DONNA MISKIN: This is the Retirement and Benefits panel. Carl Hess is the Global Practice Director of Watson Wyatt Investment Consulting and is based in the firm’s New York office. For more than two decades, Carl has consulted with many of the world’s largest corporate, non-government and union pension funds, as well as other institutional asset pools including insurers, VEBAs, and nuclear decommissioning trusts.
CARL HESS: Don’t get me mad.
So as a result, there’s a shift here in responsibility. After all, consumption needs in retirement are reasonably fixed, so if we’re reducing the employer commitment, the burden is going to the employees, and that’s done principally in two ways. One is through cost reduction, we’ve just seen, and the other is through risk transfer, whether its defined-benefit to defined-contribution or personal responsibility for retiree medical inflation, you can see here the trends are quite clear. The great shift in the orange bar is people who’ve stopped providing defined-benefit as a benefit to new employees. The decrease in the light and dark green bars are people who’ve stopped providing retiree medical, either pre- or post-65. You’re seeing a doubling of the DC-only deal and a reduction by one-third of those proving retiree medical. I would like to know who the 1% that doesn’t have a defined-contribution plan is, but there’s one in every crowd, I suspect. And here is indeed what people are handing out to newly hired salaried employees; you can see a clear trend here, a move away from pure DB and a trend toward two things: one is conversion to hybrid plans where the IRS has actually made our collective life a little bit easier, and the other of course the growth of DC only. So defined-contributions plans being the only benefit available to new workers in the workforce.
Now that, as I said, is really just a matter of risk transfer rather than risk elimination, and it’s going to have some fairly interesting results. We’ve talked a little bit about what the shift in plan types has been. The bottom left-hand corner’s rather hard to read but it’s why people have made the shifts, and the overwhelming reasons are cost level and cost volatility. We just simply can’t handle the volatility in defined benefits. A number of our panelists today are going to talk about what you can do about that, but the fact is that defined-contribution is no panacea. The top right-hand chart, which I think you probably can’t see the line—cause I can’t—shows, trust me, it swivels around a little bit and it shows the variance in what a DC plan will deliver to you if you’ve been a good person and saved a lot for your entire career, but just picked the wrong year to retire and annuitize your money. So the luck of the draw—be born lucky, don’t be born good necessarily—comes into play. But the fact is, that’s assuming you were a good person and saved like you were supposed to. What we actually see in behavior is the bottom right-hand corner, where this represents actual workforce data across hundreds and thousands of workers, ‘How much have you actually saved,’ for people between ages 50 and 59 as a multiple of their salary. Again, it’s a little harder to read, it goes from one times to seven times pay, and these are from people getting ready to retire. Well, about 8% have no balance at all. Good for them, they’ll do well. They’re joined by about 35%, sorry 25%, who’ve saved less than half of their current salary; that’s going to draw down pretty quickly, I think. Another 40% who’ve saved less than one times their current salary. I’d posit actually that this risk transfer has a bit of ‘people on your payroll you don’t want to be paying anymore, but they can’t afford to leave’ aspect to it that we still have to look forward to in years to come. So you have to ask, you know, what do we do about this?
So, today what we’ve put together as a retirement and benefit industry has quite a lot of legacy components to it: collectivized healthcare, a Medicare system that’s tottering around, but still kind of one-size-fits-all, and the shift from we’ll invest it for you to you have to invest it for yourself.
We think looking forward, there’s going to be a rearrangement of the pieces. Probably a bit more mix between what’s future and what’s current compensation. What are you going to save for retirement, looking at all sources of retirement, not just retirement income but retirement needs such as medical as well, and the industry, which thankfully is quite inventive and sometimes even in a positive sense will probably invent the vehicles to get you there. So there is a support network out there but you can’t ignore the changes going around.
So what we did is we took a snapshot of clients. We pulled 365 predictive variables -- variables we thought were going to be really robust and tell us about clients that are about to buy retirement services plans. We isolated who bought and who didn’t, with a competitor or without a competitor, and ran that through our SAS software using logistic regression. We were very, very excited when we pushed the data through and saw the results, which you’ll see in the next slide.
The score along the bottom shows basically a credit score. 600 is average. The higher the better, which means they’re going to buy a plan and the bars represent the actual enrollment rate over the next 12 months. So you can see once you hit 600, we’re way above average on the actual enrollment rates. So we were able to take our client base and isolate the clients that were ready to buy, market them intelligently, and give it over to the people that needed to have it to market those clients. The strategy that we implemented was two-pronged.
Prior to joining Thomson Reuters in 1994, Andrew held positions in operations and finance in the U.S. and U.K. with Paramount, Simon & Schuster, BOC Group, and Turner and Newall. Andrew holds a master’s from Oxford University and an M.B.A. in strategic management from Victoria University of Manchester Business School. Andrew, congratulations and welcome.
ANDREW PERRIN: Thank you very much. Ninety does seem like a lot, but some of them are very small, so we don’t worry about those. I had a colleague once who had a very good rule about presentations, which he called the three Bs: Be brief, be good, and then be gone. And as the guidelines for the presentations were six or seven minutes, I will try and be brief. I will certainly be gone at some point. Whether I’m good is up to you. With that, I’ll make my opening statement—sounds like a bit of a debate here.
Therefore we focused our attention on developing a risk management liability-focused investment strategy and asset allocation framework that would be optimal both 1) for balancing future cash contributions with reduced funded status volatility and, 2) achieving risk and return characteristics that more economically matched the underlying liability. We specifically said upfront the objective was not to maximize plan returns, but to optimize cash contributions.
I’m going to stay on this slide for just a second more because the primary diagnostic analytical tool that we used in the analysis was the use of a stochastic Monte Carlo simulation with multiple economic scenarios or future multiple economic outcomes to model the impacts of these on a spectrum of equity to fixed income ratio allocations. This was summarized graphically by representing the relative position of each equity to fixed income allocation alternative at different funded status levels in two dimensions, using as axes the present value of expected future cash contributions on average for all future economic scenarios, that’s the Y axis here, plotted against the present value expected future cash flows for the worst 10% of scenarios on the X axis. As a result of this analysis, we determined that a 60% to 70% fixed income allocation was the optimal position to balance average expected contributions with worst-case contributions or if you like, average versus tail risk outcomes.
The final part of our derisking journey took place in late 2008 and early 2009. Recognizing the unique opportunity afforded by the all-time lows in government bond yields and the all-time highs in corporate bond spreads reached in early 2009, a one-time historic opportunity we felt, we took further action to build on the strategy. We formalized the fixed income allocation now at 70%, switched approximately $600 million in assets from long government to high-grade corporate bonds in early 2009.
This reallocation not only took advantage of market conditions but also resulted in a better hedge we felt to the liability, given the discount rate used to discount the liability. These actions we believe, which involved the liquidation reinvestment of over $600 million in plan assets, preserved a further $140 million in asset values.
What changed? What changed for us was in 2006–2007 period, new regulations in the U.S., the Pension Protection Act, which sped up required contributions and then Ford—I think [Ford CFO] Lewis [Booth] this morning took you all through the rollercoaster ride the last few years—just tremendous pressure on Ford, challenges in the market, financial challenges, operating challenges. These effects really prompted us to realize that something had to change with respect to the management of the pension funds. So we spent a long time looking at this. Many of the same tools that many defined-benefit plans use and we adopted an approach—we were fortunate we were fully funded at the time—where we would alter our investment objective from maximizing returns and instead focus on reducing the risk of funding shortfalls.
We took essentially as much risk as we could off the table. We rebalanced from equities to fixed income. We embarked on a multiyear set of steps to diversify out of equity risk into alternative investments and, last but absolutely not least, we hedged a significant portion of our interest-rate risk, the mismatch between the assets and the liabilities, using a derivative overlay strategy.
Lastly, interest-rate risk. Most of the liability matching that we’ve done -– in fact all of the liability matching that we’ve done until recently was only the other cash bond portfolio and during this period in 2007–08 period we were hedged up to about 75% of the duration mismatch between the assets and the liabilities, so that helped us hugely in the 2008 period when risk-free rates fell so dramatically.
So what happened? What was the outcome of all of this? Well if we hadn’t done this, and these numbers are always so big because Ford is so big, but if we hadn’t done this, we would have ended last year with a $13 billion shortfall in the U.S. Instead we ended the year with a $6 billion shortfall. So $7 billion -– I know Lewis talked about this this morning. It came at a time -– it couldn’t have come at a better time at Ford, that pays -– well you saw what we pay in benefits around the world. We paid for more than a year’s worth of benefits just out of an investment strategy. And about 14 points of funded status, I envy Thomson Reuters their funded status but at least we can take some comfort that we would have been a whole lot worse off had we not taken these actions.
HESS: We have time for one from the audience. Yes.