actuarial issues a to z docs/annual... · –cost of benefits not affected by actuarial assumptions...

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Actuarial Issues A to Z

Jeff Amrose, EA, MAAAPaul Wood, ASA, FCA, MAAA

• Don’t Worry, We Won’t Cover Every Actuarial Issue from A to Z!

• Goals of a Pension Plan

• Role of Actuarial Assumptions

• Various Actuarial Assumptions– With Focus on Mortality and Investment Return

• The Importance of a Funding Policy

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Goals of a Pension Plan• Benefit Security

– Primary goal is to accumulate sufficient assets to pay promised benefits

• Sustainability– How the required contribution level fits into the overall

budget – Monitoring the affordability of employee contributions

• Intergenerational Equity– Costs should be paid for by the generation of taxpayers

who receive the services• Contribution Stability and Predictability

– Stable and predictable contributions assist with budgeting

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Goals of a Pension PlanReaching the Goals

• Sometimes, balancing between the goals requires tradeoffs:– Contribution Volatility vs. Intergenerational Equity

Extending the amortization period reduces volatility but hurts the goal of intergenerational equity

– Sustainability vs. Benefit Security Using aggressive assumptions to lower the required contribution

may help with short term sustainability but hurts with benefit security

– Contribution Volatility vs. Sustainability Using a more conservative asset allocation may reduce volatility

but the Plan Sponsor or employee may need to pay more of the cost so it could hurt the sustainability of the Plan

Chasing return while increasing risk may also place the plan in a position of requiring additional contributions

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Goals of a Pension PlanReaching the Goals

• Goals can be reached through management of risk• Decisions that may have to be made regarding risk:

– Avoiding the risk by deciding not to start or continue with the activity that gives rise to the risk

– Taking or increasing the risk in order to pursue an opportunity

– Removing the risk source– Changing the likelihood– Changing the consequences– Sharing the risk with another party or parties (including

contracts and risk financing)– Retaining the risk by informed decision

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Role of Actuarial Assumptions

• What dictates the true cost of the plan?

– Actuarial assumptions?

– Plan provisions?

– Both?

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Role of Actuarial Assumptions• Over time, there are four parts of the actuarial

funding equation:

C + I = B + E– C = Contributions– I = Investment Earnings– B = Benefits– E = Expenses

• This equation will balance over the long term, but not necessarily over one year or even a number of years

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Role of Actuarial Assumptions• Over time, the true cost of benefits will be borne out in actual

experience– Cost of benefits NOT affected by actuarial assumptions– Determined by actual participant behavior (termination, retirement),

plan provisions, and actual investment returns– The annual valuation is a self correcting process-the truth always

comes out

• Assumptions help us anticipate and manage what each component of the equation will be – Assumptions dictate the timing of the contributions– Develop expectations for future contributions, investment returns and

benefit payments– Important for decision making

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• Why are assumptions so important?

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• Why are assumptions so important?

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Role of Actuarial Assumptions• Why are assumptions so important?

– Overly aggressive assumptions can endanger a Plan

– Overly conservative assumptions can lead to unaffordable costs

– Optimal assumptions lead to achieving the goals of a pension plan while balancing stakeholder’s goals Benefit Security Sustainability Intergenerational Equity Contribution Stability and Predictability

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Examples of Actuarial Assumptions

• Economic Assumptions– Salary rates1

– Investment return2

• Demographic Assumptions– Mortality rates2

– Disability1

– Retirement1

– Withdrawal1

– Payroll growth rate1

1 Impact the liability for active members only2 Impact the liability for active and inactive members

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Examples of Actuarial Assumptions

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Other

Incidence of Disability/Active Mortality

Funding Method

Termination Behavior

Retirement Behavior

Individual Salary Increases

Payroll Growth

Life Expectancy

Investment Return

Impact on Determination of Funding Requirement

Post-Retirement Mortality

• A simple Google search on Life Expectancy finds the following recent headlines– Society of Actuaries Releases New Mortality Tables

and an Updated Mortality Improvement Scale “The SOA's updated tables and mortality improvement scale show that

people are living longer. For example, the updated reports show that among males age 65, overall longevity rose 2.0 years from age 84.6 in 2000 to age 86.6 in 2014. For women age 65, overall longevity rose 2.4 years from age 86.4 in 2000 to age 88.8 in 2014.”

– Living Longer “The dramatic increase in average life expectancy during the 20th

century ranks as one of society’s greatest achievements. The rising life expectancy within the older population itself is increasing

the number and proportion of people at very old ages. “

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Post-Retirement Mortality– Group Calls for Delay in Finalization of Society of

Actuaries Mortality Tables – Global Life Expectancy: Life Spans Continue To

Lengthen Around The World, WHO Says “People are living longer than ever and “dramatic” gains in life

expectancy show no sign of slowing down, the World Health Organization said on Wednesday.”

– Life Expectancy: Improvements Slowing Down? “For a number of years life expectancy has risen steadily. However

recent indicators lead us to believe that the rate of increase could be slowing down.”

– Life Expectancy In U.S. Drops For First Time In Decades, Report Finds

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Post-Retirement Mortality

• Life Expectancy for the General US Population -from Age 65

12.8 13.1 13.7 14.1 14.6 15.1 15.6

16.3 16.8 17.7 18.0

16.2 17.0 18.0 18.3 18.6 18.9 18.9 19.2 19.5

20.3 20.6

‐

5.0

10.0

15.0

20.0

25.0

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015Male Female

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Life Expectancy by State

Above data from National Vital Statistics

Legend: 80–81.3 79.5–80.0 78.4–79.5 77.2–78.4 75.0–77.2

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Post-Retirement Mortality• Nationally, life expectancies continue to improve • Improvements in future longevity were materially

changed recently with built in continuous improvement – Generational mortality (Scale AA)

• There has been a significant amount of activity on this assumption in the industry with new tables published as of 2014 (RP-2014), along with four sets of improvement scales– Improvement Scale BB, MP-14, MP-15, and MP-16

• Accurate estimates of mortality rates, life expectancies, and future improvements are a critical piece of determining how to properly pre-fund the plan

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Investment Return Assumption

• Trends in investment return assumptions

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• Trends in investment return assumptions

Source: 2017 Public Plans Database

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• How does this assumption Impact Funding?

0

20

40

60

80

100

120

6% Return 7% Return 8% Return

Perc

enta

ge o

f Ben

efit

s

EarningsContributions

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• The assumption selected should be reasonable– May be no single “correct” answer– Assumption should be a best-estimate

• Assumption is selected using a process that is mainly based on economic capital market expectations using the Plan’s target asset allocation:– Utilize a building block approach that reflects expected

inflation, real rates of return, and plan related expenses– Take into account the volatility of the expected returns

produced by the investment portfolio

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Investment Return AssumptionFive Step Approach to Setting assumption

• Step 1 – Research and Adopt an Expected Price Inflation Assumption – Many sources, currently around 2.5%

• Step 2 – Calculate the Expected Investment-related Expenses, as a percent of assets– Most actuaries use a net return assumption– Look at the last three years investment expenses as a percent of assets– Reduce the gross expected return by this percentage

• Step 3 – Rely on formal Investment Forecasts by experts

• Step 4 – Develop the Forecasted Portfolio Returns

• Step 5 – Consider a New Range of Reasonableness and Professional Judgment

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Investment Return AssumptionStep 3 - Rely on formal Investment Forecasts by experts

• Rely on formal investment forecasts by experts:

– Obtain professional forward-looking capital market forecasts from experts – “investment economists”

– Such forecasts are usually for a 5 to 15 year horizon; generally speaking, they will not go out 30 years

– Forward-looking capital market forecasts include:

Expected returns for each asset class Expected standard deviations for each asset class Expected correlation coefficients among all asset classes

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Investment Return AssumptionStep 4 – Develop the Forecasted Portfolio Returns

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Asset ClassesCase Study Planʹs Asset Allocation

Sample ICʹs Expected Nominal Gross Return

Broad Dom Eq ‐ 9.35%Large Cap 32% 9.05%Small/Mid Cap 13% 10.55%Intʹl Equity 15% 9.50%Emerging Mkts ‐ 11.75%Global ex‐US Eq ‐ 10.06%Defensive ‐ 3.25%Domestic Fixed 21% 3.80%Long Duration ‐ 4.56%TIPS ‐ 3.60%High Yield ‐ 6.15%Non‐US$ Fixed 4% 3.75%Real Estate 10% 7.85%Private Equity ‐ 13.10%Absolute Return ‐ 6.25%Commodities ‐ 6.50%T‐Bills (Cash Equiv) 5% 3.00%

Total Portfolio 100% 7.58%

Mapping Case Study Planʹs Asset Allocation to Sample Investment Consultantʹs (IC) List of Asset Classes


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(1) (2) (3) (4) (5) (6) (7) (8)

1 6.42% 2.30% 4.12% 2.50% 6.62% 0.48% 6.14%2 7.15% 3.00% 4.15% 2.50% 6.65% 0.48% 6.17%3 6.96% 2.75% 4.21% 2.50% 6.71% 0.48% 6.23%4 7.46% 3.01% 4.45% 2.50% 6.95% 0.48% 6.47%5 7.15% 2.50% 4.65% 2.50% 7.15% 0.48% 6.67%6 7.29% 2.50% 4.79% 2.50% 7.29% 0.48% 6.81%7 7.58% 2.50% 5.08% 2.50% 7.58% 0.48% 7.10%8 7.48% 2.40% 5.08% 2.50% 7.58% 0.48% 7.10%9 7.69% 2.50% 5.19% 2.50% 7.69% 0.48% 7.21%10 8.32% 2.30% 6.02% 2.50% 8.52% 0.48% 8.04%11 8.57% 2.02% 6.55% 2.50% 9.05% 0.48% 8.57%

Average 7.46% 2.53% 4.93% 2.50% 7.43% 0.48% 6.95%

Expected Nominal

Return Net of Expenses

(6)-(7)Investment Consultant

Investment Consultant

Expected Nominal Return

Investment Consultant's

Inflation Assumption

Expected Real Return

(2)–(3)

Uniform Price

Inflation Assumption

Plan Incurred Expense

Assumption

Gross Expected Nominal Return (4)+(5)


• Arithmetic Mean– “Expected Return”– Expected return for each year standing alone

• Geometric Mean– Average compounded annual return over time– Always lower than Arithmetic Mean (in the real world)– The compound return that is at the 50th percentile of

expectation– The compound return that has a 50% chance of being

achieved

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• Consider investing $100 with “Expected Return” of 7%

• Example– Earn 0% in Year 1 and 14% in Year 2 and have you would

have $114.00 – Arithmetic Mean (“Expected Return”) is 7.00%– Geometric Mean (average compounded annual return) is

6.77%

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• Consider compounding . . .

– Compounded annual return (6.77%) is less than the “Expected Return” (7.00%)

– Pension plans are all about compounding

– If your forecasters are giving you a 6.95% “Expected Return”, your compound return used in actuarial valuations should be lower

– More volatility means wider spreads

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• Consider percentiles and probabilities of compounded returns

– The “Geometric Mean” is the 50th percentile of compound returns

– Half the compounded returns are expected to exceed the 50th

percentile and half are expected to fall short– The 50th percentile return has a 50-50 chance of being achieved– The 50th percentile return has a 50% probability of being

achieved– A return assumption higher than the 50th percentile of

compounded returns will have less than a 50% chance of being achieved

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Probability of exceeding

25th 50th 75th 7.75% *(1) (2) (3) (4) (5)

1 3.77% 5.49% 7.25% 22.7%2 3.77% 5.51% 7.29% 23.2%3 4.01% 5.65% 7.32% 23.2%4 4.10% 5.83% 7.59% 26.2%5 4.33% 6.04% 7.77% 28.2%6 4.20% 6.06% 7.95% 30.1%7 4.59% 6.40% 8.23% 33.3%8 5.08% 6.60% 8.15% 33.2%9 4.84% 6.57% 8.33% 34.7%10 6.07% 7.56% 9.08% 47.1%11 5.65% 7.69% 9.76% 49.3%

Average 4.58% 6.31% 8.07% 31.9%

*Plan's current return assumption net of expenses.

Investment Consultant

Distribution of 15-Year Average Geometric Net Nominal Return


• The “Expected Return” has less than a 50% chance of being achieved as a compound return over time

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Current Return Assumption 7.75%

Average Among 11 Investment Consultants:

Raw Nominal Gross Expected Return 7.46%

Inflation-adjusted Nominal Net Expected Return 6.95%

50th Percentile 6.31%

Pressure From Investment Consultants

Investment Return AssumptionStep 5 Consider a New Range of Reasonableness and Professional Judgment

• To make the final decision on a return assumption --

– Consider the range between the two means (geometric and arithmetic)

– Consider professional judgment

– Consider a longer horizon, while being judged by stakeholders and other observers in a short/mid-term horizon

– Consider probabilities of achieving the selected assumption over the mid-term horizon

– Consider the uncertainty in the forecasts; in economics and investing, uncertainty usually provokes conservatism

– Consider avoiding large moves all at once

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Funding Policy

• Why even have a Funding Policy?

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Funding Policy

• Why even have a Funding Policy?

– Would you ever try to drive from Bonita Springs, FL to Anchorage, Alaska without a road map or a GPS device?

– What if you got into Canada and the road you were on was closed ahead? Would you not pull out your map and search for an alternate route?

– You’d probably feel pretty lost without a map or GPS device right?

– A Funding Policy serves the same purpose as a road map when it comes to navigating through the life of a pension plan

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Funding Policy

• What are the objectives of a Funding Policy?– The Government Finance Officers Association’s Best

Practice, “Sustainable Funding Practices of Defined Benefit Pension Plans,” states:

The main financial objective of public employee defined benefit plans is to fund the long-term costs of promised benefits to plan participants

GFOA also recommends that this be done through a systematic and disciplined accumulation of resources (i.e., contributions and related investment earnings) which are sufficient to pay promised benefits to plan members over their lifetimes

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Funding Policy

– Other goals cited in GFOA’s Best Practice To be consistent with the governmental budgeting

process, efforts should be made to keep the employer’s pension contributions relatively stable from year to year

The policy should satisfy the principle of intergenerational equity

To help offset related risks, efforts may be made to provide a reasonable margin for adverse experience

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Funding Policy

• To start this process, retirement boards must understand how:

The policy elements fit together

The actuarially determined contributions are calculated

The actuarial valuation

process works

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Funding Policy

• Decisions and reasoning to include:

– Actuarial cost method, asset smoothing method, and amortization method

– Funding target– What to do in overfunding situations– Discount rate and other assumptions– How often assumptions are evaluated– Benefit changes– Responding to favorable/unfavorable investment experience– Risk management

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Conclusions

• We all share a common goal of providing benefit security to the hard working members of the Public Sector

• The actuarial assumptions used today could have a significant impact many years down the road

– Poor assumptions may lead to sponsor exploring alternative plan designs or closing the pension plan

– Better to know real contribution requirements now then to have artificially low cost today and unsustainable cost over the long run

• Don’t be afraid to ask your actuary if your assumptions are reasonable and the best fit for YOUR Plan

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Disclaimers

• This presentation shall not be construed to provide tax advice, legal advice or investment advice.

• Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation.

• This presentation expresses the views of the author and does not necessarily express the views of Gabriel, Roeder, Smith & Company.

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ACKNOWLEDGEMENT

Thank you to Leslie Thompson who peer reviewed this presentation

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