Reducing DB Costs, Risk via Lump-Sum Windows

July 30, 2014 ( – There is a spectrum of de-risking strategies defined benefit (DB) plan sponsors can use.

During a recent webinar hosted by PwC, “Reducing Pension Cost and Risk Using a Lump Sum Buyout Strategy,” Jim McHale, a principal with PwC, and David Ehr, a manager with PwC, defined de-risking as taking action to reduce or eliminate a company’s pension benefit obligations, resulting in a reduction in future volatility of cash contributions and financial statement impacts.

Ehr pointed out that de-risking strategies on the “benefit design and investment” end of the spectrum include plan redesign, asset liability modeling/liability-driven investing, implementing hedging and investment strategies, and fully or partially freezing DB plans. Those on the “liability settlement” end of the spectrum include a lump-sum window for terminated, vested participants, and a buy-in annuity contract or buy-out annuity contract settlement of obligations for retired participants.

Ehr observed that the strategies under the “benefit design and investment” part of the spectrum are easier and less expensive to accomplish, while those on the other end of the spectrum, “liability settlement,” are more difficult and more expensive to accomplish. “There is a tradeoff with de-risking,” said McHale. “Plan sponsors want to reduce risk, but there is a cost to it. The question is how much risk can be eliminated for what cost. With de-risking, plan sponsors need to look at the full range of options for their plan.”

Lump-sum windows are the offering of a lump-sum optional form of benefit to former employees who are vested in their DB benefits but have not yet commenced payments, and are often available only for a set period of time. Ehr said accepted lump sums fully settle the participant’s benefit, so plan liabilities and assets are reduced by the transaction.

McHale noted that new mortality tables are under review by the Internal Revenue Service, and during this review process, more lump-sum windows are likely to be offered by companies, since offering them after the tables are approved will cost the plan more, as benefit calculations will reflect a longer life expectancy of participants.

McHale pointed out that using a lump-sum window can offer plan sponsors the advantage of “reducing risk and plan size, which can improve the credit rating of a company.”

According to Ehr, “A company should have solid reasons and a clear business case for using a lump sum buyout. They need to ask themselves how this approach will impact the company in terms of administrative expenses and other factors.” Ehr noted one consideration: Companies need to ask whether the required interest rates for lump sums favorably compare to discount rates used for DB funding and accounting obligations.

In terms of what makes a lump-sum window a success, Ehr said having clear communication with participants is important. Plan sponsors should make sure participants understand their options and what forms need to be completed as part of the process. Sponsors need to walk a fine line between informing participants and influencing them, he warned, providing participants with materials that allow them to make an educated decision in a timely manner.

Maintaining strong project management over the process is also important. Plan sponsors need to create a detailed project plan and establish a definitive time frame for the lump-sum window, as well as coordinate with relevant stakeholders such as their finance and human resources departments, as well as legal trustees, investment advisers and other consultants.

Participant data quality is also an important consideration, said Ehr. Plan sponsors need to be able locate participants well after they leave the company and retire. Sponsors also need to have a process in place for seeking out lost participants and, after performing due diligence steps, may need to consider removing these lost participants from their plan census data.

De-risking is part of a broader movement that is changing retirement plans, said McHale, with more and more companies moving away from DB plans. He noted that it is loosely following the physics principle that nothing can be created or destroyed, simply changed in form. By de-risking, he said, plan sponsors are looking to transfer their risk elsewhere.