Defined benefit (DB) super funds, which effectively guaranteed employees’ final retirement payouts decades in advance, had their heyday in the 1980s and 90s.
For those still lucky enough to be in one, it has been a blessing. For employers and public bodies tasked with funding them, it has been anything but as market gyrations and rising lifespans have made meeting those liabilities increasingly difficult.
The majority of employees may now be in defined contribution plans (they have sole responsibility to ensure they don’t run out of money in retirement), but thousands of Australians remain in DB schemes, which owe them a sizeable $342 billion.
Markets over the last five years have turbocharged all funds, but before then, many DB schemes were on far shakier ground.
An Australian Securities and Investments Commission (ASIC) review of approximately 470 DB funds released in January 2013 found that more than one-third (38%) had a vested benefits index (VBI) of less than 100%.1 The VBI is an estimate of total benefits owed to all members if they voluntarily left their employer on the same date (another common measure is the accrued benefit index).
This means a substantial proportion of DB funds were not in a “strong financial position”, even after markets rebounded from the global financial crisis (GFC) , based on the Australian Prudential Regulation Authority’s (APRA) guidance.
While the majority of those funds will now be fully funded, the VBI measure still obscures the risk inherent in DB funds. While a VBI that is positive (or even above a predefined threshold) may be considered “well funded”, it is a point in time measure that doesn’t reflect the underlying risk.
This is because trustees are managing a convex liability: when returns are exceptional, members typically retain the upside, as is the case with defined benefit “underpin” schemes. But when returns are poor, the downside to DB fund trustees can be unlimited.
Many DB funds are still strongly exposed to similar levels of growth assets and market risk as defined contribution funds. This has been a benefit in recent years but it can equally drag down funds when markets inevitably turn down.
Surplus DB assets are also typically invested in the same asset classes as accumulation assets. This means excess funding won’t offer much of a buffer when markets are stressed – these surplus assets will decline in value as fast as the rest of the fund.
The outcome could be a repeat of the post-GFC disaster. While some DB funds may have legal avenues to reduce member benefits or seek top ups from employers, going down these paths again is undesirable for obvious reasons.
Milliman worked with a client concerned about its defined benefit liability. This was a legacy multi-employer arrangement under which members retained accumulation balances in addition to a defined benefit “underpin” which essentially guarantees a minimum accumulation balance at retirement.
While this fund was well funded from a regulatory point of view and able to meet forecasted liabilities under best estimate assumptions about long-term asset returns, the fund recognised the potential for insolvency in the event of a market crash. This particular client had previously investigated asset allocation strategies and investment bank solutions to manage the DB liability. However, the options were either expensive or didn’t recognise the uncertain nature of member behaviour.
Milliman worked with this client to assess the situation and proposed a dynamic hedge strategy using liquid, exchanged traded futures. The cost of running this hedge strategy is funded by reserves and is expected to allow the fund to meet its liabilities in a wide range of market scenarios.
Milliman continuously monitors the scheme’s defined benefit liability and adjusts hedge positions as markets move and based on member behaviour.
During the recent period where US equities fell almost 7% from their January peak and Australian equities fell 4%, this particular client experienced a 10% increase in its DB surplus. Contrast this with the expected performance of typical DB funds where surplus assets are invested in the same risky growth assets as accumulation balances.
Figure 1: Recent market performance
Australia has been fortunate to experience 25 years without a recession. The ASX trades near historic highs and we have experienced a historic bull run in fixed income. As we near the 10-year anniversary of the GFC, recent equity market corrections reminds us of the inherent risks of investing.
Home insurance is best purchased well before the fire brigade arrives. Similarly, DB funds should seize the opportunity to revisit the nature of their liabilities and strategies to manage them while times are good.
It’s not a crisis if you see it coming.
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