Pension plan funding fell into a dark hole during the recession, yet once the economy rebounded, so did funding levels of most corporate plans.
Time to celebrate, kick back in a sunny place, trust that the market will just get better and better?
Hardly, say the retirement experts at Mercer.
Rather, they say, savvy plan sponsors will see the present convergence of positive trends as a good time to take action to protect their assets from the next plunge.
Referring to the bleakest days of the Great Recession, Mercer noted that the deficits those years “caused many plan sponsors to defer action on pension risk management strategies — as well as required plan funding — as they waited for rising interest rates and recovering equity markets to bring plans back onto solid ground.”
Plan sponsors began to see light at the end of the tunnel last year, as double-digit equity returns and rising interest rates resulted in significant improvements in the funded status for most pension plans. Mercer estimates that as of Dec. 31, 2013, the aggregate funded status of defined benefit plans sponsored by companies in the S&P 1500 was at nearly 95 percent, with 31 percent of plans more than 100-percent funded.
And so today’s “environment offers plan sponsors an opportunity to explore risk management strategies, though, as Mercer points out, it’s an opportunity that may be short-lived as companies face new uncertainties. The questions to pose, it says, include:
- How would changing interest rates or a moderate-to-severe market correction affect assets and liabilities?
- Will Congress look to further increase the Pension Benefit Guaranty Corp.’s premiums, on top of the significant increases incorporated into MAP-21 legislation in 2012 and the budget deal signed in late 2013?
- To what extent will new statutory mortality tables increase participant lump sums, and how will these increases affect plan funding and the bottom line?
- Are plan sponsors prepared for the complex legal, administrative and compliance issues in this new environment?
Mercer’s point, of course, is to act now, while you can.
Along those lines, the firm published a white paper offering its thinking on three areas of greatest concern to plan sponsors: glide path strategies, cashing out and retiree buyouts.
Here’s what it had to say about each:
1. Glide path strategies
The glide path, of course, remains the favored approach to managing balance-sheet volatility but there’s plenty to consider:
THE MYTH OF THE PERFECT HEDGE. The perfect hedge does not exist to balance obligations and the associated assets. “‘Set it and forget it’ hedging strategies are generally not going to result in optimal outcomes for the plan sponsor,” Mercer says, cautioning that volatile market conditions and other uncertainties argue against the passive approach.
THE NEW FRONTIER OF GLIDE-PATH TRIGGERS. The typical glide path strategy relies upon triggers tied to funded status. Mercer likes better the trend it’s seen with companies that pursue “a two-pronged approach for which funded status remains a primary driver but that also incorporates interest-rate triggers.” Benefits include locking in favorable interest-rate increases.
THE CASE FOR DERIVATIVES. Derivatives are back, you say? Yes. Mercer anticipates that more plan sponsors will use interest rate derivatives in 2014, rather than just the traditional physical bond approach to hedging.
DON’T FORGET ABOUT THE GROWTH ASSETS. The above strategies may suggest that allocation of growth assets must decline. But, says Mercer, “sponsors can reduce risk without necessarily reducing returns through optimizing the growth portfolio by adding new asset classes and investments other than equities. A diversified growth portfolio can have an expected risk level as much as one-third lower than an equity-only portfolio.”
2. Cashing out
One way to eliminate risk is to get out of the fund management business. Mercer recommends looking closely at this option, depending upon your circumstances. Mercer surveys have found that plenty of organizations are weighing this option, thinking about off-loading to third-party administrators, but aren’t sure if it’s the way to go. Cash-out plans offer the potential for considerable risk management. They have flexibility, they can streamline your system and ultimately save you money down the road. Mercer suggests considering the following:
Flexibility: “Plan sponsors have a fair amount of flexibility in developing cash-out programs by determining which groups could be offered cash-outs, fixing the maximum amounts for the lump sum, and choosing the frequency of setting interest rates for the cash-out offering. With PBGC premiums rising dramatically in 2015 and thereafter — coupled with liability increases from new IRS-mandated mortality tables — 2014 looks to be a good time to explore a cash-out of terminated vested participants.”
Lower long-term exposure: Says Mercer, “the economic benefits of lower PBGC premiums and other administrative- and investment-related costs, along with transferring the longevity risks, will typically outweigh the cost of executing on a cash-out program. Furthermore, risk management could be substantially improved as these liabilities often have long durations and are subject to significant interest rate risk.”
Streamlining operations: Off-loading as much of the administrative duties as possible to a third party offers benefits of greater efficiencies internally.
3. Retiree buyouts
If your plan has a heavy concentration of retirees, a straight buyout could be the way to go. Mercer raises these considerations in favor of this option:
Transferal of retiree liability to a third party. “The expenses, mortality risk, and other costs of self-insurance can now equal or even exceed the cost of insuring the liability through a third-party. This option is most attractive to sponsors interested in reducing the size of their obligations, especially given that self-insurance still leaves residual liability, credit, and asset risk on the balance sheet.”
Factors to consider: interest rates, credit markets, insurer capacity, reserving requirements, and opportunity costs.
Annuity purchases. “The cost of an annuity purchase for a typical retiree group may be virtually the same as the cost of keeping these retirees in the plan,” Mercer says.
In support, it pointed to data from its Pension Buyout Index in December that showed that the costs are almost identical: 108.5 percent to buy annuities for a sample retiree group from an insurer compared to 108.6 percent to hold liabilities in the plan.