DAU Flashcards

Question

Poor EE Behavioral Factors in DC Plans:

Answer 1

o Decisions required to make informed decisions may be beyond employee’s skill set o Participants tend to overweight past performance as an indicator of future performance o Younger workers may contribute less than the full match or the minimum required o Participants may not diversify investments properly

Answer 2

o Immediate Eligibility o Automatic Enrollment o Automatic Escalation o Re-enrollment o Stretch matching contributions o Discourage early withdrawals and loans o Provide limited but adequate menu of investment options o Offer access to online investment advice o Offer lifetime income options

Answer 3

* General: o Competitive position relative to cost and contribution rate o Desired balance of total compensation package o Underlying message implied by DC formula (joint savings or automatic ER cont) o Ensure DB participants are not significantly disadvantaged by new design o Encourage enrollment and participation o Establish default investment strategies o Encourage annuitization in payout stage o Ensure effective communication

Answer 4

o Determine if objective is to maintain assets of terminated/retired participants o Determine if DC plan has overall retirement objectives (income replacement goal) o Determine if goal is to provide retirement options based on how participants separate from service (term / retire) o Determine what guidance, education, advice will be made available to participants

Answer 5

* EE contributions and accrual rates vary with age: o Early leavers lose out when deferred benefits are not valued like accrued benefits o In final pay plans, workers with steep earnings profiles benefit over those with flatter profiles o Partnered members profit over single members due to survivor pensions o Women get more value due to longer life expectancies * EE contributions and accrual rates do not vary with age: o Younger workers overpay for their benefits while older workers underpay o Early joiners overpay versus those who join later in their careers o Those who leave the plan early overpay o Those with flat earnings profiles overpay versus those with steep profiles

Answer 6

* Traditional DB Plan: o Inflation risk is mitigated for participants only if benefits are paid as inflation-indexed annuities o All other risks related to benefit provisions are owned by plan sponsor o Longevity, investment, interest risk owned by plan sponsor o Replacement rate is fixed as percentage of final or career average wage * Cash Balance Plan: o Participants may not be protected against inflation risk if fixed investment return is set too low o Participants protected against investment risk (benefits can be paid as LS) * Collective DC Plan: o Pensioners face greater risks as benefits can be linked to the plan’s funded status

Answer 7

* Plan Sponsor: o Employer contributions to both plans tax deductible o Both plans viewed as vehicle for employee retention o CB plan offers more funding flexibility o DC plan shifts investment risk and longevity risk to participants o CB plan can be used to incentivize early retirement through special offerings * Plan Participant: o Both easy to understand o Both offer LS option at retirement o Investment decisions required under DC plan o Cash Balance benefits protected by the PBGC o Cash Balance plan can offer guaranteed investment return o DC plans offer loans and withdrawals, while CB plans do not

Answer 8

* Contributions: o Tax subsidies are generally in the form of tax credits to incentivize employees to save for retirement o Contribution limits are used to limit loss tax revenue. Generally only applicable to high earners. * Investment Earnings: o Generally accumulate tax free. High earners benefit more due to larger asset base and larger growth. * Benefit Payments: o Generally taxable as ordinary income o Could cause social security to be ceased or capped o Tax rates higher for higher earners

Answer 9

* No Change to Current DB; DC for New Hires Only: o Appropriate if concern of providing DC benefits of comparable value to current DB o Accounting Impact:  No adjustment for current members  DC accounting for all new active employees’ contribution * Soft/Hard Freeze of DB; DC Going Forward: o Appropriate if there is concern about the cost of converting DB balances to DC o Accounting Impact:  Curtailment accounting  DC accounting for all active employees’ contribution * GF Certain EE’s; DC for All Others: o Appropriate if there is concern DC value is not sufficient for those close to retirement * Convert DB to DC Account Balance; DC Going Forward: o Appropriate if ERs want to reduce DB commitments more quickly o Accounting Impact:  Curtailment accounting required for future service– recognition of proportionate share of prior service costs and full recognition of gain/loss equal to decrease in liability  Settlement accounting required for past service  DC accounting for all active employees’ contribution

Answer 10

* Employer Perspective: o Advantages:  Greater cost certainty going forward  Removes volatility of DB costs due to interest rate changes  Transfers investment and longevity risk to employees  Potentially simpler financial disclosures going forward (no service cost)  Harmonizes benefits across all employees  Plan design fits more mobile workforce o Disadvantages:  Short term accounting implications  Converted DC balance may be high depending on interest rate environment  Deferred vested and retirees still have DB entitlement  Fiduciary obligation to ensure participants understand change  Can no longer use DB plan to retain employees

Answer 11

o Advantages:  Greater flexibility on investment decisions  Benefit value may be more equitable for younger employees  Full value of benefit earned regardless of termination timing  More portable benefit o Disadvantages:  Employees now assume longevity and investment risk  DC plan may not provide same value of benefit going forward  No ancillary benefits in DC plan  May not have financial knowledge to manage investments  Annuity purchase costs at retirement can be volatile

Answer 12

o Private sector corporations have a profit motive and can offload costs (converting to DC) without regard to who may be burdened by this cost. o Public sector employers can also offload costs, but these costs may be picked up by other government entities or taxpayers o Most large public plans have already moved towards more risk sharing elements (e.g. inflation protection).  Cost savings for conversion to DC not fully materialized for public sector o Attracting and retaining employees is a more important consideration in public plans and DB plans generally viewed as more valuable o Unions may limit the ability to convert o Public pensions often part of negotiated compensation packages or enacted in legislation o Government has more societal considerations than private corporations o Many public plans provide portability already

Answer 13

* Defined Benefit Plan: o Sponsor assumes longevity risk by guaranteeing lifetime annuities to members o Can transfer risk to members if lump sum is available * Defined Contribution Plan: o Member assumes the longevity risk through receipt of LS at retirement o Can transfer risk to insurer by purchasing annuity * Target Benefit Plan: o Members assume longevity risk as benefits can be reduced by experience losses o Idiosyncratic longevity risk pooled amongst members if variable annuities are offered

Answer 14

* Portability: o Reduced for employee; EE can take benefit with them at termination o Vesting service requirement lower for CB plan * Longevity: o Retained by ER for those who take annuity o Transferred to EE for those who take LS * Inflation: o Pre-retirement: shifts from employer to employee; CB accrual pattern reduces real value of accrued benefit since formula based on career average o Post-retirement: if FAP provides COLA, CB shifts from ER to EE since lump sum does not have inflation protection

Answer 15

* Money-Back Guarantee – ppt receives at least the sum of their pay credits o Equivalent to put option owned by ppt * Enhanced Money-Back Guarantee – ppt receives at least the sum of their pay credits plus a cumulative floor interest crediting rate per year o Equivalent to put option owned by ppt, except strike price is different * Annual Minimum Crediting Rate – ppt receives greater of index yield and floor rate o Equivalent to series of put options on the ICR owned by the participant

Answer 16

* Advantages: o Eliminates longevity risk o No investment decisions or risks * Disadvantages: o Lose flexibility wrt timing of withdrawals and immediate access to money o Lose possibility of continued returns o No death benefit (unless specified in annuity) o Locked into one insurance company o SS already provides guaranteed monthly annuity

Answer 17

* Spend Investment Earnings: o Leave principal intact o Not guaranteed but designed to make money last for lifetime o Advantages:  Never run out of money; full access to savings; can purchase annuity later; full control of investments * Systematic Withdrawals: o Invest the assets and withdraw the principal and investment earnings with formal method o Advantages:  Never run out of money; full access to savings; can purchase annuity later; full control of investments * Annuity Purchase: o Transfer savings to insurance company to guarantee lifetime income o Advantages:  Lifetime income guaranteed; protection against investment risk; not required to make investment decisions; protected by government backing agencies * Variable Annuity: o Guaranteed minimum withdrawal benefit o Advantages:  Lifetime income; can choose investment allocation; funds available for inheritance; benefit can increase over time

Answer 18

* Adequacy and provision of lifetime income * Purchasing power preservation in retirement * Adequacy of retirement income for those terminating prior to retirement * Funding predictability and flexibility * Benefit predictability and transparency * Workforce management effectiveness

Answer 19

* Defined Contribution Pension Plan: o SC equal to employer contribution for the year * Defined Benefit Pension Plan: o Nonzero EROA o G/L excludes portion of asset g/l not yet recognized in MRVA o PSC amortization based on average remaining working life * Unfunded Postretirement Medical Plan: o SC $0 after participant reaches full eligibility o EROA is $0 o PSC amortization based on average working life to full eligibility o G/L corridor based on APBO

Answer 20

* 401(k): o Advantages:  Generally pre-tax deferrals unless Roth feature  Balances accumulate on pre-tax basis unless Roth feature is available  Catch-up contributions permitted for employees 50+  All employee contributions fully vested  Higher annual contribution limit compared to IRA/HSA  Not subject to minimum required distribution rules at 70 ½ unlike IRA  May be permitted to take loans or hardship withdrawals o Disadvantages:  ER contributions subject to vesting rules  Benefits taxed upon withdrawal  Tax penalties for early withdrawal (59 ½)  Subject to IRS contribution limits * Traditional IRA: o Advantages:  No restrictions on number of IRA’s established  Rollovers from other qualified plans permitted  Contributions tax-deductible  Account balance earns investment income on pre-tax basis  Catch-up contributions permitted for employees 50+ o Disadvantages:  Must have earned income to establish IRA  Tax-deductibility of contributions minimized if EE participates in another qualified ER-provided plan  Excise tax on excess contributions  Benefits taxed upon withdrawal  Tax penalties for early withdrawal (59 ½)  Subject to IRS contribution limits * Health Savings Account: o Advantages:  Contributions tax deductible  May allow catch-up contributions for individuals 55+ not enrolled in Medicare  Earnings not subject to taxation  Benefits not taxed upon withdrawal  ER may make contribution on behalf of employee  Funds completely portable and roll over each year  Participants can direct how contributions are invested o Disadvantages:  Must be enrolled in high deductible plan  Contributions subject to annual limits (lowest compared to IRA/401(k))  Cannot use funds to pay retiree health insurance premiums prior to 65

Answer 21

* Include professionally managed options – managed accounts, TDFs, balanced account options * Develop and document rationale for core investment lineup * Offer low number of core investment options * Offer mix of active and passive funds * Exclude or limit company stock * Review different investment vehicles * Look at retirement income options (annuity and life insurance products) * Alternative investment strategies * Assess appropriate balance of offering investment products, providing access to professional advisors, and providing guidance

Answer 22

* Longevity: outliving retirement resources o Mitigate: Deferred variable annuities or longevity insurance * Inflation: fixed income stream loses purchasing power o Mitigate: Purchase inflation-indexed annuities * Interest Rate: low interest rates can result in lower annuity value at retirement o Mitigate: Investing in long-term bonds, mortgages, etc provides protection against low interest rate environments, but value of investments will fluctuate * Public Policy: increases in taxes, reduction in SS and other gov programs o Mitigate: withdraw while in lower tax bracket * Death of Spouse: some income may stop at the death of spouse o Mitigate: life insurance, survivor income in SS, pension annuities * Unexpected Health Care Needs: ERs continue to cutback on post-retirement health care o Federal or state programs, work part time in retirement

Answer 23

* NRA usually 65 (max is 65 and 5) * Benefit formula usually fixed amount per month of service * If FAP – high 5 consecutive years is common (or 5 of last 10) * Another popular benefit formula is % of contributions made on behalf of workers * Common for ER contribution rate to be based on a dollar/hour basis * Contribution level negotiated in CBAs * Common for employees to contribute * Unreduced benefits begin no later than NRA * Subsidized early retirement benefits are common o Typically starts at 55/10 * Variety of payment options typical (although LS option not common) * Post-retirement indexing typically provided on ad-hoc basis * Disability benefit is typically integrated with SS * Full accrued disability benefit without reduction (usually with 10/15 yr service requirement) is common

Answer 24

* Difference between contribution rates and accruals: o If difference is small, plan only has limited ability to absorb experience losses  Only a small part of contribution rate is available to fund any past service contributions o Risk is higher for mature plans o An increase in age may result in an increase in accrual cost that may not be sufficiently funded by current contribution rate o Review PV of future contributions over PV of future accruals – represents the maximum experience loss that can be absorbed by the plan  Determined over the number of years the plan desires to become fully funded  Excess PV as % of liabilities provides a measure of risk for the plan  Sum of surplus plus excess contributions PV as % of liabilities provides measure of cushion that exists o Ways Sponsor Can Mitigate Risk:  Effective disclosures in actuarial report  If margin is more than sufficient, have a known point at which margin becomes too small

Answer 25

* Decline in hours: o Reduction in hours worked leads to a reduction in contributions to fund deficit o May influence part of workforce to retire earlier o Can result in negative cash flows o Risk measured by performing sensitivity and stress testing analysis  Assess the impact on the FS and ability of fixed contribution rate to satisfy funding requirements  Monitoring should increase when hours worked fluctuates more than a pre-described range  Asset/Liability studies can also provide insight into the plan’s ability to absorb variance o Ways Sponsor Can Mitigate Risk:  Reflect any other experience likely to occur due to reduction in hours when performing stress testing analysis

Answer 26

* Intergenerational Transfers: o Benefits should be reasonable based on relative proportion of contributions made to the plan o Intra-generational equity does not adhere to this principle since the relative value that similarly situated members take out of the plan is dependent on plan experience, basic plan design terms, etc. o BOT would decide the extent to which inequities are reasonable o Risk measured by splitting contributions into portion to fund normal cost and portion to fund any deficits  Greater the difference between current contributions and normal cost, greater the wealth transfer among different generations o Ways Sponsor Can Mitigate Risk:  Understand if it’s desirable to have generation of workers to bear the full impacts of deterioration or surplus, or should it be spread out?  Actuary can provide assistance to BOT * Inflation: o Value of benefit will decrease over time o Actuary should be cognizant to past inflation rates when measuring cost of benefit improvements * Mortality: o Longevity improvements may not be sufficient for plan members o Spouse’s longevity may not be related to plan members’ mortality experience

Answer 27

* Advantages: o Less administrative burden because admin done by plan o Employer has reduced governance role o Accounting is simpler; expense = contributions o Contributions are negotiated so costs are predictable o May come with investment advantages because larger assets under management o Reduced valuation costs and management fees due to economies of scale o Less funding risk because benefits can be decreased to offset poor funding position o Responsibility for funding is reduced to just contributions o Strengthened ties with union since they work jointly to provide reasonable benefits o Employees share in responsibility for retirement and appreciate benefits more * Disadvantages: o Investments tend to be more conservative so require more contributions over long haul o Less control over plan communication and employee appreciation of any benefit changes o If company later chooses to withdraw, could incur significant litigation costs

Answer 28

* Law passed in 2014 to address insolvency of struggling MEPPs as well as the PBGC * Insolvency of Multiemployer Funds: o New status certification created where insolvency is projected within 20 years o To help those that qualify for new certification, provision enacted to permit reductions in accrued benefits * PBGC Premiums: o Per person annual premium doubled

Answer 29

* MEPP vs DB Plans: o Risks borne by members in MEPPS versus by employers in DB plans o Members benefits can be reduced in a MEPP, but not in a DB plan o Both pool risks among members (longevity, investment risk) o MEPPs have known costs, whereas DB costs can be unpredictable o MEPP contributions are fixed, DB contributions based on minimum funding requirements and plan provisions * MEPP vs DC Plans: o Risks borne by members in both o Members benefits can be reduced in MEPP and balances can decrease in DC o No pooling of risk in a DC plan o Both have known costs o Contribution rate risk limited to pre-determined rate in both

Answer 30

* Trust agreement formally designates Board of Trustees to administer plan and establish design * Board typically constructed of half employer members and half employee members (union) * Board delegates tasks to officials (e.g. actuaries, accountants, consultants) and professionals report back to the Board * Board determines contributions based on CBA

Answer 31

* Reduce Equity Allocation: o No inflation protection with equities o However, could result in increased cost due to lower expected return * Increase FI Duration: o Helpful when dollar duration of liabilities exceeds that of assets o Increase duration to better match long-term payouts of benefits * Apply Immunization Techniques: o Duration matching, cash flow matching, and annuitization of retired liabilities o Annuitization of retired life liabilities ensures perfect immunization for this group; complete transfer of risk to insurer

Answer 32

* Benefit Design: o Service based on years of service in the public sector for SRPP o Service usually based on hours worked up to a maximum for one year’s credit in MEPP o Many ancillary benefits in SRPP (subsidized early ret, COLA) versus few in MEPP o A little more common to require EE contributions in SRPP o Benefit usually negotiated through collective bargaining in MEPP o Permitted to reduce accrued benefits under both structures * Regulatory Risk Management Framework: o SRPP:  May be required to perform risk management test on plan conversion to shared risk (using stochastic modeling)  On conversion, there must be 97.5% chance that past base benefits will not be reduced over next 20 years o MEPP:  No uniform framework  Some jurisdictions do not permit benefit reductions  No stochastic modeling required

Answer 33

* Funding Risk: o Contributions usually determined by CBA, which may not assure the plan will be well funded o Existing contribution by CBA may not be sufficient after participating employer withdraws * Risk of Decline in Work Hours: o Reduction in hours worked leads to lower contributions to fund the legacy deficit o Increased LS termination benefit can result in liquidity issues o Reduction in hours worked may influence part of the workforce to retire earlier * Risk of Intergenerational Transfers: o Larger portion of current contribution would be used to fund deficit of prior workforce o Board of trustees would need to decide the extent to which inequities are reasonable

Answer 34

* Participating ER’s Perspective: o Advantages:  Legacy deficit would not increase  Cash flow and liquidity needs would be better managed  No need to renegotiate CBA to address funding of legacy benefits since past contributions would still meet funding requirements o Disadvantages:  May have difficulty recruiting new employers to join  May have difficulty meeting benefit expectations of remaining plan members  Reduced contributions going into the plan may delay better funded position in the future  Other employers may consider withdrawing from MEPP

Answer 35

* Participants Perspective: o Advantages:  Past accrued benefits would decrease, but improved funding position may allow members to keep negotiated benefit accruals and ancillary benefits  Improved position may allow plan to forego future benefit accruals and provide more stable benefits – possibility of restoring lost benefits in future  No increase to active members’ contributions  Minimizes wealth transfer between generations o Disadvantages:  Decrease in morale  Reduced pension may not provide adequate retirement benefit  May affect pattern of retirements going forward – delay retirement

Answer 36

* Alternatives to Address Funding Issues: o Renegotiate CBA to increase ER contributions o Increase EE contributions o Decrease future benefits and/or ancillary benefits * Barrier to Implementing Change in MEPPs: o Regulatory barriers and anti-cutback rules may prohibit this o Nondiscrimination issues need to be considered o May reduce ability to attract new employees o Unions may grieve proposed changes o Changes can be subject to lawsuits o Plan administration may become more complex

Answer 37

* Going Concern Funded Ratio: o Determine increase in liabilities and decrease in funded ratio o Determine range at which benefit improvements will be considered o Create funded ratio target after change o Consider margin techniques to protect the plan from risks inherent in MEPP * Going Concern Normal Cost: o Evaluate plan’s future expected contributions relative to future expected accruals o Evaluate PV of both before and after plan change o Determine contribution margin and range of acceptable difference between contributions and costs * Solvency Ratio: o Determine before and after plan change; target level should be set * Future Trends: o Consider maturity of plan, average age, demographics, future cash flows, etc * Regulatory: o Consider legislation and regulations that govern MEPPs

Answer 38

* Advantages: o Employer:  Security – more secure option than domestic plan due to currency volatility, investment restrictions, and political instability  Costs of IPPS have come down in recent years  Globally attractive and can be easier than monitoring many disparate plans  Expats may be sent to country without a domestic plan in place  Can facilitate supplementary benefits (such as loss of SS) via top-up provision  Help with retention o Employee:  Can offer tax advantage if benefits accumulate during work in low-tax countries and no tax is levied by local office  May provide more retirement adequacy  Provides single benefit from one source  Regular and consistent contributions  Top-up provision can help replace lost supplementary benefits * Disadvantages: o Employer:  No tax advantages  If company is small, cost may seem too high  Can be expensive to set up trust  Retention in home plan may be better o Employee:  May be complicated and lack transparency  May be limitations on certain nationalities  Benefit security risk if plan is not funded  Recent tax regulation changes in the US complicate matters

Answer 39

* Design: o Employees:  More flexible as benefits mainly paid as LS  Investment choices can be limited in other countries  Supplemental umbrella plan makes up for difference between specified umbrella level of benefits and benefits actually provided  May prefer a DC plan over DB as DC plan is more portable  IPP can be used when EE does not qualify for home/host benefits o Company:  Most important element is determining eligibility  Can be DB or DC, but trend is moving towards DC  Benefits usually paid as LS  Need to consider legislative requirements of home/host country  Can be difficult to integrate IPP with SS benefits  Need to balance simplicity with equitable treatment among members  Should be used for attraction and retention

Answer 40

* Tax Effectiveness: o Employees:  Tax-free returns  Benefits taxed in country where they are received rather than earned  Benefits tax free at source o Company:  Relatively gray area  Contributions not very tax effective  ER can set up offshore account as a fiscal strategy  ER entitled to deduction only when benefits are paid in an unfunded plan * Funding: o Employees:  Provides benefit security because IPPs are typically unfunded o Company:  Allocating costs and funding obligations back to different locations can be difficult  Funding provides benefit security to participants  Company should consider tax treatment of contributions  Can be funded or unfunded  Funding can be administratively complex and costly  Can be implemented through a trust or insurance contract

Answer 41

* Tax: o IPP can offer tax-free growth if there is no tax levied by local office * Cost: o Greater use of low-cost passive funds and general competition can drive cost down * Trust: o Trusts provide additional benefit security since assets are separate from corporate assets o Trusts come with additional layer of governance

Answer 42

* Trust provides tax advantages as the assets grow tax-free * Company cannot access assets in trust, increasing benefit security * Trusts can be managed by professional firms (better for investment/risk management)

Answer 43

* Pros of Cash: o Easier to administer o Predictable cost o Reduces investment, longevity, inflation risks * Pros of IPP: o Tax effective over cash (cash would be taxed immediately) o Cash may be spent immediately rather than used for retirement o Cash may be less effective for EE retention

Answer 44

* Pros: o Not enough expatriates in the workforce o No longer a useful tool for attracting / retaining talent o Home and host country provisions may be flexible enough to meet the needs of employees who move locations o Contributing to the plan is not tax effective o Frees up cash and people resources * Cons: o May create attraction/retention issues amongst international employees o May need to do special accounting treatment

Answer 45

* May limit internal resources but likely increase external vendor costs * Would require potentially large up front cash cost to fully fund the plan * Would need to decide which services are provided internally vs externally * Need to decide how to fund plan – trust vs insurance policy

Answer 46

* Cross-border risk requiring ER to satisfy certain cross border regulations * Regulatory time restrictions for participating in local plan while accruing service in another country * Currency volatility and regulation accrual limits if benefits are tied to exchanged earnings

Answer 47

* To fund or not to fund the IPP (providers more willing to administer funded plans) * Trust or contract structure (if funded) – contract structure less legally onerous * Bundled or unbundled arrangement (bundled involves one provider taking the administration, investment, and trust/contract structure services) * Pros: o Can offer tax-free growth o No regulatory time restrictions for expats unlike a DB plan o Simple design, easy to understand * Cons: o May be inadequate benefit

Answer 48

* Design Features: o ER Contribution Rate:  Set at a fixed level or within a range  Clearly set out in plan text and can only change through amendment o Target Benefit Level:  Chosen based on contribution rate  Also based on risk tolerance of stakeholders and desire for benefit improvements in future  Actual benefits may differ from target  Defined in advance but not guaranteed o Investment Policy:  Defines the rules for selecting and managing plan’s investments  Policies similar to DB plan  Risk/reward affects affordability of target benefit as well as actual benefits falling short or exceeding target benefit o Benefit/Funding Policy:  Affordability Test: valuation basis used to determine if target is affordable  Triggers for Action: thresholds defined in terms of the outcomes of the affordability test  Actions to be Taken: “Benefit Ladder” or “Policy Ladder” explicit list of changes due to specific triggers hit

Answer 49

o A TBP pools demographic and economic risk o Has predefined retirement income goal – employer’s financial liability is limited to predefined contributions o Members benefits may be periodically adjusted to align with targets o Members become ultimate bearer of plan’s risk – not individually but shared among pooled participants

Answer 50

o DB plan cost is too volatile and expensive – plan sponsors bear all investment and longevity risk o TBPs can retain cost stability by adjusting benefits during volatile markets o Members within DC plans often have insufficient knowledge to effectively manage assets o High management expense ratios erode value in DC plans o TBPs retain stability of costs associated with DC plans, but also allow other benefits due to pooled assets in common fund o Target benefit is paid as lifetime pension – ee does not bear longevity risk o TBPs offer ancillary benefits such as early retirement and post-retirement death benefits o Asset pooling in TBPs provide advantages of pooling investment and longevity risks o Plan members don’t have to make investment decisions due to asset pooling

Answer 51

o Outlines the types of actions to be taken regarding contributions, investments, benefit changes and their priority, extent, and any limitations when specific triggers are hit. o May leave some actions undefined, usually in respect to triggers identifying extreme events o When a trigger is hit on the downside, the correction would ensure benefits remain affordable, typically resulting in a reduction. o When a trigger is reached on the upside, correction would redistribute excess assets, typically resulting in an increase.

Answer 52

o Allocate risk directly to participants – translate plan experience with adjusted benefits o Transfer downside risk to 3rd party by purchasing commercial hedging product  E.g. longevity risk hedging contract  Some risks may be difficult or expense to transfer completely o Intergenerational risk sharing – have different generations of participants enter hedging contracts for residual mortality, investment, inflation, and other risks

Answer 53

o Contribution Flexibility:  EE and ER contributions could fluctuate within prescribed range  Allocates greater risk to actives than retirees  Future generations would have more/less risk than current/past o Adjusting Future Service Accruals:  Retain past accruals, only adjust future  Allocates more risk to future generations  Indirectly means active members are subsidizing retirees o Static Margin in Valuation Assumptions:  Add conservatism to the affordability test (e.g. discount rate) o Projection Valuation Methods:  Incorporate future contributions and accruals of existing members into valuations

Answer 54

* Offer lump sums to actives at term/ret or adjust benefits based on plan experience * Purchase annuities for retirees and deferreds or purchase a longevity hedge product * Redistribute longevity risk by having younger generations underwrite the risks of older generations by putting their own benefits at risk

Answer 55

o Employer Perspective:  Opportunity cost of not using funds for growth of corporation  Pros: * If funded to outside trust, can receive tax advantage from immediate deduction * More potential volatility in funding in unfunded plan * Provides more benefit security to participants * Helps with attraction and retention * Avoids sudden burden placed at the time of retirement in an unfunded plan  Cons: * Easier to administer unfunded plan * Contributions subject to the claims of the company’s creditor * Not tax-deductible until benefits received by participants * Reduces the cash available for the business * Increased benefit security may not translate to increased perceived value o Employee Perspective:  More benefit security in funded plan  Depending on funding vehicle, may be subject to constructive receipt and taxed immediately  Unfunded SERP can’t support EE contributions

Answer 56

o Midcareer recruiting: can offer past service o Umbrella plan: can serve as uniform plan for executives who transfer within the organization, providing administrative efficiencies o Noncompete Provisions: forfeit benefit if executive goes to a competitor o Golden handcuff: stringent vesting requirements can encourage executives to stay

Answer 57

o DB SERP:  Benefits taxed when the benefit is known and determinable (generally when retirement date is known)  Taxable amount is generally the PV of benefit  Some companies and executives choose to do early inclusion technique rather than pay the full taxable amount at once. This presents risk if certain assumptions are not met o DC SERP:  Benefits taxed as the benefit becomes vested  Once fully vested, accruals are taxed on an annual basis * Benefit Distribution Restrictions Under 409A: o Decisions about time and form of payment must be made in calendar year that precedes year of benefit accrual o Any subsequent changes to time and form of payment delay payment at least 5 years o Payments delayed 6 months after separation for specified employees o Benefits cannot generally be paid from foreign trust o Contributions to trust containing NQ benefits are restricted if QP is not adequately funded o Payments can only be made at certain points, including:  Separation from service  Disability  Death  Specified time under plan  Change in control of the corporation  Unforeseeable emergency

Answer 58

* Eligibility: o Automatic enrollment once impacted by tax limits o Set up so certain job titles are eligible (e.g. VP and above) o Better to have less stringent eligibility requirements * Vesting: o Immediate vesting for EE attraction o Vest benefits later on in career for EE retention (vest after certain number of years, vest only if retire from company, vest on graded schedule) * Benefit Formula: o Restore lost benefit due to tax limits o Provide larger accruals than base plan o Provide salary formula more generous than qualified plan (include bonus, OT, etc) * Service: o Recognize service since employment (effectively recognize past service prior to eligibility) o Recognize service from prior employer

Answer 59

o Cash flow availability – enough cash available to make contributions and pay benefits o Volatility of cash requirements – how volatile will each funding option be? o Accounting considerations – impact to balance sheet and P&L o Tax considerations – vary according to funding vehicle o Flexibility – can the asset be used in multiple circumstances? o Benefit Security – level of security provided under each funding vehicle o Asset-Liability Matching – will liability movements be appropriately hedged?

Answer 60

* Pay-as-you-go: o No pre-funding * Corporate Owned Life Insurance: o Plan sponsor owns life insurance on executive o Policy held as corporate asset until death of executive, so either corporate assets or loans against the company must be used for payment of benefits o Growth in policy not subject to taxation for ER o Company can deduct policy premiums immediately o If policy held until executive death, corporation receives death benefit tax free o Offers little benefit security for employee o Executive taxed upon receipt of benefit o Approach has been under legal scrutiny for many years * Cash: o Company self-finances plan with cash * Taxable Securities: o Sponsor creates portfolio of stocks and bonds to fund future payments o Offers little benefit security for employee o Executive taxed upon receipt of benefit; sponsor taxed on investment income o Sponsor subject to investment risk * Rabbi Trusts: o Sponsor creates irrevocable trust for executives o Assets are limited to distribution of benefits o Executive is taxed upon receipt of benefit o No immediate tax benefit for employer (not tax deductible until benefit is paid) o More security for participants * Secular Trusts: o Sponsor creates irrevocable trust for executives o Assets not limited to creditor claims; benefit considered corporate asset o Corporation can immediately deduct contributions to the trust o Executive taxed as benefit becomes vested as well as on investment income

Answer 61

* Contributions (Initial Deferral Election): o Deferral election must be made before compensation is earned o In first year, elections can be made within first 30 days of eligibility, but only applicable to compensation yet to be earned o If eligibility is granted automatically be IRC Code limit, election can be made by 1/30 of following year * Benefit Distributions: o Time and form of payment follows same requirement as initial deferral election above o Commencement date can be postponed and election changed if:  Election is made at least 12 months before original scheduled payment  Election is effective no less than 12 months after it is made  Payment is delayed for at least 5 years o If plan designates payment installments, 409A rules apply to each installment o BCD for separation of service delayed 6 months for a specified employee

Answer 62

* Must leave the plan in place for 12 months after plan to terminate; pay out benefits between 13th and 24th month * Must fully distribute benefits to participants * Employer needs to consider impacts to employee morale and retention * Termination cannot occur proximate to a downturn in the financial market * All similar plans must be terminated * Cannot create a similar plan for 3 years * From employee perspective, benefits are immediately taxable * Employees will have lower tax-deferred retirement income since past service benefits are cashed out

Answer 63

* Agreement between company and employee that employee will receive certain benefits if employment is terminated * Examples: o Handling of deferred compensation in the event of change in control o Severance pay provision in the event of termination due to change in control o Restricted stock provisions in the event of change in control o Long-term incentives in the event of change in control o Temporary continuation of welfare benefits following change in control * Advantages for Company: o Helps attract and retain executives o Provide form of financial protection for executives o May allow executives to remain focused in the event of change in control o May incentivize executive to act in best interest of shareholders in the event of change in control o May lessen the likelihood of executive looking for other employment in the event of change in control

Answer 64

* Contributions: o Only deductible when benefits are paid or become taxable to employee in a SERP o In QP, contributions are deductible when made * Investment Returns: o Investment income on any earmarked funds totally taxable in SERP o Tax free in QP * Disbursements: o Distributions taxable as ordinary income in both o In unfunded SERP, benefits can be taxable prior to receipt if there is a nonforfeitable right to the income o No special treatment for LS distributions that can apply in certain GF situations in QP o SERP distributions not subject to early withdrawal tax like in QP

Answer 65

* Restoration: Address benefit equity due to tax limits * Retention: Address issue of turnover and retain key employees * Recruiting: Entice mid-career executives and bridge the gap of benefits that may be lost by switching careers * Performance: Reward employees for meeting performance objectives

Answer 66

* Private sector plans more likely to have jurisdictional issues for benefit reductions, marriage breakdown calculations, and termination values * Additional challenges may occur during lifecycle of a private sector TBPP due to downsizing, mergers, acquisitions, divestitures, etc * Public sectors more likely to have the size and stability to maintain levels of payroll needed to fund towards the required level of certainty * Public plans still predominantly DB versus Private shifting more to DC * Majority of public plans FAE with high annual accrual rates * Public plans likely to include COLA and generous early retirement subsidies * Surplus of public plans can be used for benefit enhancement * Public plans may include a deferred retirement option plan (DROP) which increases costs

Answer 67

* Reduce benefits of new entrants * Reduce or freeze benefits for all employees * Reduce or put caps on COLA * Reduce early retirement reduction * Raise normal retirement age * Increase vesting/eligibility requirements * Increase years used to determine FAE * Change earnings definition * Increase employee contributions

Answer 68

* Plan Design: o Public design usually provides for indexing (payments continually increase) o Public EE’s not always covered by SS o Benefits typically codified in law and difficult to modify o Generous features (e.g. ER subsidies allow for early retirement) * Contribution Policy: o Other demands for revenue streams which compete with pension contributions (e.g. schools, roads, etc) o Taxpayers more easily recognize reduced funding for other government responsibilities but not likely to notice optimistic assumptions passing on risk to future generations o Contribution holidays can pass risk to future generations o Short term decisions to improve benefits using surplus can impact future generations o Inadequately funded plan is borne by current and future taxpayers * Governance: o No single governing authority ultimately responsible for mitigating risk o Elected officials lack expertise to effectively manage plan risk o Bad decisions could result from the lack of proven analytical tools o Antagonistic relationship between employers and unions makes it difficult to make decisions o Stakeholders able to pass risk to future stakeholders

Answer 69

* Articulate who bears what risks and how before gains and losses arise * Allow participants to understand and anticipate outcomes * Increase the predictability of financial outcomes * Risks are assigned to stakeholders strategically and optimally based on who can bear those risks * Ensures both employees and employers share plan cost * Assets are pooled and invested professionally * Can be designed to target specific level of income that reduces the risk of uncertainty for plan participants by informing them of the benefit the ER is providing * Address longevity risk with lifetime benefit payouts

Answer 70

* Variable Employee Contribution Rates: o Requires contribution rates that change based on plan’s investment performance o Rates for some plans are established in relation to accrual costs * Contingent or Limited COLA: o Automatic COLA with cap – ER and EEs share risk during high inflation periods o COLA delayed onset or minimum eligibility – EE’s bear risk during waiting period o COLA applied to portion of benefit – EE’s with large benefits bear more risk o COLA tied to investment performance – EE’s and ER’s share risk based on performance * Cash Balance Hybrid Plans: o More risk (investment and longevity) placed on participants o IC rate provides guaranteed minimum rate even in low inflation environments o Reduces ER’s risk by guaranteeing benefit that relies on investment credit that is typically lower than investments of a DB plan o Retirement benefit based on age at retirement transfers longevity risk to EE * DB-DC Hybrid Plans: o DB portion fixed, DC portion variable o DC component places investment responsibility on participant o Shared longevity risk (ER have DB risk, EE has DC risk) o Inflation risk on DC portion borne by participant * Implement Employee-Funded COLA * Switch to Career Average Formula * Adjust/Suspend Accruals

Answer 71

* Society/Taxpayers: o Accurate forecasts minimize need for society to backstop the plan o Projections can help in long-term decision making process * Public Employees: o Projection study can provide insights on benefit security * Unions: o Projection study can provide information on sustainability of benefits and potential impact on any anticipated changes in trend * Public Sector Employers: o Employer needs to make budgeting decisions and has many competing needs for funds o Projection can help with long-term budget requirements

Answer 72

* ER and Plan Sponsor: o Low costs and volatility; attract and retain talent * Public Employee: o Adequate retirement benefits; low contributions * Taxpayers: o Low taxes * Elected Officials: o Re-election; postpone pension contributions to lower taxes * Unions: o Valuable benefits for employees; low contributions and high salary * Retirement Plan Governing Body: o Long-term health of plan; simple plan to administer

Answer 73

* Overview: o Arrangement where employee continues working instead of retiring and receiving benefits under the plan o Compensation and service are frozen at the time member enters the DROP o Employee has a sum of money credited to a separate account for each year of continued employment o Account earns interest until member elects to retire o Balance is paid at retirement in addition to the original DB benefit * Advantages: o Employer Perspective:  Ability to retain valued employees who are eligible to retire  May have contribution savings during the drop period depending on design  Investment risk passed onto employee during drop period o Employee Perspective:  Opportunity to continue to accrue benefits  Accrual may be more favorable than continued accruals in DB plan  DROP benefit may be payable as LS whereas original DB benefit may not be * Design Features to Limit Cost and Volatility: o Align crediting rate to actual return on assets – transfers investment risk to participants o Annuity only – eliminates volatile lump sum payouts o Remove ER subsidies – o Limit employment after the end of the DROP period

Answer 74

* Features: o Risk is borne by participants o Pension entitlement as deferred annuity o Risk-sharing with complete contract in mutual insurer yields variable annuities o Specific forms of risk-sharing contracts o Communication and risk management on basis of consumption frame o Economic valuation * Strengths: o Consumption frame can improve communication and risk management o Addresses systematic longevity risk through risk-sharing with a joint liability pool * Weaknesses: o Can lead to intergenerational conflicts o Discount methodology for valuing joint liabilities can be contentious o Volatile contributions o Does not allow for tailor-made risk management

Answer 75

* Tax-effective means of providing retirement financial security * Valuable benefit for current retirees and those close to retirement * Valuable for attracting and retaining talent * Considered social responsibility of employer * Can help provide competitive total package of benefits * Generally a big priority for unions * Employer may have history of providing these benefits

Answer 76

* Provide access to individual coverage / retiree exchange: * Provide HSA to cover some expenses o Available in some high deductible plans o Contributions tax deductible o Earnings tax sheltered o Distributions tax free

Answer 77

* Cost and Coverage: o Pre-65:  More uncertainty because market is not stable or secure.  Premiums can be volatile; coverage can vary year to year o Post-65:  Retirees have access to Medicare, so coverage is more geared towards supplemental benefits; less expensive than pre-65 * Retiree Perspective: o More risk if expenses exceed annual subsidy o Potential for lower premiums and more flexibility to use HRA dollars * Employer Perspective: o Simplified administration – handled by private vendor o Cost effective as fixed dollar subsidy * Design Considerations: o How is credit determined? Flat dollar, age based, service based? o Do retirees have to enroll with exchange? o Subject to indexing? o Rollover of unused credits? o Any interest crediting component? o How are catastrophic claims handled? o Are spouses/dependents covered? o Does HRA cover expenses or just premiums? * HR Perspective: o Relieves administrative burden o Liberates resources previously engaged in retiree communication o Plan design simpler to explain o Change may cause discontent with participants o May need to renegotiate CBAs o Transition will require significant effort * Finance Perspective: o Comparable benefits at lower cost and more predictable o Fixed costs do not allow company to capitalize savings in year where medical expenses decrease * Retiree Perspective: o Wider variety of options available o Dedicated customer support and online tools available o May receive equivalent coverage at lower costs o Wider variety of options may be overwhelming

Answer 78

* Provide large networks – ensure insurers have broad network * Make sure support exists – ensure call centers are prepared * Educate employees – communicate change and provide guidance * Survey the landscape – feasibility study * Identify conflicts with bargaining agreements * Select appropriate vendor – ensure vendor provides sufficient support during and after transition

Answer 79

* Retirement age o Can be estimated using SSNRA or retirement plan’s NRA * Length of life in retirement o Can be estimated using online mortality tool * Availability and source of health coverage * Rate at which health care costs increase o Can be estimated with historical increases

Answer 80

* Retiree Perspective: o Less risk compared to HRA+exchange o Coverage may not be adequate depending on carrier/contract specifications * Employer Perspective: o For paternalistic ER, integrated health care coverage for employees o Cost containment over premiums in the fully insured arrangement; still more volatile compared to fixed subsidy

Answer 81

* More Stringent Eligibility Requirements: o Increase age and service eligibility * Service-Related Benefits: o ER’s cost depends on years of service * Cost-Sharing Provisions: o Add retiree contributions, copays, deductibles * Establish Fixed Subsidy: o Use fixed dollar amount as opposed to percentage of plan costs

Answer 82

* Trend: o Current rates of health care inflation – impacted by:  Utilization  Tech advances  Plan design effects and cost shifting o Different rates for different services o Initial rate close to recent rates experienced in plan and nationally o Length of draw-down period o Additional cost due to leverage if plan design features fixed deductibles, copays, out of pocket maximums o Getzen model can be used to develop rates o Consider relationship of health care expenditures to GDP * Termination: o Start with standard tables; adjust for employer specific factors – occupation, work environment, unionization, location, etc. o Use relevant historical plan or plan sponsor experience – consider credibility o Consider provisions of other plans offered by sponsor – e.g. early retirement benefits

Answer 83

* Increasing Cost: o Higher utilization, new technologies, drugs, services that are more expensive o Number of retirees is growing o Layoff and ERPs mean more retirees receiving benefits sooner o Medical costs increase with age o Life expectancy continues to increase * Regulatory / Legislative Risk: o Uncertain future o Government sponsored benefits continue to be reduced o Benefits removed from government plans may automatically be covered by private employer plans o Accounting requirements could change * Legal Risk: o Several court cases involving CBAs and salaried employees o ERs include language in communications that they have a right to amend or terminate plans * Interest Rate Risk: o Unfunded liability could be larger than pension plans due to lack of assets o Lower discount rates lead to higher liabilities

Answer 84

* Large Case Management: o Majority of claims typically generated from a minority of retirees; review claims determined to be financially significant and determine if services are being duplicated * Utilization Review: o Evaluate appropriateness of treatment before services are provided; see if there are cost-effective alternatives that provide same results * Spousal Initiatives: o Introduce surcharge for spouses o Provide bonus to employees who enroll under spouse’s plan o Make spouse ineligible if other coverage is available * Dynamic Plan Provisions: o Review plan periodically to reflect more dynamic provisions (deductibles, copays, coinsurance, etc.) * Managed Prescription Drugs: o Negotiated reimbursement rates o Reduced administrative fees o Utilization review o Specialty pharmacies o Mail-order plan * Enhanced Quality of Benefit: o Provide program that provides higher quality of benefits at same or lower cost o Use centers of excellence o Encourage retirees to use specific providers o Retiree education programs * Managed Health: o Wellness programs – encourage retirees to make healthier choices o Begin lifestyle education while employees are still active o Credits for healthy lifestyle * Retiree Exchange: o Provide contribution towards medical coverage at current cost level o Limitations exist since pre-65 exchanges aren’t as developed

Answer 85

* Re-measurements/Gains and Losses: o Recognized immediately in OCI under IFRS o Recognized immediately in income statement or amortized over average service under US GAAP * Past Service Costs: o All prior service costs recognized immediately in P&L under IFRS at time of remeasurement o PSC recognized in OCI at date of plan amendment under US GAAP and amortized over average service to full eligibility * Net Benefit Pension Cost Presentation: o No requirement to present as a net amount under IFRS o All components must be aggregated and presented as net amount under US GAAP * Settlements: o Recognized when settlement occurs under IFRS o Under US GAAP, occurs if settlement amount exceeds sum of SC + IC * Curtailments: o Recorded when the curtailment occurs under IFRS o Under US GAAP, curtailment losses are recognized at time of announcement; curtailment gains are recognized at time of curtailment

Answer 86

* Split benefits into highly secure base benefit and moderately secure ancillary benefit * Pre-determined actions to change future benefits/contributions in response to plan’s funded position * Orderly reduction of benefits if deficit does not meet certain criteria * Risk management framework to keep plans on track * Includes funded ratio yardsticks (e.g. plan must be projected to be 100% funded for next 15 years)

Answer 87

* Certain jurisdictions do not have comprehensive target benefit legislation to support the framework * Benefit reductions in one jurisdiction may be prohibited in another * When reductions are required, results would be inequitable because only the jurisdiction that allows reductions would be impacted * Marriage breakdown calculations would be inequitable since they are determined differently in various jurisdictions * Termination values would be inequitable between jurisdictions that recognize the funded status and those that do not

Answer 88

* Vertical Hybrid: o First portion of employee’s salary is subject to contribution rate of the DB plan o Remaining portion of salary subject to contribution rate of DC plan o Integration point is significant to plan design o DB component provides longevity and interest rate protection * Horizontal Hybrid: o Entire salary subject to respective DB and DC contribution rates o Provide greater portability of benefits o Preserve retirement security for members who terminate before retirement o Integration point can be fixed level or indexed o DB-type risks are reduced for plan sponsor relative to full DB plan * Choice Scheme: o Members provided choice of full DB or full DC o Retirement security tied to decision relative to their specific situation o Adverse selection issues if participants make best decisions for themselves

Answer 89

* Public Sector Pension Plans: o Union rejection – typically cover unionized employees o Generous benefit – public plans typically more generous o Tax payers – costs of ERIP will be passed onto tax payers o Societal consideration – there are other budgetary uses for public funds o Governance structure – many stakeholders lack pension knowledge or have different motivations (e.g. elected officials) * Private Sector Pension Plans: o Well-defined decision makers – easier approval process o Profit motive – will it make sense from a cost perspective? o Less generous benefits – ERIP has greater value in motivating EE behavior o Post-retirement health benefit – private companies can use as motivation for ERIP o Specialized skills – employees tend to be less homogenous; unintended take rates would lead to knowledge loss * Similarities Between Public and Private Sector: o Eligibility criteria – who is the program targeting and what is the take rate objective? o ERIP design – what enhancements are offered? o Cost considerations – can the plan afford it? o Intergenerational inequity – additional costs are picked up by the plan and indirectly by future service employees o Employee morale – how will ERIP affect those eligible and not eligible? o Timing – when is the window of eligibility and window of election? o Communication – how will the program be announced? How can EE’s ask questions?

Answer 90

* Considerations When Determining Eligibility Criteria: o Consider business objectives o Criteria should be strictly objective o Decide what job classifications should be included o Ensure criteria aligns with eligibility criteria within plans o Target roughly 2 times the number of employees you want to elect for the potential eligible group * Ways to Maximize ERIP Success: o Offer age credit in plan – allow EE’s to retire earlier with better ERF o Offer service credit in plan – increase benefit, allow EEs to retire earlier with better ERF o Offer health insurance enhancement – e.g. bridge to 65 or reduce eligibility requirement for post-retirement health benefits o Offer enhanced benefits or lump sum – increase pension benefit or provide severance

Answer 91

* What to include in Communications: o Outline eligibility criteria o Explain offerings and how benefits are impacted o Include effective date o Explain how to accept offer o How long the window will be open o Deadline to respond o Who to contact with questions o Seek legal counsel o No current plans to offer subsequent ERIPs in future o Continued employment is never guaranteed * ERIP Implementation Steps: o Select effective date – employee’s last day of work o Determine length of retirement window – min 45 days to consider offer o Analyze cost/savings to ensure meets objectives o Prepare a waiver form to protect company from lawsuits o Prepare the announcement – should include details on eligibility, explain the program, benefits offered, timing, etc.  Include statement that company has no plans to offer other ERIPs in future o Prepare pension estimates o Send the announcement

Answer 92

* ERIP takes longer to develop and is a longer process * Layoffs can result in more targeted cost savings * ERIP supports employees who want to retire and gives them control over future * ERIP may reduce the need for involuntary layoffs unless take up rates are low * Involuntary layoffs may lead to decline in morale * Greater threat of lawsuits with involuntary layoffs

Answer 93

* Plan Sponsor Perspective: o Risks primarily passed onto participants in both options o LS option aligns with desire to remove terminated participants from the plan o LS option results in unexpected large payouts which can influence investment decisions o Need to consider fiduciary duties with partial withdrawal options o Can set min/max limits with partial withdrawal options to better control expected payouts o Partial withdrawal options allow terminated/retired participants to take advantage of group investment benefits (lower fees, better investment managers/options) * Plan Participant Perspective: o Both options easy to understand o Both options offer flexibility for retirees to have access and control of funds o Both options can be risky to retirees with insufficient financial awareness o LS provides options of where to move the money o LS provides control over retirement investment o Partial option offers access to funds if needed, but option to take advantage of group investment (lower fees, better managers, etc)

Answer 94

* Plan Sponsor Perspective: o Both great options in supporting participants’ financial security by taking on all (or mostly) of longevity risk o Both options require additional effort required for long-term management of EE’s retirement funds o Installment option may be more attractive to employees o Installment option comes with fiduciary responsibility to provide proper investment management o Annuity option transfers risk to insurer (if purchased with insurer) * Plan Participant Perspective: o Both options have reduced longevity risk and better financial security o Both options harder to understand; give participants less control o Advantage of large-scale asset pool investment with installment options (better fees) o Installment options require decisions on withdrawal intervals and amounts o Annuity option provides guaranteed payment for life o Advantage of group annuity rates with annuity option

Answer 95

* Payout option for retirees * Active EE’s participate in traditional DC plan during accumulation phase * Single premium life annuity whose payouts are adjusted each year based on the mortality and investment experience of the group of annuitants relative to assumed return and mortality * Actual benefits may increase or decrease year to year * Full impact of gains or losses passed on to pensioner * Retirees buy units in the variable annuity with their accumulated balance at retirement * No guarantee of benefit stability * Hurdle rate established – equal to expected long-term real rate of return * UBC Faculty Pension Plan: o Two variants offered – one with 7% return and one with 4% return o Both invested in same fund o 7% option expected to produce decreasing stream of payments; opposite for 4% o Benefit security low for 7% option * Participant Risks: o Inflation – income may stay flat or decrease, diminishing purchasing power o Financial Markets – income may decrease in poor markets o Longevity – lower than expected mortality results in decrease of income

Answer 96

* Risk Mitigation Techniques for Sponsors: o Expense risk – include expenses in the determination of the fund rate of return; results in lower return (lower hurdle rate) and expense rate is transferred to participant o Inflation – invest in assets that have historically grown during times of inflation; invest in assets with inflation protection; keep a reserve to cover shortfalls instead of reducing annuities o Financial Markets – use diversification; minimize fees and admin expenses; monitor investment performance; apply a floor rate of return o Longevity – select mortality table that closely reflects group experience; consider mortality adjustment based on prior years; purchase longevity hedging product or offer lump sum payouts * Approaches to Minimize Volatility: o Averaging Mechanism:  Accomplished by using a 5-year recognition of each annual adjustment o Longevity Risk Control:  Introduce concept of “hurdle annuity” – determined using the “hurdle rate” and the “hurdle mortality assumption” established for the plan  Hurdle annuity would be uniquely defined for any pensioner

Answer 97

* Administrator establishes a hurdle rate – set as the plan’s targeted real rate of investment return * Difference between hurdle rate and actual rate of return is used to adjust monthly pension benefits each year * Retirees not exposed to inflation risk as long as hurdle rate is close to average real rate of return * If real rate of return diminishes and hurdle rate is not adjusted, inflation protection decreases

Answer 98

* Conventional Earnings Replacement Rate (CERR): o Ratio of gross (pre-tax) income in the first year of retirement over the gross pre-retirement final year employment earnings * Living Standards Replacement Rate (LSRR): o Average annual retirement living standards / average annual working-life living standards o Goal is to capture a worker’s living standards continuity after retirement * Reasons to Support LSRR: o Uses a much broader measurement period for pre and post retirement o Measures income at a familial level instead of just the individual o Much more comprehensive definition of income o Provides guidance on how to evaluate current living standards and determine how much retirement income should be aimed for o Provides a more understandable measure so that workers can better plan for retirement o Incorporates housing wealth, debt, children, etc into a person’s living standards

Answer 99

* Relies on inadequate measurement period – just final year of pay * Doesn’t reflect other sources of income * Ignores household size and dependents * Ignores differences in expenses over the future of the member’s lifetime * Ignores tax differences over the future of the lifetime * Doesn’t account for any debt the participant has

Answer 100

* Participation Rates – target 90%-100%; use auto-enrollment and communication * Deferral Rates – optimal range is 10% - 15% total; consider auto-escalation * Asset Allocation / Diversification – consider targeted communication to review investments * Plan Fees – review against peer-based benchmarks * Income Replacement Ratio – retirement income as % of employee compensation * Retirement Readiness – review plan in context of other sources of retirement income

Answer 101

* Not planning for retirement * Leakage restriction – retirement plans typically restrict employees from withdrawing money prior to retirement * Inappropriate drawdown of funds upon retirement * No base layer of income that retirement plans provide * High annuity pricing – relative to what can be secured through a retirement plan * No ability to share investment risk with employer * Potential for poor investment decisions – retirement plan has investment advisors and education

Answer 102

* Long-term saving: o Maintain investments in retirement portfolios to avoid short-term selling * Act in accordance with investment objectives o Pension providers should adhere to their investment objectives and carefully assess new investment opportunities * Funding flexibility: o Allow for regulatory flexibility to address funding problems. Remove when emergency is over * Counter-cyclical funding: o Avoid pro-cyclical policies and allow pension funds to act as long-term investors

Answer 103

* Plan Sponsor: o Buy-in:  Mortality and interest risk transferred to insurer  Buy-in policy remains part of company’s assets  Revocable and generally contain surrender provision  Sponsor still responsible for making payments; reimbursed by insurer  Still required to pay PBGC premiums o Buy-out:  Mortality and interest risk transferred to insurer  Assets and liabilities removed  Irrevocable  Not responsible for ongoing payments  No more PBGC premiums * Plan Participant: o Buy-in:  No change to method of payment  Risk that buy-in could later be converted to buy-out (lose out on PBGC protection)  Plan sponsor still responsible, so may be more secure o Buy-out:  Change in source of payments  No longer protected by PBGC  Subject to insurer’s credit risk * Accounting Implications: o ASC-715:  Buy-in does not trigger settlement accounting * Buy-in still part of assets, measured as surrender value or value of premium paid today * PBO may be unchanged or measured equal to assets * Remeasurement would flow through AOCI and amortized into G/L  Buy-out triggers settlement accounting if greater than SC + IC * Asset transferred out of the plan; lower EROA * Liabilities transferred out; lower IC * Pro-rata portion of G/L recognized immediately o IAS-19:  Buy-in does not trigger settlement accounting * Assets reduced to reflect value of DBO * No impact to DBO * Loss flows through OCI; no P&L impact  Buy-out triggers settlement accounting * Assets/liabilities removed from plan; impacts net interest expense * Settlement loss recognized immediately in P&L

Answer 104

* Definition: o Irrevocable action o Relieves the employer of primary responsibility for a pension benefit obligation o Eliminates significant risk related to the obligation and assets used to effect the settlement * Events that trigger a settlement: o LS or annuity purchase that exceed SC + IC o Plan Wind Up / Partial Wind Up o Plan spinoff

Answer 105

* Opportunities: o Reduction of PBGC premiums and other admin expenses o Legislative uncertainty o Reduce operational risk o Reduce investment risk o Favorable annuity pricing * Barriers: o Continued funding relief provides opportunity to use cash for other business objectives o Accounting implications o Settlement accounting; higher ongoing expense

Answer 106

* Credit Defaults and Downgrades: o Insurers make adjustment for credit and other risks not captured in a PBO measurement * PV of Operating Expenses: o Plan administration costs not eliminated until plan termination * Longevity Improvements: o Cost of improvements not captured in accounting assumptions o Insurers have access to up-to-date mortality experience from annuity contracts * Other Experience: o Payment form, early retirement commencement, COLA increases, CB ICR

Answer 107

* Under ASC 715, settlement accounting triggered if exceeds SC + IC; gain/loss recognized immediately in OCI; portion of unrecognized gain/loss recognized immediately in P&L * Under IAS 19, settlement accounting required; gain/loss recognized immediately in P&L

Answer 108

* How valuable is benefit and how impactful will change be? * Are there union commitments? * What are the short-term and long-term cost objectives? * Is the timing right in terms of the economic environment? * What short-term volatility or special accounting charges will occur?

Answer 109

* Provide frequent and thorough communication * Provide ample time for retirees to prepare for change * Provide education and assistance * Ensure there are adequate choices for retirees * Perform analysis to determine any impacted groups * Provide support and ongoing guidance through transition

Answer 110

* Plan Merger: o FVA, PBO, UGL combined (GL amortization period would change to reflect combined plan) o UPSC would continue to be amortized over same periods o No remeasurement required unless there is an associated plan change o Employers not required from remeasuring but must be consistent in their accounting policy * Plan Acquisition: o Acquiring company records the funded status of the plan it’s taking over o No unamortized amounts are carried over * Plan Split: o PBO split based on who is moving o FVA split based on 4044 allocation rules o UGL assigned in proportion to assigned PBO o UPSC ideally assigned based on specific designation; if not practical, split based on PBO o No specific guidance on how to split MRVA (could use PBO or FVA) o No remeasurement required unless there is a settlement or curtailment * Plan Divestiture: o Seller reflects a settlement on the official spinoff date

Answer 111

* Assess total new workforce and determine best ways to reach them * Ensure communications don’t occur during holiday periods or busiest times * Send to homes or work locations * Consider engaging key employees as advocates for explaining plan changes to staff

Answer 112

* Event that eliminates the accrual of benefits for some or all future service for a significant number of employees * If gain, recognize once terminations occur. If loss, recognize once decision to proceed is made * Remeasure plan reflecting early retirement

Answer 113

* Remeasure plan reflecting cost increase of special benefits * Increase in liability included as one-time expense charge

Answer 114

* Balance sheet liability ignores PV of operating expenses * Insurance company profit margin * Insurance company will look at all optional payment forms available and price in anti-selection * Balance sheet liabilities based on corporate bond yields versus risk-free rates for insurers * Insurers typically use mortality assumptions with more significant mortality improvements

Answer 115

* Outdated actuarial assumptions could lead to insufficient assets transferred * Review of other plan documents would be necessary to ensure there are no hidden benefit subsidies (e.g. benefits that trigger upon sale of business) * Undocumented promises may exist or may be documented in other places * Legal risk of voiding representations and warranties * Risk of not receiving regulatory approval of the acquisition

Answer 116

* Gather information and data: o Pension and other plans involved in acquisition o Covered employees o Plan documents o Amendments o Board resolutions o Actuarial reports o Audited financial statements o Schedule of assets o List of service providers o PBGC reports o Trust agreements o IRS determination letter o Financial statement disclosures o CBA * Assess Issues and Impact: o Adjustments to purchase price based on employees covered o Any unusual plan provisions that might contravene the law o Assess if plan text is up to date o Any prohibited transactions o Assess FS of plan o Assess PBGC premium history o Assess any potential liabilities due to reported transactions o Compare fees paid from pension funds o Compare accounting assumptions to buyer’s assumptions o Assess if price adjustment is needed o Assess terms and negotiated benefits of CBA

Answer 117

* Investment Lineup: o Is current lineup sufficient for new population? Are there important differences in the two populations? * Withdrawal / Early Termination Fees: o Will any investments impose a charge for terminating the contract early? * Decision Making Tools: o Are participants receiving enough guidance? What default option is best? Are TDFs a good fit?

Answer 118

* Consider the workforce * Identify the impact of plan changes on plan participants * Plan the timing of key communications mindfully (e.g. don’t send over holidays) * Consider best means of delivery (email, letter, etc) * Consider ways to promote enthusiasm in changes (e.g. webcasts, town halls) * Enlist key employees to champion changes and ensure participants understand changes

Answer 119

* Advantages: o Minimize costs associated with maintaining separate plans o No plan disruption if not changing benefit formulas o Assets from both plans can be used to satisfy obligations of the other * Disadvantages: o Need to consider employee communications and any disruption o Collective bargaining agreements need to be considered with union o Objectives of plans could be different and may not be able to be balanced by merged plan

Answer 120

* Overall Objectives: o Identify, quantify, and obtain coverage for all risks and liabilities associated with the plan * Change in Control: o Review the plan provisions to determine if there are any change in control agreements to the extent executives are terminated upon acquisition. o If so, must quantify the impact of the CIC provisions to negotiate in the final price * Funding Vehicles: o Determine how benefits are funded and if those funds are accessible o Some vehicles (rabbi trusts) are irrevocable * Benefit Levels: o Identify overall benefit package to see if it is appropriate * Tax Implications: o Determine whether vested participants have paid taxes on an early inclusion basis and whether the other company paid employer portion * Plan Termination: o Determine implications of terminating the plan under 409A if there is a desire to do so

Answer 121

* Building Block Approach: o Investment return equals a weighted average of the individual expected return for each broad asset class based on the current or target allocations o Each return is composed of inflation plus real return o Building block inputs could be based on either historical data or forward-looking capital market assumptions * Historical Method: o Uses weighted historical returns for broad market categories based on the current or target allocations o Alternatively, the actual trust return could be used * Forward Looking Assumptions: o Forward looking assumptions derived from current long-term economic growth and equilibrium yield curve models o Models begin with current state and offer consistent path by which modeled results can reach assumed long term equilibrium

Answer 122

* New entrant assumption (number of new entrants, average age, sex, salary, etc.) * Salary scale assumption * Inflation * Mortality * Termination rates * Retirement rates * % married * Spousal age difference * Asset return assumption * Contributions * Discount rate assumption * Deterministic or stochastic?

Answer 123

* Arithmetic: o Weighted average expected arithmetic return for each asset class * Geometric: o Expected geometric return over long time horizon based on the arithmetic mean and standard deviation of portfolio * Arithmetic return higher due to the impact of volatility. Geometric average = arithmetic average – ½ of variance of portfolio

Answer 124

* Demographic Assumptions: o No new entrant assumption needed in valuation, while number of new entrants and assumed demographics is needed in projections o Short-term retirement experience deviations from expected not material in valuation, but can be in projections o May make sense to reflect select and ultimate term assumptions in projections, whereas plan specific rates can be used in valuation o Mortality based on standard table or plan experience (if credible) in both * Economic Assumptions: o Salary increase assumption usually varies by age in valuation; in projection, it may make sense to also vary by year (i.e., select and ultimate) o In valuation, investment return based on long-term expectations; in projection, reflect expected changes to the portfolio in the short-term

Answer 125

* Deterministic: o Single predetermined set of assumptions used to project population and assets o Provide single answer for each set of assumptions * Stochastic: o Random variables to bring forward the population and assets o Provide confidence intervals based on random trials

Answer 126

* Collect company specific data; isolate data to pensioners * Consider splitting experience by gender * Consider number of years of experience to include * Consider age of retirees / beneficiaries to include * Build mortality table * Select standard table to blend with subject experience * Apply generational projections * Adjust standard table to reflect plan experience

Answer 127

* Traditional DB Plan: o All mortality risk pooled; individual risks offset against each other, limiting overall risk * Traditional DC Plan: o All mortality risks borne by participants * TBP: o All mortality risk pooled; individual risks offset against each other, limiting overall risk

Answer 128

* Use blended EROA assumption – single rate that reflects both policies * Use select-ultimate assumption – anticipate different levels of return over different periods * Reflect new strategy entirely – no weight given to current allocation

Answer 129

* Traditional Approach: o Service Cost and Interest Cost determined using single effective discount rate. No impact of upward or downward sloping curve * Spot Rate Approach: o In an upward sloping yield curve, the interest cost effective rate will be lower, resulting in a lower Interest Cost. This will result in an increase net loss and subsequently, an increase to the amortized loss. o The opposite is true for a downward sloping yield curve.

Answer 130

* Find equivalent option in the market and use that to price the guarantee * Closed-form solution: use black-scholes formula for valuing options * Numerical methods: trees or monte carlo simulations

Answer 131

* Advantages (Sponsor Perspective): o Makes replacement ratio equitable for high and low earners since SS plans only cover up to a limit o Avoids giving away overly generous benefit o Offsetting the SS benefit from the pension benefit allows sponsors to avoid “double paying” the SS portion * Methods to Integrate: o Contribution Offset:  Direct integration approach  Contribute partially up to the integration point and then fully beyond the integration point  Addresses disparity of SS benefits relative to earnings for higher income individuals o Ignore a portion of covered earnings:  Indirect integration approach  Change the formula to reduce covered earnings such that reduced benefit plus SS is the same as the unreduced benefit  Easier to administer, but does not address skewness of SS benefits (i.e., have higher value for lower income individuals) * Challenges of Integration: o ER’s plan only covers service at employer while SS covers entire employment history o ER plan and SS may have different definitions of covered earnings o ER plan and SS may have different normal retirement dates o ER plan may exclude certain compensation included in SS (e.g. bonuses, OT) o SS benefit may change over time o SS benefit is indexed while ER benefit may not be

Answer 132

* Advantages for Plan Sponsor: o Keep former full-time employees who may be best suited to train younger EE’s o Retain highly experienced employees o Allows opportunity for growth for junior employees o Cost savings from reducing workload of older, higher-paid employees o Addresses needs to fill shifts or employment that is not constant throughout the year o Helps with workforce planning with natural knowledge transfer * Disadvantages for Employer: o Health benefits would need to be aligned with the work o May not be able to choose which employees select phased retirement o May introduce other issues in terms of other employee benefits (i.e., part-time status) o ER would need to provide guidance on appropriate use of phased retirement * Advantages for Employees: o Ease into retirement without changing jobs o Might continue to be eligible for other employee benefits o Provides additional source of income in retirement o Full retirement may result in inadequate benefits versus phased * Disadvantages for Employees: o May be limited to working fewer hours o May be difficult to understand o Additional spousal consent may be required o Certain restrictions may need to be met before qualifying * Regulatory Considerations: o Regulations don’t address commencement of benefits, accrued benefit calculations, spousal consent, etc. for partial benefits. Can create challenges for plan sponsors. o Limitations to how early in-service distributions can start without penalty (59.5) o May be difficult to provide required disclosure to EEs that are easy to understand o Could create nondiscrimination issues if NRD is reduced to accommodate in-service distributions or partial benefits are only allowable to those taking phased retirement

Answer 133

* Fair market value of assets required * Liability based on expected return if sponsor regularly funds actuarially determined contribution (ADC) * If funded on pay as you go basis: o Liabilities determined using blend of 20-year municipal bond rate and expected return o Project out future payments for current employees o Project out assets based on expected return, contributions, expenses, benefits, etc o For periods where assets exceed benefit payments due, discount using expected return o For periods where assets do not exceed benefit payments due, discount using 20-year municipal bond rate o Determine single effective rate that would result in same PV * Amortize change in liability over average remaining service of all participants (not just actives) * Funding Implications for Relevant Stakeholders: o Taxpayers:  Less funding today means more funding available for other public services  Could lead to less funding available for other services in future  Could see higher taxes in future years if contribution requirements are too high for government to budget o Plan Members:  Could fear their contribution levels will increase or benefit accruals will decrease  May seek employment elsewhere o Municipal Employers:  May not attract and retain wanted employees  Could benefit from having additional funding for other public services  Conflict of interest for some individuals in management who are also plan participants

DAU Flashcards

(157 cards)