Moving DB Risk, and the Risks of De-Risking

May 12, 2014 (PLANSPONSOR.com) - The “Move It” strategy for defined benefit (DB) plan de-risking applies to plan sponsors with zero pension risk tolerance or the relatively few plans whose risk footprint is so large that the company is willing to pay almost any price to eliminate it.
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Moving risk to a third party 

Moving risk is an alternative that makes sense only for the plans with the highest enterprise risk. The solutions consist of unloading liabilities and assets to another organization and can be very costly for the plan sponsor.

Annuity purchases. Commonly known as “buy-outs,” annuity purchases involve the transfer of pension assets and liabilities to an insurance company that is deemed by the plan’s fiduciaries to have a very low probability of default. Of course the insurance company will underwrite the risk and charge appropriately for the annuities. A plan sponsor typically uses a buy-out strategy to secure participant benefits when plan termination is on the horizon.

In 2012, a record $41 billion in pension risk transfer activity occurred—from just three companies: Ford, General Motors (GM), and Verizon. In GM’s case, the unfunded pension plan liabilities exceeded 70% of its entire market capitalization prior to the risk transfer. The plan sponsor felt the need to eliminate the enterprise risk and, as a result, GM paid a hefty settlement price for its annuity purchases.

Lump-sum windows. A lump-sum window simply defines a limited time period when terminated vested participants can choose whether or not to accept their pension benefits in a lump sum. Also, to incentivize the lump-sum acceptance rate, special subsidies could be included. For example, to incentivize employees to retire at age 62, a plan sponsor could offer a payout level that the participant would normally receive only if he or she waited for commencement until age 65.Offering a lump-sum window or amending your plan to offer lump sums permanently are both designed to relieve the plan of future liability risk associated with the participants electing lump-sum cash-outs.

Before executing either of these strategies it is important to bear in mind the following considerations: Lump-sum payouts to participants would tend to reach record highs at times when interest rates are at record lows. Also, there is an opportunity cost associated with lump-sum transactions because assets are also leaving the plan. Also salient is the anti-selection risk present with lump-sum offerings where the less healthy participants would elect lump sums while the healthy would select life annuities. Lastly, because of the associated transfer of risk from employer to employee, there are always some related fiduciary concerns and also concerns of negative public relations.

Voluntary plan termination. As mentioned earlier, for those sponsors with zero risk tolerance, a voluntary plan termination may be the ultimate destination. Plans en route to termination are often amended to allow for lump sums, if they do not already contain this option. This is done in order to reduce the size of the pension obligation and thus it reduces the overall dollar cost of the risk transfer transaction to an insurance company that will provide annuities for the remaining employees who did not cash out.

Voluntary plan termination is an option that sits at the extreme end of the de-risking spectrum. As such, it is the most costly of the available de-risking options. Plan termination liabilities are typically 115% to 120% percent of that of ongoing plan liabilities measured on an accounting basis. Besides the premium above ongoing costs that must be paid to an insurance company, there are also the costs of final data cleanup, benefit calculations, participant communications and notifications, legal fees, and third-party fiduciary fees. Depending on an enterprise’s financial standing, risk tolerance, and future outlook, a plan termination—in spite of the cost—may be the optimal solution. Of course in this event, the costs of a potential replacement retirement plan should also be considered in advance, as well as the potential effect on the employee population.

Risks of de-risking 

By definition, risk management deals with probabilities, not certainties. As such, advisers have to pose difficult questions to help their clients see the possible negative consequences of the recommended strategies.

For de-risking, these include:

  • What about the opportunity cost when pension liabilities and assets are offloaded, prior to a rally in the financial markets?
  • What if interest rates rise and the pension plan becomes overfunded, after the implementation of subsidized lump sum buyouts or other costly risk reduction strategies?
  • Would an organization be better off in the long run maintaining a fully funded pension plan that is generating income and showing surplus on the balance sheet instead of going through a voluntary plan termination expenditure?
  • How soon should a plan sponsor fully fund its plan and at what costs, including the costs of potentially borrowing to accelerate funding?
  • What ultimate funding level should a plan sponsor target?
  • How will changes in plan design impact an organization’s ability to attract and retain the quality employees it needs to remain competitive?

To answer these questions, plan sponsors should think about both cost and employee behavior in light of the changes in the retirement landscape, and try to use their modified retirement plan to influence behavior in a positive way for the organization. Keep in mind that balance-sheet considerations do not necessarily conflict with employee focus.

With rising interest rates, more plans will achieve surplus funding. At this point the plan’s funded status position can be stabilized by implementation of the appropriate de-risking techniques, described in detail here. The current scenario provides what may prove to be a rare opportunity to lock in pension income.

Lifetime pension gains on the income statement and plan contributions at near-zero levels would surely provide a stable platform for building an attractive employee benefits program. Perhaps there would then be a reversion to the conditions of the 1990s, when pension plans were a true asset to employees and the enterprise. Even better, this time we will all have the added benefit of the risk-reduction lessons taught to us in the 2000s.

This is the fourth, and final, article in a series. Please also see “De-risking Corporate DefinedBenefit Pension Plans,”  “Major Risks Facing DB Plans Today,” and “Managing andMitigating DB Plan Risk.” 

 

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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