A
defined benefit (DB) plan, modeled with the typical fees and asset allocation of
a large public plan, has a 48% cost advantage compared to a typical
individually directed defined contribution (DC) plan, the National Institute on
Retirement Security (NIRS) concludes in a recent analysis.
Further,
the DB pension costs 29% less than an “ideal” DC plan that features the same
low fees and no individual investor deficiencies. According to the NIRS, annuitizing
DC account balances does not erase the DB pension cost advantage. Annuities
offered by private insurance companies would only modestly decrease DC funding
requirements at historical average interest rates, and would increase costs at
2014 interest rates.
In
this updated comparison of its DB and DC plan costs, the NIRS says it takes
into account key developments in the retirement benefits landscape with regard
to fees, investment strategies, and annuities, while building an “apples to
apples” comparison through a uniform set of demographic and economic
assumptions.
In
its report, “Still a Better Bang for the Buck: An Update on the Economic
Efficiencies of Defined Benefit Pensions,” the NIRS explains that DB plans have
three structural cost advantages compared to DC plans: longevity risk pooling,
the ability to maintain a well-diversified portfolio over a long investment
horizon, and low fees and professional management.
In
order to provide lifelong income to each and every retiree, DB plans only have
to fund benefits to last to average life expectancy. In a DC plan, an individual
must accumulate extra funds in order to self-insure against the possibility of
living longer than average. They can also buy a life annuity from an insurance company,
but this comes at a cost, the report notes.
DB
plans are able to maintain portfolio diversification—specifically, stay
invested in equities—over time, while DC participants must shift to lower-risk,
lower-return investments as they age. Thus, over a lifetime, DB pensions earn
higher gross investment returns than do DC accounts, the NIRS says.
Due
to economies of scale, DB plans feature low investment and administrative
expenses as well as management of investments by professionals. According to
the NIRS, an “ideal” DC plan can theoretically achieve the same fees and
investment returns, for a given asset allocation, by removing individual
choice. When it uses more realistic assumptions—industry average fees and a
modest “behavioral drag” on investment returns resulting from well-documented
tendencies in individual investor behavior—the NIRS finds that the DB plan has
a large advantage in net investment returns.
The
Institute suggests that employers and policymakers should continue to carefully
evaluate claims that “DC plans will save money.”
In a previous analysis,
the Institute found the $476.8 billion in public and private defined benefit
(DB) pension plan payments in 2012 supported $943.3 billion dollars in overall
economic output in the national economy.
With
some equity markets near historic highs and interest rates in the U.S. poised
to rise, achieving returns going forward may be more challenging for public
defined benefit (DB) plans than in the past few years. In addition, public defined benefit plan
sponsors will need to consider a number of other important factors as they
contemplate investment strategy and asset allocation in 2015 and beyond,
according to Michael A. Moran, senior pension strategist at Goldman Sachs Asset
Management in New York City.
New
accounting standards from the Governmental Accounting Standards Board (GASB)
will move the valuation of assets from an actuarially smoothed methodology to a
market value framework. The new GASB rules were finalized in 2012 but are just
now starting to go into effect. As of now and over the course of 2015, public defined benefit plans
will start new reporting, Moran says.
He
explains to PLANSPONSOR that for valuing assets, the new rules move to mark-to-market
accounting. Previously, public DBs used an actuarially smoothed asset value, for
which gains or losses were spread over a period of time—generally five years.
The new rules say public DBs will now use market asset values.
On
the liability side, historically plans had used as a discount rate their expected
return on assets assumption (EROA), but under new rules they will be able
to use only the EROA for the expected benefit payments for which they expect to have
assets to cover. For expected benefit payments that are unfunded, they must use
the municipal bond rate.
“The
upshot is, moving to mark-to-market on asset side will introduce a lot more
volatility to that side of the calculation, so funded status will be more
volatile. On the liability side, blending the EROA and municipal bond rate will
reduce the total discount rate for some plans, so it will increase liabilities
and decrease funded status in those situations,” Moran says. He points to a
recent disclosure by the state of New Jersey as an example.
According
to news reports, in a bond offering supplement released on November 25, New
Jersey said its pension system has enough assets to cover 32.6% of projected
liabilities, as of June 30, down from 54.2% a year earlier. The state said the
lower ratio is because of new GASB rules. Fitch Ratings said New Jersey is the
first to disclose the numbers under the new requirement.
Funded status based
on asset market values now exceed funded ratios calculated based on
actuarially calculated asset values for the first time since before the
financial crisis; however, some plans
will still face daunting deficits under new rules. Moran says despite
the asset gains in recent periods, the need for return generation in portfolios
is still strong.
In
client communications, Moran says potential changes to mortality tables could
also place even further downward pressure on funded status for some plans. “It
is our understanding, based on conversations with those in the actuarial
community, that many of the largest state and local plans develop their own
mortality assumptions based on the actual experience of their participants.
Indeed, the [Society of Actuaries’] project actually excluded public plan data
from its analysis on the basis that mortality for public sector employees
differs from private sector participants. Consequently, the changes [finalized] by the Society may not have any
impact on some public plans. But for others that do rely on the Society’s
mortality tables, these proposed changes could place downward pressure on
funded levels, although perhaps implemented more slowly than what we are likely
to see in the U.S. corporate DB universe,” he wrote.
Moran
suggests that using an investment strategy to adjust risk as funded status
fluctuates (i.e., a glide path strategy) may be a
consideration for public defined benefit plans. “It has become fairly mainstream in the corporate
DB community. At a high level, a glide path strategy says, ‘I’m going to change
my risk exposure as certain factors change, such as funded status,’” he
explains. As funded status increases, corporate defined benefit plans shift, for example, to
longer-duration bonds, since pension obligations are valued based upon market
interest rates of high-quality, long-duration bonds. This results in assets having
similar characteristics to liabilities.
However,
he notes that the public plans do not value pension obligations on market interest
rates, and many will still be able to use EROAs, so buying long-duration bonds
will not hedge the accounting liability. So what change can public DBs make at
different funded levels? It could be tilting equity to less volatile strategies
or smart beta strategies, keeping equity exposure but reducing risk, Moran
says. “Glide path investing makes sense, but using different methods than in the
corporate space. Perhaps we should have more dynamic strategies in public DBs.
We could have used this in the 2000-to-2002 and 2008-to-2009 downturns to help
protect the higher-funded levels at those times,” he adds.
According
to Moran, over the past several years, the trend of public defined benefit plans increasing their allocations to alternative assets has been well-documented, though some have
maintained little or no exposure to these asset classes and the use of
alternatives varies widely between plans. He contends that it is likely more plans will at least explore increasing the allocation to alternatives, given that: 1) equity valuations are, in some markets, at historically
high levels; 2) there is an expectation of rising interest rates; 3) funding gaps
still need to be closed; and 4) some of them, potentially, desire to minimize
the volatility of asset values due to the aforementioned change by the GASB to
move toward a mark-to-market type of framework for calculating funded status.
In
addition, investors seem to be increasingly coming to the conclusion that choosing investments based on environmental,
social and governance (ESG) factors is not just about
“doing the right thing” but that these factors are fundamental and can have a material
impact on investment performance (see “Doing Well by Doing Good”). Moran says Goldman Sachs suspects more public plans will move in this
direction.
Finally,
Moran notes that under old GASB rules, public defined benefit plan sponsors had to calculate an
annual required contribution (ARC). The ARC was not really “required” because the
GASB has no authority to dictate plan funding, but it was intended to give a
guide to fund normal cost and the amortization of plan deficits over 25 years
or so. Even though it was not really required, many plans would use that as
their de facto funding requirement. With new standards, the ARC is eliminated,
so do we need something else? Moran queried. Pension funds need to think about
a new mark, he says, with actuaries involved in the calculation.
Establishing
actuarially-driven funding policies, and contributing in line with them, has proven to be a
key to maintaining a well-funded plan, Moran notes.
“With the GASB rule
change, nothing economically changes. It doesn’t change contribution
requirements or benefit payments, but we know when we have a rule change, it
tends to affect behavior and the way plans are viewed. So it will be
interesting what the reaction will be as, over the course of the next year, like New
Jersey did, public plans report new numbers,” he says.