Placing money into a secure vault has long been equated with safety. Cautious individuals have used this approach for centuries, accepting zero gross returns in exchange for protection against loss of principal. And although the thesaurus suggests “vault” and “safe” are synonyms, the strategy can be anything but, sometimes blowing up with apocalyptic destructive power.
This complacent strategy is particularly risky for sponsors of defined benefit plans, especially frozen ones on the path to termination. For them, stashing assets in the vault for safety can actually trigger mushrooming balance sheet liabilities and postpone termination for years. The source of this risk management error is not the usual culprit: lack of conservatism. Rather, it is a misinterpretation of conservatism itself, and a misunderstanding of what constitutes “safe” investment when hedging a plan termination liability (the true cost of transferring risk through lump sums and annuities).
The problem with going into a vault is there are no guarantees the world will be the same when you come out. Like Henry Bemis, the bookworm played by Burgess Meredith in The Twilight Zone episode Time Enough to Last, who emerged from a reading break in a bank vault to find the world destroyed by nuclear war, a once orderly setting can quickly become an apocalyptic scene of rubble and twisted metal.
While cash is locked in a vault, plan liabilities continue to be volatile and potentially destructive. Assets stashed in cash or ultra-short duration investments on the stated termination date of a plan will be approximately the same when funds are actually distributed.
But the interim period between stated termination and asset distribution can be 12 months or more. During this time, interest rate volatility can continue to pose a significant risk. Sharp rate declines can blow up liabilities while the assets designated to cover the obligation obliviously rest in the vault. Shock and surprise await sponsors who arrive at asset distribution day only to learn their fully funded position has gone up in smoke and their plan is now unable to terminate.
- Assume a plan has a $10 million termination liability and $10 million in assets on Jan. 1, 2014. The sponsor files the necessary forms to begin termination and moves to an allocation of 100% cash.
- At the end of the year, the $10 million is still intact and available for termination. A year less of discounting and sharply dropping interest rates, however, has pushed the cost of termination up 15% to $11.5 million.
- An approach intended to be risk-free has been anything but, and locking investments in cash can result in $1.5 million of additional cost.
The source of the risk management error is that the hedging asset for pension liabilities is generally not cash (see exceptions below). It is duration-matched, high-quality fixed income investments. Preservation of the principal is not the overriding investment objective, but rather preservation of the net unfunded liability (and avoidance of new unfunded liability from asset-liability mismatch).
Since the vast majority of our personal investment dealings focus on gross returns and not net liability, this error is entirely understandable. A gross risk versus return efficient frontier would place risky equities on the high end and cash on the low end. A net risk versus return efficient frontier, however, would have the same risky equities on the high end, but long duration bonds as the safe haven. Fiduciaries managing pension risk need to understand where those two frontiers diverge and when to change tracks when setting their hedge.
Going back to our example, had the sponsor allocated 100% into a theoretically perfect duration-matched, high-quality fixed income strategy on Jan. 1, 2014, the yields from the bonds would have covered the growth of liabilities due to the passage of time, and the market value of the bonds would have risen in reaction to dropping interest rates the same way liabilities did. On Dec. 31, 2014, the plan would have had $11.5 million in assets and the plan would have remained termination sufficient.
In real life, of course, interest rate risk can never be perfectly hedged. But the key to avoiding apocalyptic asset-liability hedging errors is to truly understand the plan’s provisions and the liability risk being managed. Specific plan design details are critical; subtleties can be worth millions of dollars.
For instance, traditional pension liabilities behave like long-duration bonds, but cash balance liabilities are usually shorter in duration. Lump-sum conversions of traditional pension benefits behave like long-term bonds, until final payment amounts are locked in for up to a year; a point where the hedging asset indeed becomes cash (learn more about lump sums in “Pension Defenestration”). Meanwhile, annuity purchase prices continue to be hedged with bonds to the final point of purchase.
Open and frequent communication among plan sponsors, advisers and actuaries is the best way to help ensure the correct liabilities are being hedged with the appropriate investments. Those who ignore this admonition and simply hide assets in a vault risk emerging to find a post-apocalyptic funding shortfall worthy of the Twilight Zone.
Clark is a consulting actuary at the Principal Financial Group, an investment management and retirement leader. He is a fellow of the Society of Actuaries and a member of the American Academy of Actuaries — and a strong advocate of shatterproof lenses in reading glasses. A version of this blog originally ran on The Principal blog.
The subject matter in this communication is provided with the understanding that The Principal is not rendering legal, accounting or tax advice. You should consult with appropriate counsel or other advisers on all matters pertaining to legal, tax or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.
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