Interviews with over 100 senior and finance executives across various industries found that 57% of companies considered pension-related risk significant relative to other financial and operational risks they faced. Though companies with plans that are well funded or whose cash contributions have minimal effect on earnings or cash flow view the risk as being manageable over the short term, most senior executives voiced concern for the potential effect of the plan on company credit ratings and cash flow.
The Case for Freezing Pension Plans
Many employers have responded to this risk threat by freezing their pension plans. Thirty-two percent of the companies interviewed by Towers Perrin had closed their plans to new entrants. However, freezing plans may not be desired by companies who still consider their DB plan a valuable employee recruiting and retention tool, and, as a recent study from SEI concluded, it does not alleviate all risks (See Study Warns DB Plan Freezing Doesn’t Mitigate All Risks). Towers Perrin said in its report, “Freezing defined benefit plans, though popular, is a half-measure that slows the growth of the plan, but does little to alleviate the market and mortality risk associated with the legacy pension plan.”
Other than company-specific factors such as the size of the pension deficit, maturity of the plan or overall company finances, companies are also freezing DB plans or considering freezing them due to recent and pending regulatory changes (See Plan Sponsors Not Waiting for Reform to Consider Pension Options and Poll: Pension Reform Will Contribute to Plan Terminations ).
In the Towers Perrin research, 72% of executives with active plans said they would consider freezing their plan if the Financial Accounting Standards Board (FASB) were to eliminate accounting smoothing mechanisms, while 62% of respondents said they would consider freezing if tighter funding requirements were enforced.
The Towers Perrin study also indicated that employers choose to freeze their DB plans because they are generally dissatisfied with other options available to them. Terminating the plan entirely through annuitization represents a cost-prohibitive option for even the best-funded plans due to the conservative market return and risk assumptions insurance companies use to price pension termination annuities. Other options companies might consider, and their downside, include, according to Towers Perrin:
- Altering Asset Allocation: Due to the volatility of the stock market, some companies have been tweaking their portfolios to include a higher percentage of assets in alternative vehicles such as hedge funds and property investments. While altering the asset allocation mix can help decrease a funding gap by generating higher returns, focusing on the asset side can only go so far in addressing risk because returns are volatile and are often not in line with liability payments.
- Cutting Operational Costs: While DB administration costs are often overshadowed by the costs of the liabilities, some companies have turned to cutting cost by outsourcing administrative parts of the plan and combining multiple services, such as actuarial and investment management consulting, under a single provider. And although some companies have realized some efficiencies and cost savings from doing so, these operational solutions haven’t captured much traction in the marketplace, primarily because they fail to adequately address the greater financial risks that are top-of-mind among executives.
Senior financial executives feel the current choice of DB plan solutions are either too expensive or ineffective at managing risk.
As part of Towers Perrin's research, the executives were asked to evaluate several potential solutions, some which are not widely available on the market today. Their reactions demonstrate that an unmet need does indeed exist in the marketplace, as does a willingness to adopt new solutions, provided they have been validated and tested, Towers Perrin said.
Suggested possible solutions, and respondents reactions, were:
- Third-Party Plan Transfer: This type of risk transfer entails "spinning off" the plan to a third party, likely a large investment or commercial bank, which would take responsibility for managing risk and meeting liabilities. Executives found this option compelling, especially those who have explored annuitization but found it to be cost-prohibitive. Executives indicated that their key concerns about this solution would be l ong-term feasibility, potential conflicts of interest with counterparties, and the cost of the transaction.
- Pension Insurance: As a way to protect pension plans from downside risk in the market, purchasing pension insurance is an option that is not readily available in the market, largely because the insurer would be required to cover any portfolio losses if the market were to fall below a certain percentage point. Many considered insurance a feasible alternative to more sophisticated financial instruments if the pricing was attractive.
- Liability-Based Asset Management: An increasingly well-known method of matching market returns more closely to liabilities, liability-based asset management - which involves reducing risk by lengthening the duration of a plan's bond portfolio -i s already being considered by several corporate pension committees. More than half (52%) of executives said that using sophisticated financial instruments would be the most interesting solution given their companies' situation, and many companies are already using this method of asset allocation.
- Captive-Based Solution: One of the more innovative solutions tested in Towers Perrin research, the use of a pension captive, which would reinsure pension liabilities, generated some interest as an innovative solution to mitigating risk. Key benefits of this solution include: Access to surplus assets - Companies are able to access and use any surplus assets generated by the plan in excess of those required to meet annuity obligation; Secure plan benefits - Employees' benefits are insured by a highly rated commercial insurer; and Active asset management - Because the plan is backed by an annuity, companies are able to undertake more aggressive investment strategies. Executives who currently use captives in their organizations and have a general familiarity with them, as well as companies with fully funded pension plans, were the most interested in the captive approach. Nearly one-quarter (23%) of respondents said they use captives to protect against risks in other areas of their organization. However, those who are less familiar with captive insurance models or whose defined benefit plans are far from being fully funded felt the solution was less appropriate for their situations.
More information can be obtained by emailing Matt Herrmann at Towers Perrin, firstname.lastname@example.org .