by Stephen M. Kloss, AIF®, MBA, Senior Client Manager
Recent market research suggests that plan sponsors of mid-sized defined benefit pension plans (those with assets of between $50 and $500 million) remain most concerned with risk management, lower future return expectations and stock market volatility.1
Pension committees with these types of worries should first take a step back. Rather than focus on an uncontrollable market environment, designing and implementing a sound de-risking plan can help alleviate market-related concerns by putting you back in control, while helping realign your plan with its intended purpose.
As pressures on pensions mount, financial executives may be best served by re-evaluating major decisions in terms of the true tools at their disposal. The strategic choices of a sponsor in managing pension risk can be distilled into four basic levers:
Asset Returns, Liability Hedges, Contribution Policy, and Benefit Management
Growth Asset Returns
Pension assets have only two ways to grow: investment returns or new contributions. Over time, actual investment returns must keep up with sponsors’ estimates to avoid detrimental impacts on pension costs (and thus a company’s financial statements) in the future. There is the dilemma.
If projections for lower long term investment returns proves to be accurate, plan sponsors will be challenged to generate returns in line with their assumptions.
Key decision that must be made on the asset return lever involve:
- How much illiquidity is realistic for the plan’s investment portfolio?
- Are there opportunities to broaden use of active managers?
- Is capital being deployed efficiently?
A pension’s benefit obligation represents an important cash flow commitment over many years. Interest rate risk can account for almost half of the expected volatility in a plan’s funded status.
The discount rate for a plan liability is of course subject to market conditions and impossible to predict or control. What financial executives can control is calibrating the plan’s sensitivity to interest rates.
However, in a low interest rate environment, de-risking the plan comes typically with much lower return. Some plan sponsors have chosen to stay in a holding pattern when it comes to their liability hedges, keeping hedges intentionally low under the expectation that as interest rates rise, they will provide relief by shrinking the liability. However, if rates take a gradual path upward instead of rising quickly, significant underperformance will be incurred relative to the pension liability. Sponsors that put all their eggs into a “rate wait” basket are making a bold tactical bet on both the timing and magnitude of beneficial discount rate increases.
The key decisions of the liability hedge lever are:
- How sensitive is the plan to interest rate risk?
- How much interest rate risk should the plan assume?
- Can the pension bear the cost of being underweight a long-duration liability stream?
The decision on when to fund and how much to contribute can substantially affect funded status in future years. Given plan contributions are irreversible, sponsors must think carefully about contributions relative to the health and needs of the overall balance sheet.
As funded status is monitored, a continual tug of war will occur between the carrying cost of the liability (the minimum yield that needs to be earned to offset the plan’s interest cost) and the investment returns of plan assets. To make such analysis more relevant, plan sponsors should develop a contribution budget that aligns with their ultimate goals, as opposed to the artificial smoothing imposed by regulators.
One of the most important choices in crafting a contribution policy is determining which measure of funded status is most important to monitor. Financial executives may choose to emphasize “GAAP” (accounting-driven) measures of funded status, particularly in situations where shareholder reporting is a chief focus. Conversely, institutions may choose to focus on the liability, as measured by discount rates. Low interest rates, while detrimental to plans in terms of pension liabilities, do offer sponsors a valuable advantage—the ability to de-risk plans through thoughtful use of debt. By borrowing to fund contributions to their defined benefit plans, sponsors can achieve multiple goals.
The key decisions of the contribution policy lever are:
- Which funded status should be monitored: accounting-based, statutory, or termination?
- How intertwined are the risk profiles of the company’s core operations and pension assets?
- Does borrowing to fund contributions make sense?
The final key lever plan sponsors can employ is proactively managing policies that govern benefit payouts.
Opportunities also exist to optimize benefit liabilities relative to plan costs, including the potential cashing out of small balances or terminated vested participants.
For those plans that are hard frozen, sponsors have also been exploring potential risk transfers, offloading pension risk in its entirety to an external provider.
Risk transfer may be a viable option for plan sponsors to consider, but unfortunately is not often the lowest risk or most cost-effective lever for sponsors.
When exploring such transactions, sponsors must determine their primary objective—e.g., to cut administrative costs, offload a relic of a legacy benefits strategy, or reduce balance sheet risk. In addition, sponsors should be sensitive to potential indirect impacts of a possible risk transfer, such as employee sentiment regarding the transaction, downstream costs associated with the process, and pro forma funded status subsequent to the transfer.
The key decision points to the benefit management lever are:
- Have the current goals and compensation priorities of the company changed sufficiently to merit modifications to future benefit accruals or payment forms (such as lump sums)?
- What are the benefits and costs of a risk transfer?
- How would a risk transfer be perceived by plan participants?
Once an enterprise has defined its primary goals, the next step is understanding the sensitivity of a plan to asset returns, liability hedging, contribution policy, and benefit management. Reviewing and quantifying the trade-offs to be made within each lever and among levers allows the development of a balanced, multi-lever approach to enable a greater probability of success in managing pension risk.
1Aggregate funded status and contributions has been estimated by Cambridge Associates based on a compilation of 10-K filings for companies in the S&P 500 Index as of year-end 2016 and year-end 2008, as provided by Bloomberg L.P. These calculations include total pension assets, liabilities, and contributions for a given company, including those for non-US plans and, in some instances, for nonqualified plans sponsored by that company.
Reference source: A Balancing Act – Strategies for Financial Executives in Managing Pension Risk published by Cambridge Associates, LLC in 2017.
This information is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation.
Defined benefit plans may be appropriate for businesses with consistent revenues for long-term funding where owners are older and earn more than the average employee. These types of plans have additional costs and generally involve engagement of an actuarial firm for plan administration.
Securities offered through LPL Financial. member FINRA/SIPC. Investment advice offered through Global Retirement Partners, DBA Oswald Financial. a registered investment advisor and separate entity from LPL Financial.