DB Plans in Decline Face Increasing Risks
The current context of pension regulation, and the steps sponsors have taken to wind down their plans, create new and significant risks for defined benefit (DB) plans, notes Kevin Wagner, senior consulting actuary at Willis Towers Watson, in Southfield Hills, Michigan.
The first he labels discipline risk—failing to maintain a realistic level of annual contributions. “One of the reasons DB plans are underfunded is that sponsors have been able to take holidays from contributions,” granted by Congress in 2012 and 2014, then most recently extended in the Bipartisan Budget Act of 2015. He explains: “When companies hear siren calls for their capital, managers have found it more compelling to fund a new factory than contribute to the pension plan, especially when they didn’t have to.”
Lower funding leads to Wagner’s second evolving concern, which he terms decumulation risk. “A plan is much more difficult to sustain when its funding ratio gets down to, say, 70%. For most of my time in the business, pension plans were growing—the money coming in from sponsors’ contributions and investment income was greater than the money going out.”
These days, the outflows are the driving factor: “I don’t think many sponsors fully understand that plans in decline have financial characteristics that are entirely different from those that are growing,” Wagner says. For illustration, if a plan is funded at just 70%, with $70 in assets and $100 in liabilities, and then distributes $10 in benefits, its funding falls to 66% ($60 in assets against $90 in obligations). He adds: “There is a snowball effect—from a low start, the funded ratios will continue to decrease as the plan goes through the natural process of paying its benefits.”
The declining asset pool brings on further risk, as the sponsor has to rein in the investment horizon of the portfolio. “When plans are expanding sponsors can take risks in the portfolio, such as in investing in stocks, that pay off over a whole business cycle,” Wagner says, “but in decumulation, equity investments may have to be liquidated to pay obligations, and may not live out a whole cycle. As plans are in a spiral to a terminal state, the time value of return and volatility have to be considered differently.”