The Risks of Sponsoring Defined Benefit Pension Plans & De-Risking Strategies
De-Risking Your Pension Plan
Sponsors of defined benefit pension plans face many risks. Fortunately, by adopting programs to reduce risk in their pension plans, they are often able to improve both corporate and plan financial statements, manage economic volatility and reduce Pension Benefit Guaranty Corporation (PBGC) premiums.
Low interest rates and volatile markets can make funding pension plans challenging, which can significantly impact an organization’s financial profile. For many companies, a pension plan is one of the largest items on the corporate balance sheet, but it is not core to the company’s business.
In the early 2010s, certain automakers had pension obligations so large that it was said that it almost didn’t matter how many cars or trucks they sold; when the pension plans’ funded status declined, those companies had a bad year. While these are extreme examples (those companies then took steps to reduce the size of their plans and manage their risks), the fact remains that external forces can have an outsized impact on a company’s overall financial performance.
So what risks are plan sponsors facing, and what can you do about them?
Risks of Pension Plans
Here are the key risks that plan sponsors face, with their potential impact on the cost and financial volatility associated with pension plans:
- Interest rate: A plan’s obligations and costs are driven by interest rates; higher rates will reduce a company’s costs, and lower rates will increase them. We have been in an environment of low interest rates for several years; further reduction during 2019 significantly increased plan costs.
- Investment return: Pension plans are supported by trusts, which have two forms of income – investment returns and company contributions. If plans lose money, or even gain but not as much as expected, contribution requirements increase. During an economic downturn, required contributions can increase sharply at a time when a company can least afford them. This was a widespread problem in the aftermath of the Great Recession.
- Operational: The Internal Revenue Service (IRS), Department of Labor (DOL) and PBGC are all federal organizations with pension plan oversight. The rules covering plan administration are myriad and complex, and they are subject to change. In recent years, increasing PBGC premiums have been an issue, as well as IRS and DOL audits leading to fines for operational failures.
- Regulatory or statutory: Corporate and plan accounting rules are subject to other federal authorities. State or local government rules may also apply. These regulations are subject to change, with a trend in recent years towards tighter accounting controls.
- Longevity: Pension plans generally offer lifetime benefits from the time an employee retires until death. If the employee predeceases the spouse, the spouse will often continue to receive benefits. People are living longer, and that trend is expected to continue. As participants receive benefits for longer periods of time, the company’s costs go up.
The only way to truly relieve your company of the long-term risks of pension plans is to terminate the plan. However, plan termination is a long, complicated process, subject to many rules and regulations. It is also expensive, particularly for plans that are not well funded, and there may be a significant financial statement impact on shareholders.
Even if you cannot afford plan termination, there are several ways to mitigate risk by reducing size, cost or volatility associated with your pension plan. Taking these steps now can make plan termination easier and less expensive later:
- Plan soft freeze: If your employees continue to earn pension benefits, you can limit participation by restricting the plan to employees hired by a certain date. You can also freeze benefit service or limit future pay increases. Soft freeze strategies will reduce future costs.
- Plan hard freeze: You can freeze or reduce future benefit accruals for active employees or eliminate future increases to retirees. Hard freeze strategies will reduce future costs more quickly than a soft freeze.
- Lump sum windows: An effective tool for many plan sponsors has been the temporary offer (or window) to participants to take the value of their plan benefit as an immediate lump sum. The participants who accept are paid a one-time lump sum and subsequently removed from the plan. This reduces PBGC premiums and administrative costs.
Lump sum windows are an especially valuable tool for deferred vested participants who would otherwise have to wait until they meet the plan’s retirement eligibility requirements to receive benefits. They may prefer a single sum now to invest with their personal retirement savings instead of receiving a comparatively small monthly benefit later.
- Annuity buy-in: You can purchase a group annuity contract from an insurance company to pay benefits for some or all plan participants. This contract becomes an asset of the plan and guarantees some or all of the cash flow needs for the identified participants, thereby reducing the plan’s investment risk and longevity risk.
- Annuity buy-out: A common strategy in recent years is the transfer of a plan’s assets and liabilities to an insurance company. The insurance company then assumes the financial and administrative responsibilities of paying the benefits, which relieves the company of its obligation to the identified participants and removes the participants from the plan. As with a lump sum window, PBGC premiums and administrative costs are reduced.
- Asset liability modeling: A plan’s economic risks can be mitigated by modeling the plan’s projected future cash flows and balancing return-seeking investments with capital preservation vehicles based on these projections. Integrating the contribution policy and investment policy can further reduce investment and interest rate risk. As contributions are made to improve the funded status, the company can gradually move to safer investments to protect the plan’s improving funded status and reduce the amount needed for plan termination.
You can tailor each of the above de-risking strategies to your company’s specific goals, objectives and risk profile. However, be aware that there are specific rules that must be followed during implementation for plan freezes, lump sum windows and annuity purchases.
For More Information
Working with a qualified consultant can help you navigate the complexities of de-risking and guide you through the strategies appropriate for your organization. If you have any questions, please contact us here.
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