The Retirement Report, Winter 2019

New Practice Note on Investment Returns and Expected Return Assumptions

Forecasting Investment Returns and Expected Return Assumptions for Pension Actuaries, intended to help actuaries recommend an expected investment return assumption, assess capital market models from an outside party, or facilitate discussion with investment professionals to better understand the basis for their assumptions.

The Retirement Report undertook a Q&A with Evan Inglis, a member of the Public Plans Committee who worked on the practice note. Inglis also will be a panelist in an “Expected Return Q&As for Pension Actuaries” session at April’s Enrolled Actuaries Meeting, jointly sponsored by the Academy.

How has forecasting returns and setting assumptions evolved in the past several years?

The most important evolution has been the understanding of how current prices affect future returns, especially for equities. Robert Shiller’s book Irrational Exuberance published in 2000 showed how strong the correlation between current prices (P/E ratios) and future returns is. Future equity returns are lower when current prices are high and higher when current prices are low. This relationship is exactly the same for bonds, but with bonds we focus on the yields, which are just the inverse of prices. The key is that current market information is very important and historical return averages are almost irrelevant.

What are some of the challenges of forecasting returns?

A big challenge today is how to do return forecasts for alternative investments like absolute return strategies, direct real estate investments, credit arbitrage, etc., etc. Allocations to alternative investments have increased in recent years. These investments may have little or no relevant data to analyze and their complexity may make return forecasts all but irrelevant. They may be marketed with fairly high return forecasts, such as CPI + 5%, which are easy to use in a forecast but may be too optimistic.

The practice note cites several actuarial standards of practice (ASOPs) that may be relevant to this topic—ASOP Nos. 27, Selection of Economic Assumptions for Measuring Pension Obligations; 23, Data Quality; and 41, Actuarial Communications—though notes this list is not exhaustive. Generally speaking, how do the ASOPs apply to this area?

The ASOPs presume that actuaries have the relevant knowledge and experience to assess future return forecasts. Because return forecasting has advanced and changed significantly in the last decade, this is a big challenge for the profession. That is the inspiration for the practice note, which we hope will be used widely within the public and multiemployer sectors. It should help actuaries be confident and comfortable assessing return forecasts and discussing them with investment experts. By the way, it shouldn’t be assumed that just because someone works at an asset manager or investment consulting firm that they are experts in forecasting returns themselves. That’s why it is so important for actuaries to be able to assess their work.

What is the significance of inflation projections in forecasting returns?

Inflation is a component of the return of asset classes like equities, real estate, and commodities and will generally increase the return as higher price increases develop in the asset class. On the other hand, higher inflation means that future cash flows, like corporate profits or rental income, get discounted at a higher rate which will reduce the current price of an asset. Because inflation is an important aspect of future returns, it’s important for actuaries to think about how their own assumption for future inflation compares to the inflation assumption that underlies the return forecast. It’s possible that either the return forecast or the actuarial assumption for inflation should be adjusted so that inflation expectations are consistent.

What are some of the next steps we might see on this topic going forward into 2020?

I believe the profession will start to consider applying different levels of return for different time periods to discount the expected benefit payments for those time periods. This is in contrast to the current approach of using a single expected return for discounting all expected benefit payments. This will improve our liability calculations because most experts do have different return expectations for the first 10 years and the period after 10 years, which is driven by the significance of current price in return forecasts. This approach has become more relevant because pension plans have become more mature—often the first 10 years of cash flow make up close to 50 percent of the liability.

Does this work draw from multiple committees of the Pension Practice Council?

The task force put together to prepare the Forecasting Investment Returns practice note was diverse, including people from the corporate, public, and multiemployer spaces. Most of the work drafting the note was done by myself and Lena Black because we have both worked with investments for many years and studied return forecasting intensely. The note was reviewed by a number of experts including actuaries working at investment consulting firms and a former public plan CIO.

What are some other resources that members can look to on investment return assumptions?

The practice note includes links to many resources that can further actuaries’ knowledge in this area. Each year, a variety of investment firms publish their capital market assumptions along with analysis and a breakdown of the components of return—for example, equity returns are usually broken down into dividend yield, inflation, real earning growth and price changes. Reading a sample of these capital market reports can help actuaries gain a better understanding of how experts do this analysis.

Lump-Sum Practice Note Released

practice note, Valuing Benefits Payable as a Lump Sum. The purpose of the practice note—an exposure draft of which was released last September—is to provide information to actuaries on current and emerging practices in the development of liabilities and cost estimates for pension plans, with benefits paid as a lump sum.

Many pension plans offer benefits in the form of a single, lump-sum payment. In recent years, as plan sponsors have looked to manage risk, lump-sum payments have become more common. The practice note discusses the valuation of lump-sum benefits for financial accounting purposes, and utilizes a number of concepts related to interest theory.

Measurements of defined benefit pension plan obligations include calculations that assign plan costs to time periods, actuarial present value calculations, and estimates of the magnitude of future plan obligations, and the practice note does not apply to individual benefit calculations or individual benefit statement estimates.

The practice note’s focus is on the application of the concepts discussed therein to accounting for single-employer plans in the U.S. for which the actuary is subject to Actuarial Standard of Practice (ASOP) No. 4, Measuring Pension Obligations and Determining Pension Plan Costs or Contributions; ASOP No. 27, Selection of Economic Assumptions for Measuring Pension Obligations; and ASOP No. 35, Selection of Demographic and Other Noneconomic Assumptions for Measuring Pension Obligations. These concepts may be extended to other applications and other types of pension plans, and the Actuarial Standards Board (ASB) has approved exposure drafts of revisions of these ASOPs but proposed revisions, if adopted, would not change the discussion in this practice note.

Committees Comment to Bipartisan Policy Center

The Academy’s Lifetime Income Risk Joint Committee, Retirement System Assessment and Policy Committee, and Social Security Committee sent a comment letter to the Bipartisan Policy Center (BPC) on the BPC’s 2016 Report of the Commission on Retirement Security and Personal Savings.

The comments cover six areas:

• Improve access to workplace retirement savings plans;
• Promote personal savings for short term and preserve retirement savings;
• Facilitate lifetime income options to reduce risk of outliving savings;
• Facilitate the use of home equity for retirement consumption;
• Improve financial capability among all Americans; and
• Strengthen Social Security’s finances and modernize the program.

Within each area the groups offer a series of considerations and recommendations, and the letter states that “[a] holistic U.S. retirement policy would allow changes to be measured against policy objectives. There are a number of stakeholders providing excellent research and perspectives that help address retirement security for the U.S. population, but there appear to be no guiding principles or direction from which these efforts could be coordinated.”

Pension Letter Addresses Retirement Legislation

sent a letter Dec. 19 to U.S. House of Representatives leadership on The Retirement, Savings, and Other Tax Relief Act of 2018. The letter notes that in recent years, policymakers have been focusing on ways to expand the portion of the workforce covered by employer-sponsored retirement plans. Among other research, this focus is supported by a 2017 report by the Government Accountability Office, which concluded that many households are not well-prepared for retirement and have little or no retirement savings, and is corroborated by research cosponsored by the Academy on retirement readiness, the letter states.

The act’s retirement provisions would relax requirements for companies to group together to sponsor a multiemployer pension plan, as well as provide a measure of protection for employers from compliance failures that occur beyond their control, the letter notes. While these provisions might not address all of the reasons that small businesses are reluctant to sponsor retirement plans, they would make plan sponsorship more attractive to these companies, which could be an important step toward addressing some of the issues identified in recent retirement readiness research, it states.

Academy Comments on ERISA Rule

The Retirement System Assessment and Policy Committee submitted comments in late December related to the Employee Benefits Security Administration of the Department of Labor (DOL) regarding the proposed rule on the definition of “Employer” under Section 3(5) of the Employee Retirement Income Security Act of 1974, as amended (ERISA).

In response to an Aug. 31 executive order, DOL proposed the rule in late October that could clarify that an employer group, association, or professional employer organization can constitute an “Employer” under ERISA if it satisfies certain criteria. The proposed rule is similar to regulations the DOL issued earlier in 2018 with regard to association health plans.

In its analysis, the committee stated that the proposed rule could help expand access to employer-sponsored retirement plans by making it more affordable for small companies to offer plans to their employees. The committee went on to outline the benefits of allowing multiple employer plans (MEPs) to be treated as single plans for ERISA purposes, rather than as a collection of unrelated employers.

EA Meeting Set for April 7–10

Enrolled Actuaries Meeting will be held April 7–10 in Washington, D.C. Sponsored jointly by the Academy and the Conference of Consulting Actuaries, the EA Meeting will offer panels, workshops, and speakers covering a variety of topics and issues relevant to enrolled actuaries and other pension professionals.

Highlights include:

• Ellen Kleinstuber, a member of the Academy’s Lifetime Income Risk Joint Committee and Joint Pension Risk Transfer Task Force, will be a panelist in the opening general session, “Reading the Tea Leaves—Where is Retirement Policy Headed?”
• Academy Board member and Pension Committee Chairperson Bruce Cadenhead will be a panelist in a “Late-Breaking Developments” breakout session.
• Former Actuarial Board for Counseling and Discipline Chairperson Rick Block will be on a “Maximum Deductions” panel.
• Tonya Manning, chairperson of the Joint Program Committee for the EA Meeting, will participate in a “Dialogue With the IRS/Treasury” panel and the closing general session on “Rise and Fall of Discount Rates.”

The meeting will also include a general session on ethics, which will include EA credit, subject to Joint Board for the Enrollment of Actuaries approval. The preliminary agenda is available online—register today for discounted registrations, still available.