Vol 3 | No. 3
Q&A: Asset Allocation—‘Don’t Put the Cart Before the Horse’
Inglis
The Pension Practice Council published an issue brief, Asset Allocation and the Investment Return Assumption, in July, which details why the investment return assumption is often determined by the asset allocation, and not the other way around. Subtitled “Don’t Put the Cart Before the Horse,” the issue brief’s highlights include discussions on:
- The expected investment return for a pension plan’s assets used as the discount rate for public and multiemployer pension plan valuations is sometimes referred to as the “actuarial” rate of return;
- The investment return assumption used to measure pension liabilities is sometimes treated as a return target for determining the asset allocation for a pension fund. Some find this practice can lead to increased investment risk; and
- Why investment risk is typically reduced as a plan matures.
The Retirement Report spoke with Evan Inglis, a volunteer who contributed to the issue brief, about some of the considerations that went into drafting it.
What prompted this project?
In the drafting group’s view, actuaries are concerned about a fundamental misunderstanding related to the investment return assumption used in pension valuations. The assumption is not intended to be used as a target that influences decisions about asset allocation. When it is, it can lead to portfolios with high levels of risk—and this appears to be happening in recent years.
How is the balance between risk and return important when thinking about the investment return assumption?
An appropriate allocation of assets in a portfolio will balance the risk of unexpected drops in market value and the desire for strong levels of return. High levels of return over time are associated with volatile and uncertain returns. Thus, plan sponsors need to assess the potential impact of unexpected markets drops when higher levels of return are sought.
What considerations are overlooked by reliance on the expected rate of return as a target in setting asset allocation?
Pension risk grows as the size of pension liabilities increases relative to the revenue stream that serves as the source of funding. As this ratio changes over the years, investment risk can be reduced to control the level of risk. Other factors such as the funded status, the net cash flow, the financial strength of the plan sponsor and how the pension benefits grow with inflation and salaries are important factors to consider as well.
Is the investment return assumption important for all pension plans?
Investment returns are a key consideration for all pension plans, but only public (state and local government) pensions and multi-employer pension plans (for groups of union employees) use an assumption about investment returns to determine the pension liability. It is these plans that sometimes perceive this assumption to be a target, in part because maintaining the assumption at a certain level controls the cost of the plan.
How does investment risk relate to future contribution requirement volatility?
High levels of investment risk create more volatile and uncertain levels of return which translate directly to more volatile and uncertain contribution requirements. Pension funds may smooth out changes in asset values with an actuarial value of assets and with amortization of gains and losses but the impact of downturns in the financial markets may be quite large and last for many years so that the impact is still significant.
Capitol Forum Webinar Looks at Social Security’s Reform Options, COVID-19 Implications
A panel of experts looked at the financial challenges of the Social Security program and possible ways to address them in the Academy’s Aug. 13 Capitol Forum webinar, “Social Security Reform Options.”
The panelists offered insight—from their own perspectives and not the Academy’s—on the current state of Social Security finances, potential ramifications of the ongoing coronavirus pandemic, and reform options to strengthen the system. The recent executive action on temporary deferral of payroll taxes was also discussed.
Presenters were Social Security Administration (SSA) Chief Actuary Stephen Goss; Research Fellow in Economics Rachel Greszler, the Heritage Foundation; Senior Vice President Bill Hoagland, Bipartisan Policy Center; and Social Security Works President Nancy Altman. Academy Senior Pension Fellow Linda K. Stone moderated.
Goss outlined the program’s current status. Social Security pays out benefits to approximately 65 million recipients, or almost one in five Americans, and current projections outlined in the latest Social Security Trustees Report show that the program’s combined trust fund will be depleted by 2035, which reflects neither the pandemic’s effects nor delayed payroll-tax contributions.
The primary reason for the impending shortfall is demographics—the number of beneficiaries compared to workers paying into the program will go up over time. Potential solutions would be to raise scheduled revenue after 2034 by about one-third, reduce scheduled benefits after 2034 by about one-fourth, or some combination of the two, Goss said, adding that potential cuts to the program “have always motivated Congress” to take action.
Greszler offered the perspective program is a “bad deal for younger workers,” and that allowing people to contribute a portion of their money currently being paid into Social Security in turn into private retirement accounts would offer better rates of return over time. “If there’s going to be a program that’s as large as 12.5 or potentially 15.5 percent of workers’ paychecks, there should be some level of ownership there, or the ability to access it,” she said.
Hoagland noted the work several years ago of a politically diverse bipartisan commission that attempted to ensure that Social Security was “actuarially sound for the next 75 years,” in line with the program’s mission. He highlighted three of 12 potential reforms offered by the commission, including increasing the progressivity of the benefits formula, and establishing a basic minimum benefit for low-income beneficiaries. Tying the recommendations together would help the program’s “long-range actuarial balance” from a negative to a positive balance over 75 years, he said.
Altman, cited President Dwight D. Eisenhower’s 1953 quote that Social Security as a retirement system is part of an American heritage of “sturdy self-reliance.” She said the program’s “end is to provide basic economic security,” and is extremely secure and backed by the U.S. government. “It seems to me the right answer is to make Social Security adequate to everyone,” she said.
Panelists took questions from attendees, several of which were about COVID-19’s long-term effects on the program’s solvency. While Goss said the Social Security Administration does not yet have projections—because the economic effects and extent of the pandemic are still not fully known—the SSA estimated in the spring the depletion date could move from mid-2035 to early or mid-2034, excluding a second pandemic wave. If the pandemic continues, “the trust fund reserve depletion could indeed be moved to earlier than 2034,” although SSA has not yet developed explicit projections for that, he said.
There was also quite a bit of discussion about the action to temporarily defer payroll taxes and what that could mean to Social Security financing, especially if the elimination of these dedicated taxes became a permanent change. Slides and audio are available to logged-in Academy members.
Pension Webinar Covers ASOP No. 51 Practice Note
The Academy hosted an Aug. 20 webinar, “Practice Note on ASOP No. 51: Risk Assessment in Practice,” covering the July practice note about Actuarial Standard of Practice (ASOP) No. 51. Referencing the practice note, the presenters—Paul Angelo, a member of the Public Plans Committee; Tammy Dixon; and Julie Ferguson; with Pension Committee member Grace Lattyak moderating—shared perspectives from corporate, public, and multiemployer plans.
The practice note offers information on current or emerging practices in which actuaries are engaged that may be affected by ASOP No. 51, Assessment and Disclosure of Risk Associated with Measuring Pension Obligations and Determining Pension Plan Contributions. Dixon remarked that the practice note could “help us along the way” as the profession continues to incorporate the new standards. One recurring theme was the centrality of professional judgment in the identification, assessment, and communication of risk to plans.
The presenters put forth various considerations that actuaries typically take into account when working to identify risk, and discussed possible effects of the interplay that can arise between two or more risk factors. “The answers can be very different, depending on the plan type,” Ferguson said. They discussed investment risk, asset/liability mismatch, interest rates, demographics, and contribution volatility in detail, and covered others such as inflation and covered employment.
Presenters also covered the four common approaches to quantitative risk assessment listed in the standard. In some instances, they said, a general risk assessment may be conducted along purely qualitative lines, without further quantitative calculation or detail, while noting that conditions specific to a plan may play a role in determining what form a general assessment takes.
Presenters addressed what circumstances lead an actuary toward recommending a more detailed assessment and how the actuary makes the determination of whether such further assessment would be significantly beneficial.
The panelists took questions, providing opportunities to dig deeper into the “gray areas” that actuaries must navigate in identifying risk. “All of this relies on the actuary’s professional judgment,” Angelo said—a key takeaway for an engaging session that covered many considerations.
Slides and audio are available for logged-in Academy members.
Health/Pension Webinar From ASOP No. 6 Practice Note Work Group Set for September
Join the Academy in September for a public policy work group webinar, “Practice Note on ASOP No. 6: A Discussion of the Exposure Draft.” The webinar will provide an overview of a July exposure draft of a practice note, ASOP No. 6 – Development of Age-Specific Retiree Health Cost Assumptions for Pooled Health Plans, Including Applications to Non-Pooled Health Plans, the purpose of which is to provide information for actuaries valuing retiree health benefit plans. The webinar will be held on Sept. 17, from noon to 1:30 p.m. EDT.
The presenters who helped prepare the practice note—James Rizzo, chairperson of the ASOP No. 6 Practice Note Work Group; and work group members John Bartel; Colleen O’Malley Driscoll; Piotr Krekora; Jim Whelpley; and Dale Yamamoto along with Retiree Benefits Chairperson John Schubert, who will moderate—will provide their perspectives on the exposure draft, and there will be ample time for questions. For a previous more expansive discussion of the issue, see the Summer HealthCheck.
Please note: This is not a professionalism webinar sponsored by the Council on Professionalism or the Actuarial Standards Board, but rather a public policy webinar designed to give attendees valuable information on this challenging area of practice.
Continuing education credit will be available. Register today.
Committee Comments on Proposed Form for Multiemployer Plan Actuarial Certification
The Multiemployer Plans Committee submitted comments to the Internal Revenue Service (IRS) about a proposed form for reporting the annual actuarial certification for multiemployer defined benefit plans.
The comment letter’s suggestions included:
- Evaluating whether the proposed collection of information is necessary for the proper performance of the functions of the agency, including whether the information will have practical utility;
- Evaluating the accuracy of the agency’s estimate of the burden of the proposed collection of information, including the validity of the methodology and assumptions used; and
- Enhancing the quality, utility, and clarity of the information to be collected.
SECURE Act Issue Brief Released
Impact of the SECURE Act on Retirement Security, was developed by Senior Pension Fellow Linda K. Stone in conjunction with the Retirement System Assessment and Policy Committee and the co-chairpersons of the Lifetime Income Risk Joint Committee.
Highlights include:
- An examination of how the law contains a wide range of provisions to strengthen the retirement system, some of which will have an immediate impact, while others will depend on whether employers implement them.
- An explanation of how the law’s mandated disclosure requirement for defined contribution (DC) plans will educate participants on how to make their assets last for their lifetimes by showing numerical examples of how much income might be derived from their account balances.
- A description of the law’s provisions intended to increase the number of DC plans offering annuity options. Utilizing annuity options can improve retirement outcomes for some participants, especially those without access to a defined benefit plan.
Issue Brief—Actuarial Perspectives on Determining a Retirement Income Budget
The Lifetime Income Risk Joint Committee released an issue brief, Actuarial Perspectives on Determining a Retirement Income Budget. The issue brief’s points include:
- Deciding on a retirement income budget is a challenge for many retirees as a result of varying circumstances, goals, and uncertainties about the future;
- Several approaches from an actuarial perspective are described that can be used in addressing the challenges of lifetime income budgeting ranging from as simple as required minimum distributions to complex probabilistic analyses; and
- It is important that retiree find an approach that creates a structure for retirement finances.
Issue Brief Covers Actuarial Assumptions
The Multiemployer Plans Committee released an issue brief, Selection of Actuarial Assumptions for Multiemployer Plans. The issue brief “is meant to contribute to the public policy analysis of multiemployer pension plan issues by providing insights into some of the considerations that go into the selection of actuarial assumptions, and the approaches that actuaries use in practice.”
Committees Comment on ASOP No. 4 Exposure Draft
The Pension Committee, Multiemployer Plans Committee, and Public Plans Committee submitted joint comments to the Actuarial Standards Board regarding the second exposure draft of ASOP No. 4, Measuring Pension Obligations and Determining Pension Costs or Contributions. The letter offered suggestions on several sections of the ASOP, and definition clarifications.
Intersector Group Releases Meeting Notes
The Intersector Group released the notes of its May conference call with the Pension Benefit Guaranty Corporation.
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