The Pension Protection Act (PPA) passed in August represents the most significant change in US pension regulation in more than 30 years and is likely to have far-reaching consequences in how plans structure and manage their investments. After years of heated debate, US plan sponsors, like their European counterparts before them, now face stricter rules for funding ratios and for valuing plan assets and liabilities. We expect this will hasten a move in the US toward liability-driven investing (LDI), as we saw in Europe, in which plans use projected liabilities as their investment benchmark.

As US sponsors continue sifting through the implications of the new legislation for their plans, we thought it would be helpful to review the sorts of changes we saw when similar rules took effect in Europe. For several years, we have been working extensively with European clients who have switched to LDI frameworks as part of their deficit recovery programs in the wake of stricter funding requirements. The following essay illustrates ways to approach the new world of pension liability management and portfolio growth.

The PPA focuses on three key provisions:

• Valuation: Applying a more conservative, market-based valuation methodology for measuring the plan’s assets and liabilities as well as the rates used for discounting liabilities to more accurately reflect a plan’s current funding gap and reduce the potential for valuation smoothing techniques to obscure funding shortfalls.

• Funding Levels: Raising the minimum funding level requirement from 90% to 100%; establishing a seven-year incremental period for compliance; and standardizing the defeasance of funding shortfalls.

• Remedial Actions: Increasing PBGC premiums for all firms, imposing additional fees to “at-risk” companies and redefining the “at-risk” designation while providing exemptions for the airline and auto industries.

Additional provisions disallow the counting of credit balances that arise from historical excess contributions unless the funding status is above 80%; raise the tax-deductibility of corporate contributions from 100% to 150%; and allow pension funding surpluses above 125% to be applied towards funding retiree health benefits.

Plan Funding Implications
We expect the US act will affect plan sponsors differently, depending on their current level of promised benefits and the liability profile linked to their particular demographics. As new funding targets emerge from the legislation, sponsors must begin taking the necessary steps toward implementation. It is important to note that the PPA extends the current AA corporate bond rate for plan years through to December 2007; beginning in 2008, they will operate under the new rules which use three distinct rates along the AA corporate bond curve depending on the maturity of the cash flows.

The basic aim is to get plans incrementally back to full funding: the funding target will be 92 percent in 2008; 94 percent in 2009; 96 percent in 2010; and 100 percent thereafter. The present value of all accrued pension benefits will be consistently measured using the new valuation methods at the beginning of each year, and any shortfalls will be amortized over seven years as part of a recovery plan (with the exception of airline companies which have an extended 10-20 year phase-in allowance). It seems the legislation also allows for greater amortization of any plan surpluses to mitigate higher sponsor contributions in an effort to help reduce the volatility many plans could encounter under the new system. Understanding the implications of funding level volatility is crucial for appreciating the need for a liability-driven framework as we illustrate below. Should a plan miss even one annual target, its funding requirement immediately shoots up to 100 percent.

Understanding the “At-Risk” Funding Level
Contention in the run-up to the reform centered on how to determine a plan’s funding level and what can be defined as an “at-risk” position. This debate directly addressed concerns over current smoothing practices that allow plan asset values to be averaged or smoothed over five years and to range from 80-120 percent of their fair market value. While this reduced the volatility of funding levels, it also led to wide discrepancies between recorded asset values and their fair market value. The new act reduces the smoothing period to two years and tightens asset valuations to 90-110 percent of their fair market value. Beginning in 2008, plans must use either a modified yield curve that includes three segment rates averaged over two years, or a yield curve of rates that have not been averaged. Plans will be assessed according to two criteria:

• Did the funding level for the previous plan year fall below 80 percent of its regular funding target?

• Was the plan’s funded status less than 70 percent of its at-risk funding target?

Failure to pass both these tests categorizes the plan as at risk; plans that remain at risk for two of the previous four years are subject to penalty payments.

In future, the US Treasury Secretary will determine the three rates based on a yield curve of investment-grade corporate bonds. This “Modified Yield Curve Treasury Secretary Method” will be phased in beginning in 2008 and 2009 and fully implemented by 2010. Retaining a wriggle factor in the liability discount methodology is likely aimed at having a safety valve to mitigate some of the forthcoming pain. As plan sponsors get used to the consequences of the new regulatory environment, they will gradually adopt discount rates close to the AA swaps curve.

Plans seeking a liability benchmark that keeps ahead of the regulation change would be well advised to use the swaps curve to discount liabilities. The importance of this cannot be overstated when reviewing assets and liabilities together.

Consequences for Future Asset Policy
Looking at how similar funding rules affected UK plans provides insights on what US plans can expect. In our UK case study, the actuarial adviser has informed the plan he has applied the UK’s new rules to discount the liabilities, and the money required today to pay all projected liabilities is 100 million pounds. The plan has an asset valuation of 85 million pounds and therefore a typical funding level of 0.85, or a deficit position today of 15%.

Before reviewing the asset policy, we first need to understand the sensitivity of plan liabilities to changes in interest rates; in other words how that 100 million pounds will rise or fall with interest rate changes. As regulation in the UK moved away from smoothing to market-based valuations, we immediately saw how the present value of the liabilities could change quite dramatically, introducing considerable funding level volatility risk. This is because the liabilities have always been a stream of zero coupon bonds with duration. The duration of the liabilities is very important, as is the shape of the liability cash flow profile and their projected certainty. If we are to achieve a surplus position, we must now adopt the liabilities as the benchmark to beat. With the PPA in the US, plan sponsors will be forced to understand how their liabilities change with more market-based discount rates. Figure 1 illustrates the typical dinosaur shaped liability cash flow profile we see in the UK, which is our 100 million pounds of liabilities today shown in future value terms.

Each bar in each year is a future cash payment the plan has promised, so we can now identify that longer-dated payments carry higher risk than near-term payments. This is due to their long duration in the same way that a 30-year bond has a higher volatility than cash. If we placed these cash flows on a pair of scales, we would see that the average of all these liability payments occurs in 2026. This gives us an average scheme duration of 20 years. A 1% change in the discount rate means a 1% change for every year of the liabilities; hence, we can multiply the 1% change by the average duration to get a good approximation of the scheme’s liability sensitivity. When bond yields rise or fall between valuation points, the liabilities will likewise move by approximately 20 times the change in yields. Naturally, the sensitivity is not exactly linear as plans will exhibit a secondary effect to the change, known as convexity. The implication is now clear: duration is a risk that cannot be ignored under the new act. It is a concentrated bet on the direction of interest rates.

Considering liabilities and assets under the new rules means understanding this risk. In other words, the tracking error between assets and liabilities needs to be considered in the context of expected return. Most plan sponsors would not accept a 10% tracking error against the S&P 500® for a 2% outperformance target, but this is essentially what they will be doing.

Previous Asset Allocation Practice
Historically, plan sponsors have kept a higher weighting in their asset allocation to risky assets such as equities because of expected outperformance over bonds over the longer term. A conservative estimate of the equity risk premium is generally thought to be about around 3% and linked to real economic growth. Hence, a typical passive allocation of 70% equities and 30% bonds will have a liability tracking error of 10% per annum, but the expected return above the liabilities will not be more than 2%.

Returning to the hypothetical UK plan with 85 million pounds in assets and 100 million in liabilities for a typical deficit of 15%, we can see the implications of this kind of allocation. If passive equities return 3% above AA bonds or swaps and we hold 70% in passive equities, this 3% in excess return improves the 15% funding gap by less than 2% (that is: 70% of 85 million pounds in assets, or 59.5 million pounds X .03% = 1.785 million pounds).

Before stricter funding regulations, many sponsors felt comfortable with a 30% bond allocation especially if invested in long-dated conventional bonds with a duration of 13.3 years. However, if we recall our example’s liabilities duration of 20 years, we see we are 16.6 years short the liabilities. This is easy to calculate, as it is simply 13.3 years from bonds held at 30%, times 85% of assets we hold, which is 3.4 years contribution, compared to the liabilities at 100% times 20 years duration.

Placing our assets alongside our liabilities in this way indicates that if bond yields rise by 1%, we would be nearly fully funded, probably very pleased and not “at risk” under the new pension rules. This also assumes our equities remain unchanged. Conversely, if bond yields fall by 1% and remain low for a year or two, we will be in trouble under the new regulations. Our 70% in equities, which is approximately 60 million will need to rise by a whopping 70% to keep the funding level unchanged at 85%, as the liabilities rise to 122 million.

This is a particularly dramatic illustration of the unrewarded liability risk under conventional asset allocation. There is almost no associated extra asset return from our 30% bond allocation, but we have accepted unrewarded risk. Maintaining large, unintended short duration positions, if bonds perform reasonably well, will not facilitate deficit recovery. Hedging interest rate risk using swaps if bond yields have reached fair value may be the first significant step for many plans on the road to deficit recovery.

Liability-Driven Investment Solutions
Identifying this significant and unrewarded liability risk does not imply the need for a full-scale allocation to long-dated bonds. Most plans could not afford foregoing the expected return premium on equities. Instead, liability-driven investing begins with measuring the overall portfolio risk against the liabilities and considering two interrelated portfolios that directly address the different investment objectives: liability protection and funding level growth. We define the two portfolio objectives as managing liabilities while seeking diversified return above the liability portfolio.

• Liability Management: The aim of this portfolio is to better match, or hedge, the plan’s underlying liabilities to the total value at risk specified by downside protection. A liability-matching portfolio can therefore be considered as a better bond portfolio or a synthetic hedging overlay with less overall liability mismatch risk from inflation and interest rates. The portfolio will not, however, protect against longevity or sponsor risk. The liability-matching portfolio is likely to contain a mixture of liability hedging instruments, such as longer-dated swaps, in either a pooled or segregated structure.

• Growth Portfolio: The objective of the remaining assets would be to seek a diversified return above the liability portfolio, such as liabilities plus 2.0% at the overall portfolio level (LDI + 2.0%). The growth portfolio will contain higher return diversification within the constraint of the value at risk, so it cannot jeopardize a plan’s overall funding level.

Combining liability management with the growth portfolio implies an additional 2.0% return per year over the liabilities with a lower 4% funding rate volatility (tracking error) than a conventional 70/30 portfolio. Naturally, the target can be higher or lower depending on the desired level of the risk dial. The important relationship is between the liability plus return and the annualized volatility.

Figure 3 illustrates the annual value at risk or tracking error deviation in the funding level between assets and liabilities on the horizontal scale according to changing allocations. We expect to maintain or improve the expected return by combining diversified active assets and suitably constraining the allocation to a reliance on alpha. We can directly measure and compare different return scenarios against the current portfolio aimed at superior returns with less risk. The result is steady, controlled growth in the funding ratio to redress deficits.

Dividing the liability plus return by the liability tracking error risk creates a new measure of efficiency for risk taken. This provides a single score that plan sponsors and consultants can compare. The higher the ratio, the higher the efficiency of the deficit recovery program.

The new pension rules will require sponsors to reconsider their “set it and forget it” attitudes toward asset allocation. Our experience with clients in Europe in this new regulatory environment suggests that rethinking investment policies along the dual lines of liability management and capital returns, with liabilities as the point of reference, offers a more reliable roadmap toward deficit recovery.

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This material is for your private information. The views expressed are the views of Joe Moody only through the period ended October 3, 2006 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: October 25, 2006