Plan sponsors must manage their pension plans just like any other line of business.
This is highlighted by the fact that there is increased motivation in corporate finance to address problems with defined benefit (DB) pension plans since the underfunded size of a pension plan is debt.
Pension obligations are being viewed as a riskier form of debt because pensions carry additional volatility. As such, there should be a premium associated with managing that risk and companies are weighing this risk alongside others. This is a fact regardless of whether the DB pension plan is a strategic part of a company’s total compensation offerings.
The merry-go-round continues with the steady circle of annual reviews of DB pension plans with the same process of reviewing funded status, expense levels and future contributions. Yet, not much has really changed. Many companies say that in addition to curtailing pension benefits, they are focused on managing risks posed by their DB plans.
Specifically, they are concerned with reducing the volatility of funded status reported on balance sheets and the level of required contributions. This trend is a result of:
- Accounting transparency mandated by the Financial Accounting Standards Board (FASB)
- Pension Protection Act (PPA) time-frame squeezes on addressing funding gaps
- Phasing out of temporary funding relief programs provided by Congress
- Lack of a significant rise in interest rates or improvement in market conditions
- Updated mortality tables released by the Society of Actuaries magnifying longevity risk
Why can’t employers not simply wait for market conditions to improve? Relying upon market conditions to close funding gaps is a risky proposition because equity markets and interest rates can be unpredictable. Plan sponsors may also misjudge the risk based on the belief that the recent rise in short-term rates will assist in improving funded status.
However, an interest rate increase for long-duration investment-grade corporate bonds would benefit plan sponsors more than an increase for shorter-duration bonds. This is because DB plans are required to discount future liabilities based on the prevailing rates on investment-grade corporate bonds matching the duration of their plans’ liabilities.
Moreover, a rise in interest rates for these bonds will not benefit the typical plan sponsor if it coincides with an equity market decline.
As a result, companies have significant incentive to reduce funded status volatility. For some plan sponsors, the prospect of engaging in a pension risk transfer via the purchase of non-participating annuity contracts for current retirees or offering a lump-sum window for deferred vested participants (former employees who separated from service and would have to wait until retirement eligibility to receive their benefits) and current retirees may seem cost prohibitive.
The cost of transferring risk is lower than what many sponsors perceive as the transaction will generate a long-term savings on expenses that the sponsor would otherwise incur, including administrative expenses, Pension Benefit Guaranty Corporation (PBGC) premiums, investment management fees and changes in mortality tables.
How Lump-Sum Payment Options Shape De-Risking Strategies for U.S. Companies
U.S. plan sponsors are always searching for favorable opportunities to reduce volatility and debt. One approach is to offer a voluntary lump-sum window option to deferred vested participants. A recent IRS ruling now permits this option to current retirees who are already receiving monthly distributions. Plan sponsors can potentially reduce liabilities in a favorable manner as a result of the interest rate differential. In addition, the provisions of the law require rigid standards to compute the lump-sum equivalent, so a plan sponsor has no subjective opportunities to alter factors in a favorable way. Furthermore, these offers are strictly voluntary, so a plan participant is not required to make this selection. Also, a plan sponsor is not permitted to offer any enticements outside the plan to attempt to convince participants to make this selection.
Other Strategies to Potentially Reduce Financial Risk
As employers continue to identify means to reduce their DB risk, employees today often believe that when an employer makes changes, it is to improve their bottom line. So, what are the benefits of de-risking for retirees?
- It takes the plan sponsor out of concern, if either a lump sum is taken, or an outside annuity contract is purchased by the plan sponsor
- The offering of a lump sum option is strictly voluntary, so a plan participant is not required to make the selection and can always maintain their DB plan
- Access to a lump-sum of cash:
- Cash available for investing can generate a monthly benefit to financially support employees through retirement years
- Cash available to take at time of offering (this is a very risky option as retirees need to understand the depth of planning for many years into retirement and allowing for a monthly benefit to support their retirement years as well as the tax consequences involved)
- Cash would be available for beneficiaries (this is specific to single retirees) who would otherwise lose any value of their DB plan upon their death
For companies, it is not possible to simply invest a way out of an underfunded pension situation. Therefore, companies should manage their pension plans like any other lines of business with ongoing strategies, budgets and what-if forecasts. It does not matter if the pension plan is frozen (no additional benefit accruals) as in this situation, it is identical to a discontinued operation that also must be effectively managed.
Yet, it is possible to pursue a strategy of selected purchases of annuity contracts for either deferred vested participants or current retirees. It does not have to be an all-or-nothing type event. As such, a strategy that selects the participants who generate a gain (on a funding and/or accounting basis) or a smaller loss are the best choices. This approach minimizes the potential negative impact of increasing cash contributions and/or expense. This is why a detailed plan of how to handle this matter permits plan sponsors to quickly move to a particular course of action.
But, there are certain obstacles that are often raised when considering a de-risking strategy. Plan sponsors may be concerned that DB risk-reduction strategies may harm certain financial measures, such as accounting settlement charges. Specifically, if the amount of the payout for either the purchases of annuities or other lump-sum payments exceeds the amount of service and interest costs, a settlement event will occur.
The amount of the actual charge is tied to the percentage reduction in the benefit obligation, creating an equivalent percentage acceleration of previously unrecognized losses. If this non-cash charge is a concern, the settlement charge can be effectively managed by periodic settlements that are under the threshold amount, combined with straddling the purchase between plan years. Furthermore, a recent accounting change has effectively removed the cost of pension benefits, other than the service costs, to a non-operating expense (below the line). This may soften the accounting blow and it is worth noting that the amount of the underfunding is already part of a total financial picture, reflected on a company’s balance sheet and retained earnings.
In the final analysis, reducing DB risk will most likely narrow the projected range of cash contributions. By removing volatility for a portion of the liability, future cash flow will be favorably affected.
It is imperative that plan communications be objective, and not biased by the employer’s objective of accomplishing the de-risking transaction.
Employers need to have a full communications strategy inclusive of:
- Pre-election announcements
- Election packages
- Face to face/group meetings
It is just as important is that the plan sponsor provide accurate and high-quality information to members about plan features so that they are well understood.
To enable plan members to take the fullest advantage of their employer’s pension offering, it is important that the plan sponsor consider availing participants access to independent financial advisors to assist in making decisions.
Elliot Dinkin is president and CEO at Cowden Associates, Inc., specializing in helping corporate clients find the best solutions, both for the enterprise and its employees, with regard to compensation, healthcare benefits, retirement and pension issues, and Taft-Hartley fund consulting.
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