PENSION INVESTING IN THE POST-PPA WORLD
PENSION INVESTING IN THE POST-PPA WORLD
The Pentegra Defined Benefit Plan for Financial Institutions' primary investment objective is "to preserve principal and provide at least an adequate return to meet benefit payments to present and future retirees". The Plan's other objectives are to minimize year to year volatility in contributions in different markets by minimizing the volatility of the funded ratio; and to seek over time to reduce employer contribution rates.
What has changed in the post-2006 Pension Protection Act (PPA) world? Put simply, our basic investment policy has not changed. How we get there-our investment strategy - is what has evolved in the PPA environment.
A defined benefit plan is a promise that participants are entitled to receive a fixed monthly dollar payment during retirement. It is like a debt obligation- i.e. a liability-consisting of a stream of future payments. Therefore, the objective of a defined benefit plan's investment program is to invest its assets so as to be able to meet these liabilities. One of the major results of the PPA is a significant change in the process of measuring these liabilities. This change obviously impacts how to invest the assets.
Before the PPA, defined benefit pension plans valued their liabilities based primarily on actuarially assumed rates. The key assumption was a single discount rate to calculate the present value of the projected future liability cash outflows. The higher the assumed rate, the lower the present value of liabilities. A higher discount rate assumption was generally justified by using long-term equity market returns. However, as a result of PPA, liabilities are marked to market based on either (1) a corporate spot yield curve calculated each month by the US Treasury based on debt securities rated A and better or (2) on the 24 month average of three segments of this bond yield curve. The yield curve segments are comprised of three maturity intervals: 0-5 years, 5-20 years, and 20+ years. As a result of the PPA, actuarial valuation results are tied to current capital market returns and volatility, especially to changes in longer term interest rates. A plan's funding ratio (assets divided by liabilities) is a key metric. For example, the PPA considers plans "at risk" that are below 80% funded and imposes payout restrictions on such plans. As a result, pension plans are increasingly shifting their focus from maximizing asset returns to minimizing funding ratio volatility-a focus that Pentegra has had for many years.
Before the PPA, shortfalls in funding could be amortized over periods of up to 30 years. The PPA requires the amortization of any shortfall over seven years, and has a 100% funding target. Prior to the PPA, valuations of plan assets could use five year asset smoothing. Under the PPA, plan assets are valued based on either their current market values, or their average value over two years. Shortening the time horizons for funding and smoothing increases potential contribution volatility. In combination with the increased sensitivity of liabilities to market based interest rate changes, volatility is significantly increased.
As a result of using a single discount rate to value the future liability cash flows, a common portfolio management strategy prior to PPA boiled down to creating an asset portfolio that would seek to generate returns that would equal or exceed the liability discount rate assumption. If the plan outearned the discount rate, the impact on the actuarial valuation was to make a positive offset to the growth in liabilities and thereby lower employer contributions. Given that the discount rate assumption was generally partially derived from long-term equity returns, most pension funds were heavily tilted to equity investments.
Attempts to beat the long-term market rate of return led to volatility in actual portfolio returns and created tracking error between the return on assets and the discount rate. Pre-PPA rules allowed for asset returns to be smoothed over a five year period, and shortfalls between asset and liability values could be amortized over a period up to 30 years. This allowed portfolio managers to smooth shortterm volatility of asset returns and lower the volatility of sponsor contributions. As a result, the impact of tracking error in year to year portfolio performance was muted and could be absorbed over time. In order to manage the risk related to funding its retired lives liabilities, Pentegra created a portfolio of fixed income securities that was constructed such that the cash inflows from coupons and maturities can largely offset the projected cash flows of the liabilities related to retirees. These liabilities were shorter in duration (where duration is the sensitivity of a bond or liability stream's value to changes in interest rates) and more predictable than the projected cash flows related to non-retired or active participants, and therefore enable the use of medium and long maturity bonds in a cash match portfolio. The cash matching portfolio is rebalanced periodically to meet changes in the projected behavior of the retired lives liabilities.
Separately, Pentegra used a "meet or beat" strategy to manage the Plan's assets allocated to participants that were not yet retired. The projected cash flows related to these active lives were more uncertain than retired lives because of, for example, future salary, years of service, turnover and other estimates. Pentegra used equity and equity oriented investments to generate returns for this segment of the Plan, to meet or beat the liability discount rate over time and provide real rates of return to offset salary growth embedded in the liabilities. Various risk management methods were employed including diversification, hedging strategies, periodic rebalancing, etc. For example, managers that earned excess returns over time had their allocations reduced to lower the concentration risk of the Plan and to minimize expected mean reversion in those managers' returns.
The new PPA valuation and amortization rules have incented pension sponsors to rethink large allocations to equity investments since changes in PPA yields can create volatility in the present value of participant liabilities. Pentegra has determined that the goal of minimizing volatility of plan sponsor contributions requires additional performance and risk metrics for the Plan under the PPA. The funded ratio, which is the present value of the liabilities discounted by the PPA curve compared to the market value of the Plan's assets, must be assessed on an ongoing basis. Since the funded ratio is a key metric driving employer contributions, minimizing the volatility in employer contributions requires minimizing the volatility in the funded ratio. To minimize this volatility, a liability focused strategy is required.
Post-PPA, the Plan has been reducing the difference in duration between its assets and liabilities in order to manage volatility in its funded ratio. To accomplish this, the Plan has lowered its equity exposure and lengthened the duration of the fixed income assets in the Plan. The Plan has also used interest rate swap overlay portfolios to synthetically lengthen duration. This strategy allows the Plan to receive the return on instruments of varying maturities in return for paying a short term LIBOR rate. Implementing its post-PPA strategies have lowered the Plan's exposure to the equity market and increased the duration of the Plan's assets through increases in long-term fixed income and swap positions. Increased fixed income duration is expected to reduce the exposure of the Plan liabilities to yield curve changes. Going forward, the Plan is also developing greater refinement of its liabilities in order to achieve fuller matching of the capital market characteristics of its assets and liabilities.
The Plan's historic focus on risk management considerations has positioned Pentegra to effectively address the changes resulting from the PPA. The Plan's portfolio segmentation and matching strategies reflect Pentegra's risk management focus. These liability focused strategies have served Pentegra well by positioning the Plan to enter the post-PPA period more liability focused than many pension funds. Further refinement of this strategy is an important element of the Plan's goal of meeting/exceeding liabilities.
While the PPA has created new challenges in managing the Plan, the key tenets of Pentegra's strategy remain intact. The Plan's primary investment objective is to preserve principal and provide at least an adequate return to meet benefit payments to present and future retirees. In addition, minimizing the volatility of the plan sponsor contributions is a key goal of Pentegra's portfolio management strategy. While the investment tools employed to meet this goal have been expanded as a result of the PPA legislation, our basic investment philosophy has not changed.