Interview | Published in July 2012

Hidden Costs and Hidden Risks in Defined Benefit Pension Plans

It is no secret that market volatility, low interest rates and the underfunded status of many defined benefit (DB) pension plans are having a significant influence on the way plan sponsors approach de-risking such plans.

By PLANSPONSOR staff | July 2012
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With uncertainty about the financial and regulatory environments, many plan sponsors have been taking a “wait and see” approach with regard to devising and implementing pension risk management strategies. However, there may be strategies that sponsors can pursue now to avoid unanticipated contributions and prepare to de-risk when the time is right.

Greg Falzon, senior vice president of Retirement & Benefits Funding at MetLife; Edward Root, vice president and actuary of U.S. pensions at MetLife; and Jason Richards, senior consultant at Towers Watson’s Retirement Risk Management group, recently discussed how the current environment—coupled with the recent actions taken by some large plan sponsors—may affect how and when different de-risking strategies are viewed and considered. They also discussed how some “hidden costs and hidden risks” facing their defined benefit pension plans may help inform plan sponsors’ de-risking strategies, moving forward.

PS: Are low interest rates and the underfunded status of many plans affecting the way that plan sponsors view de-risking strategies?  

Falzon: There’s little doubt that the funded status of DB plans and the current low interest rate environment are impacting sponsors’ view of de-risking.

Funded status is the best indicator of the cost of the plan. The lower the funded status, the more costly your plan is going to be. Funded status is also an indicator of what types of de-risking activities are available to a plan at any given time.

If you look back 10 years ago, many plans were extremely well-funded—some even overfunded. At that time, there were unlimited opportunities to de-risk but little desire. Ten years later, after plan sponsors have weathered two serious economic downturns, we see many underfunded plans where the cost is increasing. Desire to de-risk appears to be high, but there may be fewer options for doing so with a plan that isn’t well-funded.

This catch-22 highlights the need for plan sponsors to look at funded status volatility as a risk in its own right. It is impossible to predict the future, and plan sponsors cannot assume that the economy will pick up, interest rates will rise and funded status will improve.

Therefore, plan sponsors can refresh their strategic view of the plan and go back to first principles. Determine what it is you are trying to accomplish with your plan and how you can achieve those goals in light of the macroeconomic environment and in a way that satisfies both the organization’s strategic focus and the needs of the plan participants. Opportunities for de-risking should be much clearer with that backdrop in mind.

PS: How have plan sponsors’ views of de-risking shifted over the past 10 to 15 years? Does this influence the way they view their plans today?  

Richards: Two periods of prolonged economic challenges in the past 10 years are leading plan sponsors to alter their thinking around de-risking. They understand that it is very difficult to predict when and how the market will react. Furthermore, they understand they will experience significant losses when the market is bad, regardless of the plan’s holdings.

This kind of economic pain in such a short period of time is pushing plan sponsors to think about taking action, despite what some say is a low market environment. Additionally, a combination of factors, such as lower borrowing costs, improved business performance and major market movers, are also leading plan sponsors to be more proactive.

At the same time, the rules have changed. The Pension Protection Act of 2006 [PPA] dramatically altered funding requirements for qualified DB pension plans. As a result, plan sponsors may now have to make large contributions to their plans.

The combination of external economic forces and new regulations is forcing plan sponsors to consider their de-risking options now, despite low funded status and low interest rates.