For Pension Plans – To Risk or to De-Risk: That is the Question!
Insights Thomas M. White · September 29, 2014
Rimon Partner Tom White was recently published in the Wolters Kluwer Law & Business Employee Benefit Plan Review. He and his co-authors cover the best risk management strategies for employers offering retirement benefits. His co-authors are Corwin Zass, Tim Leier, Richard Farr, and Kelvin Wilson. Corwin Zass is a principal at Actuarial Risk Management, a BDOUSA Alliance member. Tim Leier is a senior pension consultant for ARM. Richard Farr is a partner and head of pensions advisory at BDO (UK) LLP. Kelvin Wilson is director and head of de-risking at BDO (UK) LLP.
This article is reprinted with permission from the September 2014 issue of Employee Benefit Plan Review.
U.S. private-sector retirement plans are voluntary in nature. There is no legal requirement that employers adopt or contribute to retirement plans in addition to the social security system. However, once established, retirement plans often give rise to risks and responsibilities for adopting employers. It is essential that those responsible for the operation of businesses and other stakeholders understand the legal and practical landscape affecting retirement plans if they are to manage business operations in a productive manner. Private sector organizations with defined benefit plans are not in the benefits business so it is critical for these businesses to efficiently and effectively manage all the risks associated with their plans. Some risks are more influential than others on the long-term solvency of plan sponsors.
Legal Rules Regarding Pension Funding
At the outset, it would be beneficial to understand the nature of the legal rules regarding pension funding. Under ERISA and the Internal Revenue Code, defined benefit plans are subject to minimum funding and maximum contribution rules. The goal is for these plans to be fully funded, meaning that their assets equal their liabilities. The current minimum US standards require the plan’s sponsor to contribute each year the cost of benefits accrued for that year and, if the plan is underfunded, to pay an additional amount necessary to amortize over seven years the difference between the plan’s assets and liabilities. There are statutory limits on the maximum plan contributions that employers may use to reduce their taxes, and this will affect efforts to fully fund plans.
Pension Obligations Strain Operations
The truth of the matter is that pension obligations can create significant strains on the employers’ operations. Akin to upgrading the factory floor with new equipment or adding the latest technologies to manage the margins on new products, pension plans have many hidden, and sometimes misunderstood, risks embedded in their promises. Thus, to minimize the effect of the proverbial “tail wagging the dog” situation, plan sponsors should consider objective oversight and practical (and frequent) analysis that will produce short-, medium-, and long-term strategies. Entrenched interests, and, at times, hardened methods have narrowed plausible strategies for plan sponsors, albeit times are changing and the need to holistically evaluate the plan from all sides will soon become more common.
Types of Risks
Risks associated with defined benefit pension plans can generally be categorized as undesirable exposures from:
1. Financial or economic (micro- and macrolevel) conditions;
2. Changes to the legal and regulatory landscape; and
3. Unexpected and potentially significant volatility from adverse changes in demographic conditions.
Financial or Economic Risks
Financial risk stems from the fact that there is a complex funding fulcrum affecting defined benefit retirement plans, which means that required plan contributions may increase at the time when an employer’s financial resources are limited or better used elsewhere. The increased contributions may be due to either or both a reduction in applicable interest rates (which increase the value of liabilities) or a decrease in the value of plan assets. On the upper end, an employer reaches a limit on its contributions because under current tax rules, such amounts cannot be in excess of deductible standards, despite the excess contributions being in the best interest of the business and the plan’s participants. This produces the situation in which a plan sponsor may be required to increase contributions when it is least able to and then restricted to the amount of contributions when flushed with cash. In addition, employers with overfunded plans may have to pay an excise tax (in addition to ordinary income tax) if they seek to recover the overfunding upon plan termination.
Legal and Regulatory Risks
With regards to the second risk, legal and regularory changes in the future can increase the plan sponsor’s obligations without the sponsor’s capacity to minimize these additional burdens. In this light, one can review congressional action since the enactment of ERISA in 1974 and determine that many later-enacted statutory amendments increased employer burdens from both a financial and administrative perspective.
Demographic Trend Risks
Finally, demographic trends may affect the costs of funding a plan because plan costs are dependent upon the size of the benefits and the length of time they are to be paid.
For example, it is well-accepted that longevity improvements will increase and, in many situations, materially increase the period during which benefits must be provided, and consequently increase the costs of providing those benefits. Longevity risk is the risk that pension plan participants will live longer than had been expected in the calculation of retirement liabilities. There exists misalignment between mortality experience, both current and that expected into the future, versus the “base” mortality tables mandated by governing rules. Because defined benefits provide benefits over a lifetime (or joint lifetimes if the participant is married), any increases in longevity will influence the payment term. The reality is that forecasted US longevity experience continues to be missing in the value of liabilities and therefore will ultimately lead to an increase future funding requirements. Depending on a plan’s census, these disconnects can give a false sense of real funding levels.
The Interplay Between Plan Asset Value and Plan Liabilities
Defined benefit plan funding, by definition, is predicated on the interplay between the value of plan assets versus the plan’s liabilities.The plan liabilities behave similar to bonds: when interest rates decline, the value of liabilities increases. Small changes in interest rates will have a large effect on the value of liabilities. In addition, incremental declines in the value of assets may increase the likelihood that those same plan assets are insufficient to cover liabilities. During the Great Recession (circa2008-2011) we saw the perfect storm: the value of assets and interest rates declined simultaneously. The funded ratio of most plans declined precipitously and the plan sponsors realized increases in their required plan contributions. To some, pension funding rules seem to operate counter to business operations as additional financial stresses on the business simply come at a time when many businesses can least afford such strains. With an uncertain political environment, employers are retooling and renewing their attention to pension plans because the funding levels are looking stronger than in many years. This rejuvenation must include “taking chips off the table” via a thorough analyses of both plan assets and liabilities, while simultaneously evaluating the economic circumstances of the business. Through a careful analysis employers can minimize the likelihood that their plans will adversely affect the operations of the business. The creation of a roadmap may include multipronged risk reduction strategies, which cover the gamut from shifting plan risk(s) to other parties to other strategies that reduce the level, or volatility, of liabilities.
Mutil-Pronged Risk Reduction Strategies
Although some strategies may have commonality across employers, methods that work for one employer may not be most effective or efficient for others. The basic framework of options offer employers a means to control and reduce risk resulting in an improved long-term plan funding position and, therefore, assist the business in achieving its business objectives. Strategies may take several forms:
Closure – Even though a relatively simple concept, the closing of the plan to new and current members can result in backlash to some employers. The concept is to “freeze” plan accruals or the class of covered participants. This strategy is often accompanied by the establishment of a 401(k) plan or the amendment of a current 401(k) plan to increase employer contributions.
Plan Design – Careful changes in a plan’s structure can produce decreases in certain aspects of the plan’s risk. Some approaches include converting the plan to a cash balance or pension equity plan, which can reduce or eliminate longevity –and some interest rate risks. Other methods include altering the benefit formulas to current pay rather than the final pay, which can reduce or eliminate some economic volatility.
Liability-Driven Investing (LDI) – Under LDI, the key objective is “matching” the cash flows of the fixed-income investments (i.e., long-term bonds) to the longer nature of the benefit distributions. From rudimentary to complex, a plan hedging strategy has the plan intrinsically “buying insurance” via swaps and the like. One example includes an interest rate swap to protect the plan against the risk of falling interest rates. Because the value of assets and liabilities tend to move in conjunction under an LDI approach, the result will tend to reduce the volatility of required contributions. This proactive risk management approach has surprised many employers because the outcome is that employers gain more predictability in their plan funding requirements, and thus have greater certainty in deploying assets for other business purposes.
Liability Reduction-Many believe the total plan liabilities are rigid in their amount. However, some plans include amendments permitting lump-sum payments to plan participants that, in essence, “cash them out” thus reducing the liabilities. This technique requires an evaluation of marker interest rates to calculate the lump-sum distribution. Regardless, an employer that removes a portion of the plan’s participants can immediately realize longevity risk reduction and some administrative expense reduction, net of the cost of the analysis. This technique works if plan assets increase at rates above those used in calculating the value of the distributed benefits.
Participant Age Management-The UK pension plan market has produced a swap transaction involving longevity. These longevity swaps are slowly coming to this side of the pond. The transaction, in simple terms, provides protection against unexpected increases in life expectancy. The parties (which can include a third-party insurer/reinsurer or an investment bank) to the arrangement agree to exchange (i.e., swap) cash flows produced on the differences realized between actual mortality and that underpinning the arrangement.
Amtuitization-This has become more common, and it has taken two different forms. In one form, the plan acquires, as an investment asset, an annuity contract, which is used to fund benefits. Under another approach, some or all plan assets and liabilities are transferred from the plan to an annuity carrier. The annuity carrier is then responsible for paying all benefits to the plan members.
Alternative Financing/Funding Solutions-What if you could design a solution that has the main stakeholders-employer and plan trustees-working in a collaboration to improve the overall employer finances, while recognizing the plan needs some necessary security? For the last five years, these virtual concepts in the United Kingdom now have become common ground, and equally, an important mechanism for building a stronger pension plan foundation. Such UK-tested solutions address scenarios in which the plan sponsor, due to macroeconomic and business environment issues, faces cash flow pressures or asset challenges, which make it difficult to immediately fund the pension plan. Alternatively, the plan itself recognizes that the ” building of the factory” is a better means of long-term security. These custom solutions involve designing flexible, parallel vehicles that will provide a source of funding and security to the plan. Early on those UK regulatory limitations made way for creative structured-finance solutions, because the economics made it a necessity to overcome the slippery slope of an employer’s insolvency. Some of the tested UK strategies include:
- granting the plan equity upside on the performance of the employer;
- the employer granting the plan direct charge over balance sheet tangible an intangible assets; and
- the employer providing letters of credit or a guarantee from a stronger parent to the pension plan.
With the UK successfully “beta testing” these employer-plan partnership-like strategies, when might the US pension plan governing bodies-the Department of Labor, Internal Revenue Service, and Pension Benefit Guaranty Corporation-begin exploring such quasi-private-public partnership as a practical alternative to the US taxpayer being the ultimate pensioner’s safety net?
Each of the previous options may be considered in conjunction with other ones. No one-size-fits-all circumstances, and it is therefore important for a plan’s advisers to review the facts on a periodic basis to determine whether liability reducing strategies make sense and, if they do, which ones are ideal. There was never a magic potion in Shakespeare’s day and there is not one today. No colorful potion can be taken by a sponsor but with a carefully thought through proactive set of management pension strategies, businesses will quickly realize that the holistic view works well across all types of scenes and acts.
Thomas M. White is a partner in the Chicago office of Rimon, P.C. Corwin Zass is a principal at Actuarial Risk Management, a BDOUSA Alliance member. Tim Leier is a senior pension consultant for ARM. Richard Farr is a partner and head of pensions advisory at BDO (UK) LLP. Kelvin Wilson is director and head of de-risking at BDO (UK) LLP.