DB Risk Management Priorities for 2014

Many plan sponsors have adopted de-risking glide paths with an increased allocation to assets that provide a hedge against liabilities. The majority of the glide paths have triggers based on funded status, with some plans also adopting interest rate triggers. Mercer anticipates plan sponsors will continue to use a two-pronged approach, with an increased emphasis on interest rate triggers given expectations of tapering by the Federal Reserve in 2014, and the potential for an increase in the level of interest rate volatility. This approach would help plan sponsors lock in interest rate increases when they occur.

Also, a number of plan sponsors are introducing time-based triggers. This pertains mostly to plan sponsors looking to terminate the pension plan within a specific time frame. Mercer also expects to see greater interest in these types of triggers as more plans seek to terminate.

2) Review the optimal LDI (liability-driven investing) benchmarks for liabilities.

Pension plans that have a substantial allocation to liability hedging assets in their portfolios should ensure that the choice of bond benchmarks fits the liability characteristics. This will be an important theme in 2014 and Mercer anticipates an increasing number of plans will explicitly set the benchmark to the plan liabilities.

3) Don’t forget about derivatives.

Pension plans utilizing LDI have increased their exposure to liability hedging assets as funded status has improved. However, physical securities may not be sufficient to manage interest rate risk, or may be an inefficient use of capital, and more plan sponsors will begin to deploy the use of derivatives. Mercer anticipates an increased use of interest rate derivatives in 2014.

4) Optimize growth assets.

De-risking glide paths are intended to reduce risk as funded status improves. If the de-risking action is to reduce the allocation to growth assets, then the expected return for the assets will fall as well. Another way to reduce risk without necessarily reducing returns is to optimize the growth portfolio by adding new asset classes and investments other than equities. A diversified growth portfolio can have a risk level that is as much as one-third lower than an equity-only portfolio. This would permit a plan to take a step or two along its de-risking glide path without lowering its expected return.

5) Evaluate whether a completion manager right for the plan.

As a plan develops its LDI strategy, it will move from using standard long bond benchmarks to a measure that is tailored to its own liabilities. This can involve specifying interest rate durations at key tenors to more closely match the liability cash flows and therefore fill-in any potential gaps that are generally not addressed by duration matching strategies. Mercer expects the use of these techniques to develop further in 2014 as more plans extend their LDI strategies.

6) Consider accelerating contributions.

The funding relief provided under the Moving Ahead for Progress in the 21st Century Act (MAP-21) allows for many plans to fund at lower levels.  However, many plan sponsors are making discretionary contributions to improve the funded status of the pension plan, especially plans that are on a de-risking glide path but have a funded status that is much lower than the first trigger point. Accelerating contributions has the added benefit of reducing Pension Benefit Guaranty Corporation (PBGC) variable rate premiums, which gives an effective “free” return of nearly 2% to these assets.

7) Pension surplus planning is on the rise.

The rapid rise in plans’ funded status has left an increasing number of plan sponsors having to consider the “problem” of surplus management. Surpluses in pension plans can potentially be managed by merging underfunded plans into overfunded plans arising, for example, from mergers and acquisitions, paying for retiree medical costs and shifting other types of benefits into the overfunded plan (e.g. non-qualified SERP benefits).

8) Check on governance needs.

Once a strategy, such as a glide path approach or LDI, has been chosen, determining the appropriate implementation approach is the next step. These strategies require integrated governance structures to ensure they meet the implementation objectives of the program. Many plan sponsors, especially those with limited internal resources, have decided to delegate these functions to focus on their core business. Mercer expects an increased pace in delegation of investment responsibilities to a third party such as monitoring of the glide path and trade executions, as well as manager selection, contracting and oversight.

9) Analyze cost advantages of a cashout.

Mercer anticipates a significant increase in cashout programs in 2014, which will generally be directed towards former employees with vested pension benefits.

PBGC premiums are expected to increase dramatically in 2015 and thereafter, as part of budget negotiations in Washington. Premiums are expected to rise to $57 per participant in 2015 and then to $67 in 2016, compared with 2014’s premium of $49 (indexed with wage growth). Coupled with rising interest rates, 2014 looks to be a very good time to cash out terminated vested participants and avoid paying these annual premiums for the rest of these participants’ lives.

Furthermore, the introduction of new mortality tables is expected to increase liabilities by 2% to 3% by 2016. Cashing out participants before the tables are implemented can result in further significant cost savings.

To prepare, plan sponsors should now be looking at the legal, administrative and financial implications of such a program to ensure optimal results.

10) Annuity purchase may be a viable option.

The cost of an annuity purchase for a typical retiree group may be virtually the same as the cost of keeping these retirees in the plan. The November update of the Mercer US Pension Buyout Index (see "Pension Buyout Costs Tick Up") indicates the cost of purchasing annuities for a retiree group from an insurer is 108.3% of a typical balance sheet liability. By comparison, the economic cost of holding liabilities in the plan is estimated to be 108.2%, which includes an allowance for future retention costs (administrative, PBGC premiums and investment expenses), as well as a reserve for future improvements in life expectancy. Transferring these retiree liabilities to an insurer removes considerable volatility from the balance sheet and income statement. The improvement in funded status has resulted in annuity purchases being much more attractive.