-regulate.

“While we know the measure is not perfect, it is an improvement on a complete absence of such information,” ASFA stated.

The standard risk measurement divides investment options into seven risk bands, from very low to very high.

If an investment option is forecast to have six or more negative annual returns over any 20-year period, it falls into the highest band. At the other end of the scale, an investment option predicted to have negative annual returns 0.5 times over the same time period would fall into the lowest band.

For an investment option to be labelled conservative, it must only experience a negative annual return less than twice in a 20-year period.

 

Conservative bias preferred

The standardised risk measurement is only one component of risk management, with funds required to disclose to regulators risk-management plans.

These should include consideration of the potential size of negative returns and the chance that while returns may be positive, they may be less than what is required to meet the objectives of fund members.

Funds should also consider what risks are associated with a particular investment strategy, such as market, hedging and liquidity risk.

In outlining the methodology for calculating the risk measurement, ASFA warns that underlying assumptions should be structured to reflect a conservative bias. Trustees are permitted to use alpha assumptions but they should also be conservative.

“Trustees should be cautious of using any assumptions that materially reduce the expectation of negative returns,” ASFA and the FSC advise in a guidance paper for trustees.

A retirement solution that focuses on outcomes and is customised for each participant cannot be met by existing defined-contribution designs, according to Nobel Prize-winning economist, Robert Merton, who advocates a “next-generation DC solution”.

Merton, who is the Massachusetts Institute of Technology Sloan School of Management’s distinguished professor of finance and resident scientist at Dimensional Fund Advisors, says the criteria for a good retirement solution are not met by traditional defined benefit (DB) or defined-contribution (DC) plans.

He says DB plans have their own problems, and are unsustainable because accounting standards and actuarial principles underestimate their cost, while DC plans are not designed to provide core retirement benefits.

Specifically, existing DC plans are not integrated with other retirement assets, require members to make complex financial decisions and focus on the wrong goal – wealth instead of income.

“Income and wealth goals are not the same. If you look at a real annuity in dollar terms it looks very volatile, but the income is guaranteed. If you measure a real annuity in annuity or income terms, then it’s a plotted flat line. It’s the difference between communicating in income and wealth, or dollar, terms. All we’re doing is changing the units. It’s the same as reporting to a client in their currency. This is just a different currency, the annuity units, and you customise for each individual because each has their own risk profile. Under the hood, the whole thing is a laser focus on the goal.”

Merton says a next generation solution should offer robust, scalable low-cost investment strategies, focus on income, not portfolio value or return, and manage the risk of not achieving this.

“The risk to be managed is the risk that the ultimate income goal will not be realised,” he says.

Resources squandered

Merton, whose Nobel Prize in 1997 recognised a new method to determine the value of derivatives, says financial innovation and engineering is required to solve the global problem of funding retirement and produce this next generation of retirement solutions.

This will require giving up the idea of DC funds aiming for a return of ‘something more’ above a certain target.

“All the resources that are dedicated to that will take away from reaching the goal. You can exchange that for a better chance of success,” he says. “This is not window dressing; it’s very different to the standard way things are done. A dynamic-portfolio strategy cuts out the excess upside possibilities to improve the chances of achieving the desired income target.”

This next-generation DC solution needs to integrate all sources of retirement saving into a tailored dynamic-portfolio strategy based on age, salary, gender, plan accumulation and other retirement-dedicated assets.

It also need to be effective for the member who is not engaged, while providing meaningful information and choices for those who do engage, and allow trustees to control their costs and eliminate balance-sheet risk.

“Engagement is only useful if it helps you get to the goal; we’re not in the entertainment business,” he says. “There is a tendency to clutter in the industry.”

Innovate to be individual

Merton, who among other things was a co-founder of Long Term Capital Management, says these solutions have to be customised for every individual – to be individually managed accounts.

By way of example, he says if person one has 90 per cent of their retirement income in future contributions, and person two has 90 per cent in super and 10 per cent in the contributions of the future, the effect of a downturn will be dramatically different in terms of their overall retirement income.

“If, for example, both of them had 100 per cent of their pension assets in equities, in August 2008 equities were 40 per cent down, person one would only have a 4-per-cent loss on their total retirement assets, but for person two, it would be a 36-per-cent loss,” he says. “You must know the individual information. It’s an important innovation to be individual and not to pool.”

He demonstrates the difference between a managed DC plan and a typical fund allocation of 70 per cent growth and 30 per cent defensive.

The first point is that the managed DC plan allows for an individual’s particular circumstances and the range of fixed-income allocation over time will depend on those circumstances.

Taking one person who is 25 years old and doing Monte Carlo simulations against market conditions throughout a lifecycle produces a range of allocations.

“At, say, age 37 the optimal allocation can range from under 18 per cent to nearly 100 per cent in fixed income, depending on what happens to them and where they are on reaching their goal,” he says.

According to Merton, a “glide path” based on the average of those ranges could be very far from what’s best for the individual depending on what happened to them or is right for their circumstances.

http://www.nobelprize.org/nobel_prizes/economics/laureates/1997/merton-autobio.html/

 

 

 

Reaching-for-yield — the propensity to buy riskier assets in order to achieve higher yields — is believed to be an important factor contributing to the credit cycle.

This Harvard Business School finance working paper analyses this phenomenon in the corporate bond market.

The paper’s authors Bo Becker and Victoria Ivashina show evidence for reaching for yield among insurance companies, the largest institutional holders of corporate bonds.

Insurance companies have capital requirements tied to the credit ratings of their investments.

Conditional on ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds.

This behavior appears to be related to the business cycle, being most pronounced during economic expansions.

It is also more pronounced for the insurance firms for which regulatory capital requirements are more binding.

The results hold both at issuance and for trading in the secondary market and are robust to a series of bond and issuer controls, including issuer fixed effects as well as liquidity and duration.

Comparison of the ex-post performance of bonds acquired by insurance companies does not show outperformance, but higher volatility of realized returns.

To read Reaching for Yield in the Bond Market click here