DB of the Future: Greater Funding, Less Risk

July 15, 2008 (PLANSPONSOR.com) - Among other conclusions made in a recent report, Russell Investments says the defined benefit plan of 2017 will likely be better funded and accept less risk than pension plans today.

Projections of the status of a wide range of DB plans based on the projection engine of Russell’s Strategic Review process indicate barely one plan in every four will be below 90% funded in 2017. Russell says this is understandable given new funding rules dictated by the Pension Protection Act.

In addition to reduced variability in funded status from plan to plan, Russell says it expects to see increased variability in contributions for the DB plan of the future. Under the new rules, contributions will be more responsive to short-term variations in the plan: bad experience increases contribution requirements, and favorable experience reduces contributions. “This is intuitive if we think of contributions as an option; the more volatility in the system, the more valuable the option,” the report says.

The three main influences on plans in the future will lead to plans accepting less risk, Russell contends. For one, decisions around benefit design (in particular, whether to keep, close, or freeze plans) in order to reduce expected contributions or costs has the effect of making risk-taking less attractive. Funding policy, which now must focus on 100% funding, also discourages risk-taking. Similarly, a plan’s investment policy will reflect the same.

Traditionally, pension plans have accepted a great deal of interest rate risk (the mismatch between the interest rate sensitivity, both nominal and real, of the assets & liabilities) and taken significant market risk, chosen to implement with active management, and enjoyed a relatively minor amount of longevity risk, Russell notes. In the future, Russell expects the extent of the risk taken in each of these areas to decline, with the possible exception of longevity risk, and plans will become better balanced.