Investing August 18, 2021

Climate Change and Benchmarking Risk for Retirement Plans

Experts discuss how to conduct climate-change analysis and whether such an inquiry is a fiduciary duty, as forces are aligning in support for greater inclusion of such analysis in retirement plan management.
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Institutional investors generally don’t mine coal, make cement or indiscriminately strip large forests. But the companies in which they invest might be engaged in such activities that experts say will prove incompatible with the shift to a lower-carbon world. And, they add, a retirement plan’s holdings of these at-risk investments could have negative consequences for plan participants.

Plan Exposures

Climate change risks can affect plans in several ways, says Therese Feng, vice president of research for The Climate Service, a climate risk analysis firm in Durham, North Carolina. Physical climate risks such as droughts, fires and rising sea levels can result in both market and credit losses in a portfolio. For example, imagine that drought conditions continue to worsen in California, which accounts for almost 15% of the U.S. economy. At some point, the lack of water and resulting rationing conceivably could constrict the state’s businesses, particularly agriculture, and reduce employment levels. The resulting slowdown to such an important component of the U.S. economy could then affect national business conditions and stock market values.

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For corporate and government instruments, losses from physical damages and diminished asset values can lead to lower instrument values, increased return volatility and increased credit risk, Feng says. Instruments collateralized by physical assets, most notably mortgages, carry increased credit risk due to physical climate risk.

Investors also face climate transition risk, she adds. Transition risk is the potential financial impact of the economic transition to lower greenhouse gas emissions, which includes a shift to using lower-carbon energy sources and increased use of lower-emission technologies. To date, investors have focused more on transition risk than on physical risk due to access to data and methodology, says Feng. “But institutional investors need to be knowledgeable of how both physical and transition risks can affect their strategies, both in the near- and medium-term,” she cautions.

Source: GAO analysis of reports from Merce and TCFD.: GAO-21-327


Additional Exposures

Adam Gillett, global head of sustainable investing at Willis Towers Watson in London, says institutional investors also should consider regulatory pressure related to climate change. For example, a blog post from law firm Dentons’ UK-based associates notes the United Kingdom’s Pension Schemes Act 2021 “allows the government to make regulations that impose climate change governance and disclosure requirements on trustees of large trust-based pension schemes (whether defined benefit [DB] or defined contribution [DC] schemes).”

“It wouldn’t surprise me at all if other regulators from around the world who had a similar agenda looked at [the UK’s Act] and thought, ‘Well, let’s do something similar,’” says Gillett. “‘Let’s put in similar instruments, in whatever context, to accelerate action.’”

In fact, the United States might not be too far behind the UK, he adds. On May 20, President Joe Biden issued an executive order on climate-related financial risk that called for “consistent, clear, intelligible, comparable and accurate disclosure of climate-related financial risk … including both physical and transition risks.”

On an agency level, in June, the Government Accountability Office (GAO) issued a report criticizing the Federal Retirement Thrift Investment Board (FRTIB), which oversees the $735 billion Thrift Savings Program (TSP) for federal employees, for not taking “steps to assess the risks to TSP’s investments from climate change as part of its process for evaluating investment options.”

Sources note that it’s still unclear how climate-benchmarking risk concerns will influence companies’ DC plans. Sponsors control plan lineups and could increase the presence of environmental, social and governance (ESG) funds, but participants still choose their own investments. DC plans, and the way they’re set up with a menu of options, present a slightly different challenge than DB plans, in which the sponsor can take a holistic portfolio view, says Gillett. It’s perhaps harder to assess risk looking at an individual investment offering or option, because each investment might have different roles in that menu’s structure of options, he adds.

TCFD 101

The UK’s regulations and the GAO’s report both reference the Task Force on Climate-Related Financial Disclosures (TCFD)’s recommendations. TCFD’s supporters believe the recommendations will benefit investors, particularly those with a longer-term focus like plan sponsors, by providing “clear, comparable and consistent information about the risks and opportunities presented by climate change.” Per the report: “Compounding the effect on longer-term returns is the risk that present valuations do not adequately factor in climate-related risks because of insufficient information. As such, long-term investors need adequate information on how organizations are preparing for a lower-carbon economy.”

The TCFD recommendations form a voluntary framework for climate-related disclosures, covering governance, strategy, risk management, and metrics and targets, explains Joost Slabbekoorn, senior responsible investment and governance specialist at APG Asset Management in the Randstad, Netherlands. “The TCFD can be used by corporates as well as asset managers and asset owners. Right now, the TCFD is a voluntary framework but elements of it have already surfaced in regulation, for example, in the EU Sustainable Finance Disclosure Regulation [SFDR],” Slabbekoorn says.

And the TCFD recommendations are gaining global acceptance. The Financial Stability Board’s 2020 “Status Report” states that more than 1,500 organizations have expressed their support for the TCFD recommendations and nearly 60% of the world’s 100 largest public companies support the TCFD, report in line with the TCFD recommendations, or both. 

Scenario Analysis

The GAO and TCFD also both cite the need for organizations to conduct scenario analysis, which is an analytic technique for projecting the possible impact of climate-related change.

“Scenario analysis is trying to ask, in the future world, when we do respond to climate [change] and we have the policies in place that respond to it, what does that actually do to your business?” says Laura Zizzo, co-founder and CEO of climate-risk consulting firm Manifest Climate in Toronto. “For instance, if we can no longer run internal combustion engines, what does that actually do for my business?”

Sarah Bratton Hughes, head of sustainability, North America at Schroders in Brooklyn, New York, says Schroders has built its own toolkit for scenario analysis, but she warns there is “no silver bullet” or perfect scenario analysis.

“We’re focused on assessing [companies’] physical risk, their transition risk in our carbon value-at-risk model, which is essentially stress-testing portfolios for carbon pricing, and we’re focused on understanding stranded asset risk—how exposed they are to what we would consider climate growth around a technological perspective,” she explains. “And the next area that we’re really focused on is climate alignment: How aligned is this company’s future trajectory with a one-and-a-half-degree world, which is essentially the same thing as being net-zero?”

The Benchmarking Challenge

Investors can choose from a range of benchmarks to track their investment results and operational performance. Benchmarking a portfolio’s investments for climate change risk is more of a challenge, however.

Zizzo says she believes the problem arises because traditional financial benchmarks are not risk-adjusted for climate change. “I think we have to think about that and figure out how we risk-adjust our financial benchmarks for climate change, because we are seeing contraction of GDP [gross domestic product] based on physical risk alone that is not factored into the benchmarks,” she says.

Current fund benchmarking focuses on assessing fund impacts on the environment, Feng explains. “The converse––benchmarking for the climate risk of investments––is nascent, as risk methodologies to estimate climate impacts continue to evolve to represent both physical and transition risk, and physical asset data become more reliable,” she says.

Feng reports that The Climate Service has recently calculated the climate-related financial risk for the S&P 500 within its Climanomics platform, allowing users to benchmark and compare global industry classification sectors. “By year-end, we will have climate financial impacts for major U.S. corporate bonds and global listed equities, followed in 2022 by coverage of sovereign and municipal bonds,” she adds.

Is It a Fiduciary Duty?

Even if an institutional investor agrees that including climate-change risk analysis in its investment management makes sense, does its inclusion rise to the level of fiduciary duty?

Thomas Tayler, a senior manager in London-headquartered insurer Aviva Investor’s Sustainable Finance Centre for Excellence, says he believes it does. Fiduciary duties require investors to act in the best interests of their beneficiaries and to take all material factors into account when making decisions, he explains. Climate risks are financially material risks to the investments that sponsors or their delegated asset managers make on behalf of their beneficiaries and therefore should be taken into account alongside any other risk with the potential to have a material impact.

“The longer term the investment horizon, the more likely it is that climate will not only be a material risk, but the most material risk,” Tayler maintains.

Feng expresses a similar sentiment. In the absence of a legal redefinition under the Employee Retirement Income Security Act (ERISA) by the Department of Labor (DOL) of fiduciary duty to include ESG factors, at the most fundamental level, sponsors need to assess if climate change has an impact on fund solvency and the ability to pay benefits, Feng says. She believes that in the same way a corporation’s failure to disclose risk or mitigation means it is difficult to assess the impact on share price, a fund’s lack of understanding and disclosure of climate risk make it difficult to assess the impact on portfolio performance and for plan participants to be fully informed.

Looking Ahead

The sources interviewed all agree that market and regulatory forces are aligning in support for greater inclusion of climate-change analysis in retirement plan management. And, given the Organisation for Economic Co-operation and Development (OECD)’s estimate that pension funds held more than $35 trillion of assets worldwide at year-end 2020, the result could be a profound impact on global capital flows.

Administration August 9, 2021

Actuarial Assumptions Do Not Affect Actual DB Costs

'Experience studies’ and certain types of modeling will help plan sponsors find a better balance between assumptions and experience to avoid future cost surprises.
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Art by Miriam Martincic

“A crucial point about actuarial assumptions is that they do NOT affect how much a pension plan costs,” says Brian Donohue a partner at October Three Consulting in Chicago. “They can only more or less accurately anticipate future experience in order to make provisions for discharging pension obligations in an orderly fashion and avoiding surprises.”

When will participants retire? How much will their benefit be? How long will they live? How much will assets earn? The answers to these questions—what actually happens—determine the cost of a corporate defined benefit (DB) plan promise, Donohue tells PLANSPONSOR. “Changing an assumption has no effect on what actually happens,” he explains. “It is incorrect to say, for example, that we have ‘reduced’ plan liabilities by increasing future assumed mortality rates. It is more accurate to say that if the new assumption more closely tracks the future pattern of mortality, then the liability is lower than what we previously estimated.”

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Assumptions do determine IRS-required contributions plan sponsors have to make each year, Donohue clarifies. However, he compares that with paying a mortgage; the amount paid each year is not the true cost, it’s just paying down a debt, similar to pre-funding a DB benefit promise.

Jonathan Price, senior vice president and retirement practice leader at Segal, says DB plan sponsors have two timeframes to think about; the ultimate cost over the lifetime of the plan and the allocation of cost to a given year. The ultimate cost of the plan consists of administration expenses, Pension Benefit Guaranty Corporation (PBGC) premiums and the benefits paid out. These costs are borne by either contributions to the plan or investment returns, he explains.

In any given year, plan sponsors need to figure out how to determine the cost for that year of benefits promised to be paid out in the future, Price says. Assumptions used for accounting and funding purposes show plan sponsors how to allocate costs from one plan year to the next.

There are good reasons for estimating short-term pension finances, though. “The whole point of having actuarial models is to produce a level or predictable pattern of costs,” Donohue says. He notes that prior to the Employee Retirement Income Security Act (ERISA), there were no rules that required plan sponsors to pre-fund a plan or recognize costs on their balance sheets. “If an employer is solvent and can make good on benefit promises, that would be ok. But there’s a problem if a plan sponsor gets into a sour financial situation or goes bankrupt. That’s why it is good to set aside money as benefit promises are made.”

In addition, for most publicly traded companies, there’s the issue of profitability, Donohue adds. If plan sponsors use conservative assumptions, they will end up reporting lower profits in years in which they might haveearned more and will adjust and report greater profits in later years. The opposite is true if they use aggressive assumptions.

Donohue further explains that adopting a “conservative” set of assumptions (e.g., assuming everyone lives to 110) will overstate liabilities and frontload the recording of costs. “Aggressive” assumptions, on the other hand (for example, assuming everyone dies at age 75), will understate liabilities and backload the recording of costs.

Donohue says the typical DB plan today carries substantial “unrecognized losses,” i.e. historical investment experience that was worse than expected that will show up as future pension expense. In these situations, assumption changes that reduce current year funding expense reinforce the “backloading” of cost recognition to future years that these plans face today, further distorting the orderly recognition of costs under the plan. “Sometimes ‘managing current year cost’ by changing assumptions is a substitute for real cost management, which involves managing actual plan costs, like service-provider costs and PBGC premiums,” Donohue says. “Sponsors shouldn’t think they have solved a pension cost problem merely by reducing current year expense.”

Constrained Latitude for Some Assumptions

Because assumptions used in DB plan liability calculations might not get realized—participants don’t retire when plan sponsors think or they live longer than assumed, etc.—sponsors are constantly truing up the value of liabilities, Donohue says.

However, accounting calculations are now very constrained, he notes. The discount or interest rate used in assumptions is prescribed by ERISA and is driven by what’s happened in capital markets. If plan sponsors try to use a rate that’s out of bounds, the auditor might ask the plan sponsor to justify it because it is much different than what everyone else is using. There’s a very small range to work with, Donohue says.

Likewise, for mortality rates used in assumptions, if a plan sponsor uses something other than the Society of Actuaries (SOA) tables adopted by the IRS, plan sponsors might have to convince an auditor the mortality rates are justified, Donohue adds. The goal would be to justify shorter life expectancies, and smaller plans don’t have enough credible experience to use special mortality assumptions, he adds. Jumbo-sized plans with credible mortality experience can use this experience to justify customized mortality assumptions, but for most plans, standard mortality assumptions (dictated by IRS for funding and heavily encouraged by auditors for accounting) are the rule nowadays. “Mortality tables get updated every year. The current ones are based on 2012 mortality, but every year, they get adjusted based on current experience,” says Donohue. “The SOA uses the most current experience but also assumes mortality in the future will increase.”

However, Price says, one thing plan sponsors are keen to focus on is managing the volatility of costs, and the largest source of volatility is investment returns. They want to decrease uncertainty in funded status—how plan assets compare with plan liabilities—from year to year. Calculations that use IRS prescribed assumptions are recorded on the liability side of the plan sponsor’s balance sheet, while calculations that use an expected rate of return are recorded on the asset side, and plan sponsors want these to match as closely as possible. The expected rate of return assumption is not as prescribed as interest rates or mortality; there is a collar on rates that can be used, but ultimately it is the plan sponsor’s or the actuary’s best estimate, he adds.

Still, the latitude for “discretion” in setting assumptions has narrowed considerably over the past 25 years, Donohue says. For the most part, using a (subjective) expected return on assets to measure pension liabilities is no longer considered reasonable outside of the public sector. For both funding and accounting purposes, liabilities are measured based on prevailing interest rates as dictated by bond markets, and sponsor assumptions consequently clump in a very tight range, he adds.

Price says asset liability or stochastic modeling is frequently used to quantify expected rates of return by taking into account the experience of capital markets and the potential volatility of different asset classes. “Modeling is a good way to measure uncertainty in near-term costs,” he says. “If plan sponsors get near-term costs wrong, they will be in a bad situation later.”

Price adds, “We find that once plan sponsors go through this modeling, they then evaluate whether they have the right portfolio allocation or whether there is one they can use that is less volatile or would help them with a lower required contribution.”

Donohue says it is useful to monitor ongoing plan experience and perform full blown “experience studies” every five years or so in order to ensure assumptions are reasonably tracking experience and make appropriate updates to these assumptions based on the results of these analyses.

Make Assumptions Based on Purpose

Another factor plan sponsors need to remember is that the purpose for measuring the plan’s liability will have an impact on what assumptions should be used, Price says. “Knowing ‘why’ is critical to understanding the approach to take,” he says. “Prescribed interest and mortality rates are used for funding purposes, but for other purposes, a different set of assumptions may be important,” Price says. “For example, if planning for a pension risk transfer [PRT], the plan sponsor might want to use a different set of assumptions to measure liabilities. It’s important to use the right numbers in the right place.”

Donohue notes that when a plan sponsor goes to market to settle liabilities through a PRT transaction, there might be a reckoning about how accurate the estimate of liability is. “Plan sponsors don’t want to go to market with an estimate that is more likely 10 years of liability rather than 15,” he says. “But current mortality assumption seem to be matching with what insurers use, which is a good indication. Hopefully what plan sponsors are assuming is lining up with insurers.”

Donohue adds, “Some plan sponsors want to use conservative assumptions to decrease the liability recognized on their balance sheets, but that won’t work if they go to market for a PRT.”

For plans with significant “early retirement subsidies,” the future cost of the plan may be closely tied to future retirement patterns, Donohue says. For such plans, understanding the sensitivity of plan costs to different retirement patterns can be very important, and accurately estimating future retirement patterns will be very helpful to orderly cost recognition and avoiding surprises. “For these plan sponsors, assumed retirement ages are likely the most ‘material’ assumption that is still subject to significant discretion,” he says.

For ongoing plans, particularly those with backloaded benefit formulas or early retirement subsidies, preretirement employee turnover may also be an important assumption, Donohue adds.

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