Understanding Pension Risk Management Arthur M. Scalise, ASA, EA, FCA Managing Actuary, Cammack Retirement Group

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1 Understanding Pension Risk Management Arthur M. Scalise, ASA, EA, FCA Managing Actuary, Cammack Retirement Group Throughout the United States, sponsors of defined benefit (DB) plans have been reviewing their plans funded status and cost, with an eye towards managing risk. Historically, plan sponsors defined the risk within a DB pension plan in terms of asset performance relative to an expected return. The interest rate used to measure the liability of a plan was set to equal the asset portfolio s expected return. Thus, assets and liabilities were projected to increase at the same pace. The surplus (or the shortfall) was measured as the excess (or the shortage) of the plan s assets, compared to the liability. As long as asset volatility stayed under control, the plan s funded status and costs remained stable. Accountants, meanwhile, continue to take a hard look at the measurement of the plan s obligation on a sponsor s balance sheet. At the same time, the enactment of the Pension Protection Act (PPA) prescribes actuarial methods and assumptions to measure the plan s liability for a sponsor s cash outlay. By both measures, the liability interest rate is no longer tied to the expected return of the assets. This separation increases volatility of a plan s funded status and cost. Many sponsors of DB plans have therefore been reviewing their plans, taking a fresh look at managing that volatility. Pension Risk Management (PRM) represents a shift from an asset-only risk focus to the practice of managing the assets and liabilities in concert, in order to minimize volatility generated by the plan s surplus risk. Because DB plans represent legacy liability on plan sponsors balance sheets, finance personnel may utilize PRM as a means to prevent DB plan liabilities from controlling the balance sheet. PRM continues to attract attention, due to improved plan funded status in 2015, legislated increases in Pension Benefit Guaranty Corporation (PBGC) premiums (three times in four years), and the possibility of increased cash costs associated with future legislated mortality improvement. CONSTRUCTING A ROADMAP The first step, using input from human resources and finance personnel, is to gather a list of objectives for the DB plan and prioritize these goals. Below are some typical objectives voiced by plan sponsors: Termination of the DB plan Fully fund the plan Stabilize or reduce contributions Stabilize annual accounting cost Reduce balance sheet Lower administrative costs Reduce PBGC premiums 1

2 Once the objectives have been determined and prioritized, it is time to formulate a roadmap to meet them. This guide may include decisions that alter the course of the DB plan. Some choices may be simple, causing minimal financial impact in the short run. But often decisions carry more significant financial consequences, thus it is imperative to quantify and evaluate the associated risks. The perspectives of human resources and finance personnel are often contradictory, so it is beneficial to educate both on how their objectives may intersect. Traditional ongoing plans use compensation near retirement (e.g., final average pay plans) to determine a participant s retirement benefit. Additional benefits are earned with further years of service. Eligibility to participate typically becomes automatic after a waiting period and is open to all eligible employees. Benefits, which are not linked to asset performance, are preserved until retirement. Note, however, that these plan designs are sometimes confusing to the employee and often underappreciated. Plan sponsors have taken several approaches to modify their traditional plans in an effort to manage their cash or accounting cost. PRM calls for decisions in several key areas: Because these issues may overlap, human resource and finance strategies often require tactical decisions across multiple functions. We now examine the various plan designs, funding strategies and settlements illustrated above. PLAN DESIGN Account-based plans are more transparent to the employee. The annual attrition of an employee s retirement benefit is based on current earnings and may ultimately be paid as an annuity (e.g., career average pay plan) or in a lump sum (e.g., cash balance plan). Ultimate retirement benefits are typically lower than those of traditional ongoing plans. A prospective lump sum option allows prospective terminated or retired employees to withdraw the value of their DB plan benefit, akin to withdrawing a defined contribution (DC) account balance. The participant receives a single sum distribution at termination, with the ability to transfer the funds to an IRA or a prospective employer s plan. Participants value the single sum distribution as 2

3 a benefit, rather than waiting until they are retirement-eligible and collecting a monthly payment. Since they are no longer participants in the plan, sponsors are not required to reflect them in their valuation, easing plan administration and reducing PBGC premiums. Closing the plan to new entrants allows existing employees to continue to earn future benefits via the current DB plan, while prospective employees will earn benefits in a separate plan, typically a DC plan. This is often the first step when a sponsor transitions from a DB to a DC program. The impact on short term costs is negligible; however, the long term costs will resemble those of a DC plan. By freezing benefit accruals a sponsor terminates the capacity to earn future benefits in the current DB plan and provides for future benefits under a replacement plan, typically DC in nature. Benefits earned before the freeze remain within the DB plan, subject to its vesting and eligibility requirements. Existing employees will have benefits from two plans (frozen DB plan for historical benefits and replacement DC plan for future benefits) and prospective employees will earn benefits from the DC plan. When considering closing the DB plan to new entrants or freezing benefit accruals, it is important to perform a DB to DC migration study. Through the study, sponsors can analyze the ongoing annual costs and the level of benefits provided under alternative DC plans, demonstrating how current DB participants will be affected by the transition and how best to minimize the negative impact to senior employees nearing retirement. In addition, the study presents an opportunity to get the most out of your retirement program by incentivizing and encouraging maximum employee participation. Through the modeling of various alternatives, we are able to design a DC program that fits your organization and its demographics, enabling sponsors to establish a replacement DC plan that is within budget, cost-effective and, most importantly, provide employees with secure retirement savings. FUNDING STRATEGIES Increased funding permits plan sponsors to contribute additional tax-deductible amounts to improve the funded status of a DB plan. Additional funds are professionally managed, with the expectation of earning 6% to 8% annually. The improved funded status will decrease prospective cash requirements and accounting costs. If sufficient funds are available, a plan sponsor can employ a targeted surplus strategy to effectively eliminate all future cash costs, which would likely provide accounting income rather than an accounting cost. If additional funds are unavailable, a fixed rate loan may be affordable at the current low rates (4% to 5%), effectively replacing the variable DB plan cost with a fixed loan cost. It should be no surprise that by contributing the statutory minimum funding requirements, the plan will not be fully funded to terminate. The premium for purchasing an annuity is not required to be included in the plan s annual valuation and exists to protect the insurance carrier. Fully funding on a termination basis often requires some additional cash above the minimum required to close a portion of the gap (i.e., the premium). 3

4 Most plan sponsors are unable to contribute the plan s entire shortfall, or even a fraction of the shortfall. Simple forecasts can illustrate cliffs and valleys with future contribution requirements, often creating difficulty with plan sponsor budgets. By strategically prefunding some of the required contributions, plan sponsors are filling the valley by lowering the cliff and ultimately creating a more stable contribution pattern. INVESTMENT STRATEGIES Liability-driven investing (LDI) constructs a target investment return mirroring the inherent liability return. With the asset and liability returns more closely matched, the plan s funded status is less volatile, which in turn reduces volatility of cash requirements and accounting cost. For example, in the US corporate and non-profit arenas, a plan s liability is measured using a hypothetical US corporate bond portfolio. However, this is not considered ideal for underfunded DB plans. A dynamic asset allocation (DAA) or glide paths may be introduced to exchange, over time, the current asset portfolio of an underfunded plan for a liability matching portfolio to fully fund the plan. The liability matching portfolio is nearly 100% invested in US corporate bonds and the asset and liability returns are matched, preserving the fully funded plan status. These exchanges typically occur when the plan s funded ratio improves in incremental steps, for example, every 5% increase in the funded ratio. Occasionally, plan sponsors may force the exchanges each calendar year, regardless of funded ratio. Nevertheless, the purpose of DAA is to gradually remove investment risk as the plan s funded status improves. SETTLEMENTS Bulk lump sums may be distributed to former employees. Unless the DB plan has a prospective lump sum option, employees who terminate must wait until they become eligible to retire, which may be many years later, before they can collect their monthly income. This costs the plan sponsor hard dollars in rising PBGC premiums and soft dollars in plan administration, such as issuing required notices. Offering a lump sum to all former employees via a window eases future plan administration and may reduce future PBGC premiums for each former employee who elects the lump sum distribution. The lump sum take rate is sensitive to the level of communication, the size of the distribution, the length of the window, and whether a prospective lump sum is concurrently offered. In the current fixed income environment, lump sums are generally greater than the carrying value in the plan s annual valuation; hence why these windows may have a material negative impact on plan s funded status. Annuity purchases may be offered to selected participant groups, in particular, to retirees. In a structure typically described as a buy-out, assets are distributed from the DB plan trust to an insurance company, which assumes the obligation to pay the monthly distributions. Annuity purchases make sense for current retirees, but the approach can also be tailored to future retirees who may be currently or formerly employed by the firm. The participant will retain the same monthly benefit payments or benefit options as those available from the DB plan. From the plan sponsor s perspective, plan administration is eased and PBGC premiums are reduced. The annuity purchase price is frequently greater than the lump sum or carrying value in the plan s annual valuation and will therefore have a negative impact on plan s funded status. 4

5 The settlement options discussed above focus on subsets of plan participants and are aimed at reducing the DB plan to a manageable size by prospectively removing these subsets from the plan. Besides the additional cash cost of lump sums or annuity purchases, the settlement options will have associated costs in terms of administering the settlement program, in addition to the usual annual expenses associated with the DB plan (e.g., legal, actuarial, accounting, benefit administration, etc.). Plan termination combines lump sum and annuity purchase settlement strategies, typically with the goal of transferring the entire benefit obligation to the individual or a third party, such as an insurance company. By doing so, the plan sponsor completely eliminates the risk, since the DB plan no longer exists. However, plan termination comes at a price. Besides the additional costs noted for lump sums and annuity purchases, a plan termination is subject to statutory filing requirements by the Department of Labor, as well as added filing requirements for the Internal Revenue Service and the PBGC. Lastly, a plan termination may take up to 18 months from start to finish. If not properly planned, the process may require some additional cash to be deposited in order to pay the lump sums or to fund the annuity purchase. There is developing interest in providing lump sum distributions to active participants. Currently, statutory rules restrict lump sum disbursements to active participants in a DB plan without creating a distributable event. For an active employee, the only distributable event is a DB plan termination. By dividing the DB plan into two separate plans (i.e., spinoff), the plan with the active participants may be terminated via a standard termination. While on paper this may sound ideal, the desire to implement this kind of program is not without additional costs. Splitting the DB plan into two requires separate plan documents, actuarial valuation reports, plan audits, trust agreements, investment policy statements, etc., additionally, there is a one-time cost for performing the spinoff and the cost for termination of one plan. PREPARATIONS Even if no immediate action is taken to execute a PRM strategy, plan sponsors can still prepare themselves in the event they revisit the issue down the road. Taking preparatory steps today can shorten the timeline to implement a future PRM strategy. As a plan sponsor of a DB plan, the following questions should be asked: With the continued trend from DB to DC, is our retirement program competitive in the market and/or against competitors? It may be time to consider plan design changes. What would our communication strategy be to senior management and to the entire employee population? What about externally to the public and other interested parties? If we want to use a liability-driven investment approach, what restrictions exist in our Investment Policy Statement? Does the Investment Policy Statement need to be revised? Assuming we want to implement a lump sum window for former employees, is our valuation data clean and up-to-date? Can final accrued benefits be validated? What is the financial impact of a window? If we want to terminate the DB plan, can missing participants be located in order to execute the benefit elections? How should the plan s assets be invested to minimize additional cash obligations? 5

6 CONCLUSION PRM strategies will depend on the economic environment, employee demographics, fiduciary requirements, and the general fit of a DB plan in a plan sponsor s benefit program. The overall risk of a DB plan should align with the objectives of both the human resource and finance department. With improvements in plan funded status, rising PBGC premiums, and the uncertainty of future mortality improvements, plan sponsors will continue to entertain the PRM topic. The pros and cons of any PRM strategy should be carefully considered, as no one approach works best for all plan sponsors. ABOUT CAMMACK RETIREMENT GROUP Cammack Retirement Group is a leading provider of investment advisory, consulting and actuarial services. We work with the nation s leading healthcare providers, academic and research institutions, corporations, non-profit organizations and public sector employers to help them manage fiduciary risk. For more information on our services, please contact Mike Volo, Senior Partner, at or mvolo@ cammackretirement.com. Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Investment products available through Cammack LaRhette Brokerage, Inc. Investment advisory services available through Cammack LaRhette Advisors, LLC. 100 William Street, Suite 215, Wellesley, MA p insurance products and general pension consulting, including actuarial services, provided through Charles W. Cammack Associates, Inc. 40 Wall Street, 56th Floor, New York, NY p