How Investment Smoothing Helps Employers Avoid a Contribution Rollercoaster

If there is one thing employers want when it comes to pension cost, its stability. Budget predictability is key in making LAGERS, or any retirement benefit for that matter, feasible.  And while many local government units across the state seek LAGERS out to help attract and retain quality public servants in their communities, they all first want assurance that the cost is something that they can reasonably budget for from year to year.

One of the great benefits for employees of Defined Benefit Plans, like LAGERS, is that the investment risk is shifted off of the backs of individual workers. Members of the LAGERS system don’t individually bear the same type of investment risk as someone who relies solely on an individual 401-k type retirement account for income in retirement.  That’s because LAGERS members receive protected payments based on how much of their career they devoted to serving their communities, not by how well they fared in the markets.

Ultimately, however, investment income is an important part of funding retirement benefits and because individual benefits are not affected by swings in the markets in LAGERS, employers must absorb that risk. So how does LAGERS  safeguard against this market risk to help prevent wild swings in contribution rates from year to year? Investment Smoothing.

If you were to look at the last five 1-year returns for LAGERS, you would see a great deal of fluctuation: anywhere from -0.2% to 19%.

2016 -0.2%
2015 2.2%
2014 19.0%
2013 14.5%
2012 3.6%

And if an employer had to realize -0.2% one year and then 19% the next, they could see great volatility in their contribution rate year over year making it near impossible to reasonably budget for such a benefit. That’s why LAGERS uses investment smoothing when realizing gains and losses in employer contribution rates.

So what exactly does that mean? Each year, LAGERS smooths the investment gain or loss over a five year period. In other words, only one fifth of the gain or loss is realized in the first year, and for the next four years an additional one fifth is realized.  In the above snapshot, the employer’s cost for benefits wouldn’t be based just on the most recent year’s investment experience, but rather on 1/5 of each of the five years gain/loss.  If we look at the past five years of returns in LAGERS, some were better than others, but because we smooth the gains and losses across all five years, this makes the market volatility that is felt from year to year less like the Grand Tee Tons and more like the rolling hills of Tuscany.

There is no way to completely eliminate market risk, but there are tools, such as market smoothing that we can use to help control and manage that risk from year to year. Smoothing helps to remove the high and low ‘bumps’ that the markets will inevitably experience, and to provide stability to pension cost so that employer can continue to provide security and peace of mind to the hardworking public servants of Missouri.

Elizabeth Althoff
Communications Specialist

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