Greek mythology recounts the tale of Sisyphus, a king who was punished by being forced to roll a massive boulder up a steep hill, only to see the boulder roll backwards before reaching its final destination at the top of the hill……each and every time he approached the summit. This tale is often used to enhance descriptions of everyday activities which might be seen as wasteful, unproductive, or endlessly challenging. Thus, we have an nice backdrop for a more pointed discussion surrounding the challenges of a pension committee with a similar massive boulder (monthly benefit payment obligations) and steep hill (navigating investment markets targeting smooth 8% annual return targets).
Retiree obligations comprise 30-50+% of the typical defined benefit pension program. The cost of these liabilities can run 4-8% of plan trust assets annually (depending on demographics and plan rules). Pension sponsors fund their obligations thru a combination of investment returns and cash contributions. Most plan sponsors attempt to maximize investment returns in order to minimize their own cash outlays, thus the traditional reliance on risky assets to earn higher targeted returns. Theoretically, funding and asset allocation decisions at their most basic are a pretty simple exercise in risk vs. reward:
- More Risk = More Volatility = Potentially Smaller or Larger Expected Contribution Costs = Less Certainty (think less fixed income)
- Less Risk= Less Volatility =Larger Expected Contribution Costs= More Certainty (think more fixed income)
In practice, these decisions can be more difficult against a backdrop of historically low interest rates, plan underfunding, and the sponsor’s core business enterprise which is competing for capital which might be otherwise allocated to the pension program. Thus the comparison to Sisyphus, who endlessly struggles to productively move his boulder.
Others have written more extensively around the topic of money weighted returns/sequence of returns being the real driver of economic value in a pension plan program. Actual plan cash flows (benefit payments) are an important element to determining the money weighted asset returns. Once benefit payments are issued they leave the plan trust and are unavailable to participate in future market cycles. I’ve linked below some papers by Norman Ehrentreich “The Asset Return Cost Paradox” and Cutwater Asset Management “Developing an LDI Mindset” which touch further on this issue which is often lying silently under much higher level discussions and decision making focused on a targeted rate of return approach.
EhrentreichLDI Paper: http://www.ldi-research.com/uploads/The-Asset-Return-Funding-Cost-Paradox.pdf
Cutwater LDI Paper: http://www.cutwater.com/pdf/research/cutwater_ldi_white_paper.pdf
Liability driven investing and pension de-risking is an area which has evolved rapidly in the last half a dozen years or so. Corporate pension plan sponsors now have a wide array of tools at their disposal to help manage the efficient de-risking of their pension program. These strategies will be most appealing to organizations who are challenged by volatility and open to considering some of the cost tradeoffs which are often necessary to obtain more predictable outcomes.
One such de-risking solution involves a partial risk transfer where the pension plan annuitizes its current retiree population with a highly-rated, well capitalized, private insurer. This strategy is commonly employed as part of the plan termination process where all benefit obligations are fully funded and distributed as part of the formal plan wind-up process. A retiree carve-out annuity purchase involves a more strategic decision (by a non-terminating pension plan) to reduce the size and complexity of its pension program. After annuitization, which formally settles the benefit obligation, the pension trust’s asset portfolio is no longer subjected to the difficult task of trying to serve two masters (#1: income and liquidity needed for current pensioners & #2: growth needed for minimize the costs of future pensioners). In the case of the Sisyphus analogy, this approach could be akin to increasing the size of the boulder (added costs to annuitize) while reducing the steepness of the hill (less near term cash flows to distract the growth potential of the remaining asset portfolio). While the simple elegance of the annuity based risk transfer strategy is clearly appealing, this approach is not a silver bullet, and will involve an organization having to come to terms which a variety of issues related to cash costs, accounting costs, IRS funding impact, asset allocation, and regulatory & fiduciary compliance.
Verizon, is a notable example of an organization which recently concluded that the benefits of this approach outweighed the costs, at least as it relates to their business, objectives, and outlook. Their decision last year to annuitize $7.5 billion of retiree obligations serves to validate this strategy. Also important to note, that this strategy is not new, it’s been around for years as an option which is readily available and fairly simple to execute. What is new, is the environment and mindset of CFO’s and pension consultants who are tasked with managing pension volatility, which creates an opportunity for the retiree carve-out/partial pension risk transfer strategy to become a useful option within the larger LDI/De-risking solution set. Finally, I’ve attached a link below to an older SEC Form 8-K from a small cap company that made a similar decision years ago to pay $75 million to purchase a group annuity contract that covered its 1,500 current retirees. This public document provides some interesting insights around how the company viewed and positioned this strategic decision to investors through its regulatory filing.
Good luck to you and your clients as you work to manage the Sisyphean task of balancing pension cost & risk issues.
Stunning Video Depiction of Sisyphus Struggling