Risk is inherent uncertainty associated with every retirement plan over time that cannot be avoided. Although we commonly perceive risk as something negative, it is worth keeping in mind that there is also an upside to risk. Investors who understand that duality refer to risk and reward as two sides of the same coin. However, most retirement plan decision makers are concerned about what exposes the plan and plan sponsor to unexpected negative outcomes.
Examples of risks faced by pension plans include:
In attempting to quantify the implications of risk, plan sponsors turn to projections — both deterministic and stochastic. Deterministic projections display the consequences of a particular future event and are based on the assumption that this particular event will occur — such as that plan assets will return 7.5 percent next year, and perhaps every year thereafter. Stochastic projections, on the other hand, display the likelihood of all possible future outcomes and are based on the aggregation of thousands of deterministic projections. For example, using stochastic projections, one can determine, for a specific investment portfolio and set of capital market assumptions, what the probability is of the value of future contributions remaining below a threshold level.
A new Actuarial Standard of Practice, Assessment and Disclosure of Risk Associated with Measuring Pension Obligations and Determining Pension Plan Contributions (ASOP No. 51) effective later this year, codifies into actuarial practice our view that it is important to address retirement plan risks.*
ASOP No. 51 requires actuaries to identify and assess risks that may reasonably be anticipated to significantly affect a pension plan’s future financial condition. The goal is to help users of actuarial reports better understand those risks. The new standard applies to annual funding valuations and valuations to evaluate the funding impact of proposed benefit changes. While the standard does not apply to valuations for financial accounting purposes, pension plan sponsors should also understand the risks that apply for these purposes as well.
The new standard permits actuaries to use various methods to assess risks. It also requires actuaries to recommend that a more detailed risk assessment be performed if the actuary judges that it would be significantly beneficial for the plan sponsor to understand those risks.
ASOP No. 51 requires actuaries to identify risks that “may reasonably be anticipated to significantly affect the plan’s future financial condition.” Investment risk, asset/liability mismatch risk, interest rate risk, longevity and other demographic risks are cited as examples.
The assessment can be qualitative or quantitative (based on numerical demonstrations). The table below notes examples of those latter methods.
|Scenario Test||Assesses impact of one possible event or several simultaneous events (economic recession may impact investment returns and turnover)|
|Sensitivity Test||Assesses the impact of a change in a specific assumption about future events|
|Stress Test||Assesses the impact of adverse changes in one or relatively few factors, such as what it will take for the funded status to drop below a certain point, thus triggering “benefit restrictions” with regard to certain forms of benefits, like lump-sum distributions|
|Stochastic Modeling||Assesses the range and likelihood of all potential outcomes by allowing random variations, usually with respect to investment returns|
The actuary may also use non-numerical methods for assessing risks that might take the form of commentary about potential adverse experience and the likely effect on future results. It could include:
The actuary should calculate and disclose any plan maturity measures that are significant in understanding retirement plan risks. Examples may include the ratio of the number of inactive participants to total participants or the amount of liability for inactive participants to the total liability and the ratio of benefit payments to contributions over time. Plan maturity is important because it can make it difficult to recover from adverse experience.
The actuary may recommend that a more detailed risk assessment be performed. When making that decision, the actuary will take into account such factors as the plan’s design, maturity, size, funded status, asset allocation, cash flow, and current market conditions.
Your Sibson consultant will continue to work with you to identify and analyze retirement plan risks. Our annual valuation presentations will include a brief risk assessment for investment risk and other significant risks. In addition, the plan actuary will recommend a more detailed assessment, if appropriate.
|This Ideas is not intended to provide guidance on actuarial standards. For interpretation and application of ASOPs, plan sponsors should rely on their plan actuary for advice.|
For more information about pension plan risks, ASOP No. 51 and/or to discuss how Sibson Consulting can help you to manage those risks, please contact your Sibson consultant, the nearest Sibson office or one of the following experts:
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Today's employers face many challenges when managing retirement plans:
In this dynamic environment, employers need sophisticated analytical tools to create and maintain retirement plans that work. Sibson helps clients with these emerging developments through the strategic design, funding and monitoring of pension and related deferred-compensation plans.
Sibson has been helping employers with their retirement plans for decades. We pioneered the practice of designing retirement plans to meet the special needs of employees at distinct career stages. We have also been a leader in crafting hybrid defined benefit pensions (such as pension equity plans and floor-offset arrangements) to address the unique financial circumstances of our clients.
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* ASOPs are established by the Actuarial Standards Board (ASB), which sets standards for appropriate actuarial practice in the United States. ASOP No. 51 and other ASOPs are available on ASB's website. (Return to the publication)
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