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The Value of a Funding Policy

Jason L. Russell, EA, FSA, MAAAConsulting ActuaryHorizon Actuarial Services, LLCSilver Spring, Maryland

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Presentation Topics

• What is a funding policy?• Funding measurements• Sample funding policies• Case study• Stress testing• Lessons learned

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What Is a Funding Policy?

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Acknowledgement

• “Creating a Funding Policy”– Cary Franklin: Horizon Actuarial Services, LLC

Presentation: 60th Annual Employee Benefits Conference

Article: July 2016 Benefits Magazine

This presentation borrows heavily from these publications.

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What Is a Funding Policy?

A funding policy is a set of rules that:• Establishes a connection between

contributions and benefits• Determines when benefits and/or

contributions can (or must) be changed

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Funding Policy Requirements

• ERISA Section 402(b)(1):– “every employee benefit plan shall provide a

procedure for establishing and carrying out a funding policy consistent with the objectives of the plan . . .”

• Funding policy must be disclosed in the Annual Funding Notice (AFN)

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Sample AFN Policy Descriptions

• “Contributions must be sufficient to fund the annual normal cost and amortize any unfunded liability over 15 years.”

• “Contributions must be sufficient to fund the annual normal cost and also lead to full funding of all accrued benefits within a reasonable period of time.”

• “The funding policy is to meet the minimum funding requirements of ERISA.”

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Why Have a Funding Policy?

• A good funding policy provides stability– Less volatility, more predictability– More “cushion” against adverse events

• Less severe actions, but further in advance– Stay ahead of ERISA/PPA funding requirements

• Imposes discipline – On trustees and/or bargaining parities– Objective and orderly plan changes

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Key Questions

• Who decides?– Board of trustees (fiduciaries)?– Bargaining parties (settlors)?

• How to document?– Trust agreement?– Formal funding policy statement?– Trustee meeting minutes?

• What does the policy say?

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Creating a Funding Policy

• Define clear rules for plan funding:– Based on specific funding measures– When to improve benefits or reduce contributions– When to reduce benefits or increase contributions

• Be clear on roles:– Trustees– Bargaining parties

• Have attainable, realistic goals

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Funding Measurements

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Funding Measurements

• Funded percentage• Contribution “margin”

– Not a statutory measure

• Funding standard account “credit balance”– Measures statutory funding requirements

• PPA/MPRA “zone” status• Employer withdrawal liability

– Could be very important, but not covered here . . .

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Pension Funding

Asset Value(Funded Liability)

Unfunded Liability

This Year’s Benefit

Accruals

Future Benefit

Accruals

+           =  Actuarial Accrued Liability (Past Service)

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Funded Percentage

• Funded percentage= Asset value/actuarial accrued liability

• Asset value– Fair market value or smoothed actuarial

value?– Actuarial value: used to determine PPA status

• Actuarial accrued liability– Value of benefits already earned– Different methods for measuring

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Funded Percentage: Example

Funded Percentages 2016 2015

A. Actuarial Accrued Liability $ 1,100 $ 1,000

B. Asset Value1. Fair Market Value 2. Actuarial Value

$ 850$ 900

$ 800$ 860

C. Funded Percentage1. Fair Market Value2. Actuarial Value

77%82%

80%86%

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Annual Plan Costs

(1) “Normal Cost”(a) Cost of this year’s benefit accruals(b) Expected operating expenses

(2) Unfunded liability amortization– Pay down unfunded liability (past service)– Payment period varies

• 15 years is common• Shorter period for more mature plans

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Contribution “Margin”

• Do expected contributions exceed plan costs for the year?– Positive margin: implies funding will improve

over time– Negative margin: implies funding will not

improve over time (or get worse)• Can express as annual dollars, cents per

hour, or solve for amortization period

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Contribution Margin: Example

Contribution Margin ($Millions) 2016 2015

A. Unfunded Liability1. Actuarial Accrued Liability2. Asset Value3. Unfunded Liability4. Unfunded Liability Amortization

(15 Years, 7.50% Interest)

$ 1,10085025027

1,00080020022

B. Annual Plan Costs1. Normal Cost2. Unfunded Liability Amortization (A.3.)3. Total Annual Cost

$ 222749

$ 202242

C. Contribution Margin1. Expected Contributions2. Annual Plan Costs (B.3.)3. Margin/(Shortfall)

$ 50491

$ 50428

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Credit Balance

• Funding standard account– Notional account (not “real money”)– Accumulated contributions vs. costs– “Credit balance”: contributions > costs– “Funding deficiency”: contributions < costs

• Annual costs:– Normal cost (benefits + expenses)– Amortizations of unfunded liability

• “Lagging” indicator?

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Credit Balance: Example

Funding Standard Account($Millions)

2016 2015

A. Charges1. Prior year funding deficiency2. Normal cost3. Amortization charges4. Interest5. Total

$ 049

11012

171

$ 046

11012

168B. Credits

6. Prior year credit balance7. Employer contributions8. Amortization credits9. Interest10. Total

$ 55502910

144

$ 130502816

223

C. Credit balance or (funding deficiency)

$ (27) $ 55

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PPA/MPRA Certification Status

“Green Zone”(none of the below)

EndangeredUnder 80% funded or a projected funding deficiency in the next 7

years (unless special rule applies)

Seriously EndangeredUnder 80% funded and a projected

funding deficiency in the next 7 years

CriticalIn general, a projected funding

deficiency in the next 4 or 5 years (other factors may apply)

Critical and DecliningIn critical status, and projected

to become insolvent within the next 15 or 20 years

• “PPA” = Pension Protection Act; first effective in 2008• “MPRA” = Multiemployer Pension Reform Act; first effective in 2015

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Corrective Action Under PPA

Funding Improvement Plan

Required for Plans in Endangered Status

• Goal: Reduce underfunding by one-third in 10 years

• Actions: Increase contribution rates and/or reduce future benefit accruals

Rehabilitation Plan

Required for Plans in Critical Status

• Goal: Emerge from critical status in 10+ years (or forestall insolvency)

• Actions: Same as above; may also reduce “adjustable” benefits

The above rules are simplified. Plans in seriously endangered status plans must also adopt a funding improvement plan. Under MPRA, additional tools are available to plans in critical and declining status to avoid insolvency.

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“Snapshot” vs. Projections

• “Snapshot” = Current results– Where the plan is now, not where it’s headed– Usually focus of actuarial valuation report

• Projections = Future results– Where might the plan be headed– Mandated by PPA

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Projection: Example

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Focus on Funded Percentage

• Current and projected funded percentage– If contributions cover costs, funded percentages will

increase over time

• Better than other measures?– Credit balance = important for statutory

requirements, but “lagging” indicator– Contribution margin = good “snapshot”

measurement, but less relevant with projections– Withdrawal liability = important consideration, but not

always related to plan funding health

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Sample Funding Policies

Source: “Creating a Funding Policy” by Cary Franklin; July 2016 Benefits Magazine

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Sample Funding Policy #1

• Increase contributions or reduce future benefit accruals if 100% funding is projected to be more than 10 years away

• Benefits cannot be improved unless the funded percentage is projected to reach at least 100% within seven years

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Sample Funding Policy #2

• Benefits can be improved only if the 10-year valuation forecast indicates, after consideration of the improvement, a:– Positive credit balance each year– Positive contribution margin at the end of the

10-year period

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Sample Funding Policy #3

• Previously-reduced benefits will be restored to the extent that the plan can maintain for 10 years (with the benefit restoration):– At least 90% funded percentage each year– A positive credit balance each year

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Sample Funding Policy #4

• No benefit improvements are permitted unless the funded percentage, with the benefit improvement, is projected to exceed 110% within 15 years.

• Corrective action (increased contributions or reduced benefits) must be taken if the plan is projected to be certified as endangered or critical status within the next 5 years.

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Case Study

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Sample Funding Policy

• Cannot improve benefits unless:– Projected funded percentage in 15 years at

least 120%, after reflecting improvement• Must reduce benefits or increase

contributions if:– Projected funded percentage in 15 years is

less than 100%

Note: For simplicity, examples change future benefit accrual rate only. Changes to adjustable benefits, accrued benefits, and future contribution rates are not considered.

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Example A: Baseline

Per funding policy: 15-year projected funded percentage is at least 100%, so no corrective action is required. (Benefits also cannot be increased.)

Example A

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What if One-Time Loss in 2016?

Investment loss in 2016: plan remains in “green zone,” but 15-year projected funded percentage is below 100%. Per funding policy, corrective action is needed.

Example A

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2017 Funding Policy Action

Corrective action per funding policy: reducing future accrual rate from $100.00 to $82.00 will increase 15-year projected funded percentage to at least 100%.

Example A

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What if Another Loss in 2019?

Investment loss in 2019: plan remains in “green zone,” but 15-year projected funded percentage is again below 100%. Per funding policy, further corrective action is needed.

Example A

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2020 Funding Policy Action

Further corrective action per funding policy: reducing future accrual rate to $67.50 will increase 15-year projected funded percentage to at least 100%.

Example A

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What if No Funding Policy?

Without funding policy, plan would be certified in endangered status in 2022. Under funding improvement plan, future accruals would be cut to $50.00 effective 2023. (simplified example)

Example A

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Example B: Baseline

Plan in Example B is better funded than Plan in Example A. 15-year projected funded percentage is at least 120%. Therefore, per funding policy, benefits can be improved.

Example B

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Increase Future Accruals?

Benefit improvement: future accrual rate is increased from $100.00 to $135.00. As required by funding policy, 15-year projected funded percentage remains at least 120%.

Example B

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Stress Testing

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Stress Testing

• Investment sensitivities– Expected returns are lower over short term?– What if actual experience is even worse?– How much “cushion” do we need?

• Also important to stress test work levels– These examples focus on investment returns,

for simplicity

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Actual Returns: 2005-2014

Source: The Multiemployer Retirement Plan Landscape: 2005-2014 (to be published)

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Actual Returns: 2005-2014• Exhibit shows annualized net

investment returns for multiemployer pension plans for the 10 years from 2005-2014.

• Results include 569 calendar year plans with complete data; plans with non-calendar plan years or missing data were excluded.

• Median 10-year annualized return for 2005-2014 was 5.6%.

• For comparison, median 10-year annualized returns were:

5.9% for 2004-20136.0% for 2003-20124.0% for 2002-2011

Source: The Multiemployer Retirement Plan Landscape: 2005-2014 (to be published)

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Expected Returns

Expected ReturnsHypothetical Pension Plan

10-Year Horizon

20-YearHorizon

75th Percentile Results 9.3% 9.6%50th Percentile Results (Median) 6.6% 7.6%25th Percentile Results 3.9% 5.7%Expected returns are geometric

• Expected returns are based on average assumptions from the 2016 Survey of Capital Market Assumptions by Horizon Actuarial.

• Asset allocation for hypothetical plan is illustrative.• See the survey report at www.horizonacturial.com for more detail.

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“Select & Ultimate” Returns?

“Select and ultimate” return assumptions represent 50th percentile (median) outcomes per average assumptions from 2016 Horizon survey. Note: annual returns of 6.6% over 10 years, followed by annual returns of 8.4% in years 11-20, annualize to 7.5% per year over 20 years.

Example B

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25th Percentile Returns?

Example B

“Select and ultimate” return assumptions represent 25th percentile outcomes per average assumptions from 2016 Horizon survey. Note: annual returns of 3.9% over 10 years, followed by annual returns of 7.5% in years 11-20, annualize to 5.7% per year over 20 years.

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What if No Benefit Increase?

Example B

“Select and ultimate” return assumptions represent 25th percentile outcomes per average assumptions from 2016 Horizon survey. Note: annual returns of 3.9% over 10 years, followed by annual returns of 7.5% in years 11-20, annualize to 5.7% per year over 20 years.

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2005-2014 Returns?

Assume median investment returns from 2005-2014 for all multiemployer pension plans will repeat in 2016-2025, with annual returns of 7.5% thereafter.

Example B

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What if No Benefit Increase?

Assume median investment returns from 2005-2014 for all multiemployer pension plans will repeat in 2016-2025, with annual returns of 7.5% thereafter.

Example B

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Considerations

• Stress testing is simplified– Separate analysis: how would funding policy

require action in these scenarios?• Additional funding policy features?

– Minimum benefit accrual? – Delayed action following large investment

losses (i.e., wait for bounce-back)?

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Lessons Learned

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Strategies for Healthy Plans

• Goals: Secure promised pensions, minimize volatility, maximize predictability

• If projected to remain in “green zone”:– Develop investment and funding policies– Review policies often– Stress test funding cushions

• Funded percentage should show grow, even after any benefit increases

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Strategies for Unhealthy Plans

• PPA effectively forces funding policies:– Endangered status: funding improvement plan– Critical status: rehabilitation plans

• Maintain discipline; save investment and economic gains as they arise

• Maintain participation among all employers• Once plan emerges into “green zone,” develop a

new funding policy

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Manage Plan Liabilities

• Consider lower accrual rates?– Can “backfill” past service following gains– But consider equitability for new participants

• Consider de-risking investments?– Reduce volatility as funding improves– Align funding and investment policies– But lower expected returns = higher costs

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62nd Annual Employee Benefits ConferenceNovember 13-16, 2016Orlando, Florida

Session #P17

The Value of a Funding Policy

• ERISA requires every plan to have a funding policy, but many policies—though compliant—offer only minimal guidance for plan operations.

• A funding policy should help a plan achieve stability in long-term funding, and it should recognize that contributions are not easily changed.

• The policy should specify when a plan can or must change benefits and contribution rates.

• Among the various funding measures, the funded percentage (both current and projected) matters most.

• A funding policy can be developed and monitored by stress-testing against adverse investment experience and downturns in work levels.

• The funding policy must be customized to each plan’s unique funding patterns and characteristics.

Source: “Creating a Funding Policy” by Cary Franklin; July 2016 Benefits Magazine

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2017 Educational ProgramsPensions

63rd Annual Employee Benefits Conference October 22-25, 2017 Las Vegas, Nevadawww.ifebp.org/usannual

Trustees and Administrators InstitutesFebruary 20-22, 2017 Lake Buena Vista (Orlando), FloridaJune 26-28, 2017 San Diego, Californiawww.ifebp.org/trusteesadministrators

Certificate of Achievement in Public Plan Policy (CAPPP®)Part I and Part II, June 13-16, 2017 San Jose, CaliforniaPart II Only, October 21-22, 2017 Las Vegas, Nevadawww.ifebp.org/cappp

Related ReadingVisit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books.

2016 Retirement Plans Facts Item #9060www.ifebp.org/books.asp?9060

816

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