While the final goal for defined benefit and defined contribution plans may be the same — retirement savings that workers can use to support themselves when their working days are over — those plans operate in different environments and with different priorities.
On Dec. 19, Mercer released its list of 10 priorities for defined benefit plans to address risk management in 2014. The firm released simultaneously a list of 10 steps that defined contribution plans need to undertake to secure retirement outcomes for participants.
Mercer noted that as of Nov. 30, defined benefit plans at companies included in the S&P 500 had an aggregate funded status of 93%. A quarter of those plans were funded at over 100%. Now’s a good time, then, for those plans to examine ways to manage risk without increasing costs.
The double-digit equity returns and rising interest rates of 2013 have yet to trickle down to workers in defined contribution plans, though, according to Mercer. With plan participants shouldering more of the responsibility for retirement through DC plans, plan sponsors need to ensure plans are designed to help them achieve the best possible outcomes.
Risk Management Priorities for Defined Benefit Plans: 1-5
1) De-Risking Strategies for Glide Paths
Mercer recommended DB plans incorporate interest rate triggers into their glide paths, in addition to funded status triggers. Mercer anticipates an increase in interest rate volatility as the Fed begins tapering in 2014.
Mercer also expects to see more time-based triggers in DB plans as employers look to terminate pension plans.
2) Growth Assets in De-Risking Glide Paths
If DB plans reduce allocations to growth assets as they de-risk glide paths, the expected return will decrease as well. To compensate for this decrease, they should allocate to other growth assets than equities.
3) Liability-Driven Investing Benchmarks
DB plans should make sure their bond benchmarks are aligned with their liability characteristics, especially if they have a substantial allocation to liability hedging assets.
4) LDI and Derivatives
Plans that use LDI have increased their exposure to hedging assets, Mercer noted. Mercer anticipates more DB plans will use interest rate derivatives in 2014, as physical securities may not be an efficient way to manage interest rate risk or capital.
5) Tailoring LDI Strategies
As DB plans begin tailoring their liability-driven investment strategies to their own needs, they may specify interest rate durations to match liability cash flows. Mercer expects to see more DB plans developing these strategies next year.
Risk Management Priorities for Defined Benefit Plans: 6-10
6) Discretionary Contributions
The Moving Ahead for Progress in the 21st Century Act, or MAP-21, included a provision for DB plans to fund pensions at lower levels. However, Mercer said that some plans have opted to make discretionary contributions to jolt funded status. Plans that are on a de-risking glide path but have a funded status lower than the first trigger point are prime targets for these discretionary contributions.
7) Managing Surpluses
Believe it or not, some DB plans have a surplus. Mercer suggested those surpluses might be managed by merging underfunded plans into overfunded plans through mergers and acquisitions or by shifting certain benefits.
Mercer expects to see more DB plans delegating investment responsibilities like glide path monitoring, trade executions and manager selection, contracting and oversight to third parties.
9) Cost Benefits of Cash-Outs
2014 could lead to an increase in cash-outs, Mercer said, as PBGC premiums are expected to increase in 2015 ($57 in 2015 compared to $49 in 2014). That, combined with rising interest rates, suggests some DB plans may start cashing out terminated vested participants while the premium is lower.
Also making payouts more expensive in the future are changes to mortality tables, which could increase liabilities by between 2% and 3% by 2016.
10) Consider Annuities to Reduce Volatility
Mercer’s U.S. Pension Buyout Index tracks the cost of keeping retirees in a plan or purchasing an annuity for the group. In November, the cost of purchasing an annuity for a retiree group was 108.3% of a typical balance sheet liability. The cost of keeping those retirees in the plan: 108.2%. Plans can clear a lot of volatility from their balance sheets by transferring liabilities to an insurer.
Steps for Success for Defined Contribution Plans: 1-5
1) Define Success
DC plans need to examine how they define success, Mercer said. It’s not about account balances or participation rates, but how well the plan is working to meet the sponsor’s goals.
2) Delegate Risk
Plan sponsors should consider creating risk profiles that take into account the principles of behavioral finance based on all or part of a plan’s demographics as a way to leverage time and transfer fiduciary risk.
3) Evaluate Target-Date Funds
As target-date funds become ever more popular, the Department of Labor is more interested in these funds to make sure they’re being used appropriately. DC plans need to consistently review—and document those reviews—to prove they’re evaluating them for suitability.
4) Avoid Revenue Sharing
Mercer expects revenue sharing will be used less frequently, as it can lead to higher administrative costs on funds that include it. If it is used, Mercer suggested allocating it back to participants.
5) Plan for Inflation
DC plans need to help participants plan for the impact of inflation on their accumulated assets. Mercer suggested plans consider a diversified inflation option in the plan.
Steps for Success for Defined Contribution Plans: 6-10
6) Consider Financial Wellness Programs
With more responsibility for retirement on participants’ shoulders, Mercer noted financial wellness programs that help workers manage stress improve outcomes, as well as creating a more productive work force.
7) Build Diversification Into Funds
Since it’s been proven that too many options can derail participants’ decision-making abilities, Mercer suggested DC plans create custom funds that take care of diversification for them by including exposure to alternatives, opportunistic fixed income and real asset strategies.
8) Evaluate Evolving Needs
Now is a good time for plans to look back at what’s changed since a plan was first implemented. Some vendors may have changed their strategies, and the plan itself has likely grown into new needs.
9) Overcome Behavioral Biases
There are ways to invest in global DC plans can overcome participants’ behavioral biases by offering global investment opportunities across multiple asset classes.
10) Build Effective Communication Strategies
DC plans need to stay on top of communication trends to make sure participants are getting plan information. Mobile technology is increasingly important and the most effective communication strategies include generational targeting and behavioral finance principles. Mercer predicts utilizing online games will also improve the success of education initiatives.