De-risking Corporate Defined Benefit Pension Plans

April 21, 2014 (PLANSPONSOR.com) - The funded status of corporate defined benefit (DB) pension plans has been experiencing unprecedented volatility since 2000 and, for plan sponsors, it’s been a high-speed roller coaster ride.
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The chart in below tells the story. It shows the history of the Milliman 100 Monthly Pension Funding Index, which measures the funded status of the 100 largest U.S. corporate defined benefit pension plans.

Milliman byline Pension Funding Index

When Milliman established the Index in 2000, DB plans were in a surplus position. The Milliman 100 pension plans fell to a deficit position in the wake of the dot-com crisis and the 9/11 terrorist attacks of 2001. An all too brief economic and funded-status recovery followed in 2007 and early 2008, but those gains were obliterated before the start of 2009 because of the real estate crisis and recession. Deficits in funded status have existed from late 2008 through today, the first quarter of 2014.

Now a surplus position is approaching for the third time. Investment returns for the Milliman 100 plans exceeded expectations in 2013, as they have done for four of the last five years. A strong rally in U.S. equities led the way, as the S&P 500 Index advanced 29.6%. Overall, Milliman 100 plans produced a 2013 investment return of 11.2%, as the negative performance of fixed income investments tempered total returns.

This is an alert to plan sponsors of a strategic opportunity: Assuming that a pension plan reaches a surplus position, a variety of tools exist that can maintain that surplus into the future, reducing the risk that the plan will go into deficit again. Every plan sponsor should at least consider risk reduction measures as their plans approach a fully funded position. It is also incumbent upon plan advisers to discuss de-risking tactics with their clients. In general, these discussions can be structured as an introduction to a three-step process.

The first step in a de-risking program is to understand the plan’s risk exposure. This is a matter of systematically working through the different categories of pension risk. In each case, the plan sponsor needs to analyze how its plan’s specific exposure to risk impacts the balance sheet, pension expense, and cash contributions.

The second step involves determining the plan sponsor’s risk tolerance. What is the plan sponsor most concerned with and to what extent—interest rate risk, investment risk, administrative risk? Plan sponsors need to prioritize the risks they wish to mitigate. Keep in mind different de-risking strategies will be implemented depending on whether the top priority is managing cash flow, the balance sheet, or volatility. Costs are also a factor; there may be some trade-off between what de-risking measures a plan sponsor would like to implement and what is affordable given budget constraints.

The third step views pension risk in the context of the enterprise’s acceptable risk tolerance, and deals with bringing the pension plan’s risk exposure within an acceptable tolerance level as defined by the enterprise. What could cause the company to fail? How do total compensation and benefits strategies impact the company’s long-term health? This is easiest to see in an extreme example such as General Motors (GM). Some analysts commented that GM’s balance sheet looked more like an insurance company, which was due to the magnitude of its pension obligations. GM’s de-risking measures were taken to reduce the size of the footprint its pension plan had on its balance sheet, offloading liabilities despite paying a heavy premium to a third party for taking on its pension risk.

However, on many companies’ balance sheets, the pension plan does not show up as a first-order-of-magnitude line item. Therefore, the enterprise risk is correspondingly lower, which implies less justification for pursuing costly strategies such as pension risk transfers as the first option.

In subsequent articles, we will cover topics in greater detail: The major risks facing DB plans today; managing and mitigating risk, which will catalog the key options on both the liability and the asset sides of the equation; and moving risk and the risks of de-risking, which will look at third-party risk transfers—and what can go wrong.

 

John Ehrhardt and Zorast Wadia, principals and consulting actuaries with Milliman in New York  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.   

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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