The Next Great DB Risk: Complacency

February 14, 2014 (PLANSPONSOR.com) - What a difference a year makes—strong investment performance and a modest rise in interest rates during 2013 caused a steep increase in the funded status of the typical defined benefit (DB) plan, reversing a multi-year downward trend.
By PS

The improvements moved most frozen plans closer to being ready for termination and gave active plans a welcome reprieve from the pains of the last several years.  

But the drastic improvements could lull plan sponsors into a false sense of security that could result in complacency at a time when they should be evaluating what actions to take.  DB plan risks didn’t go away just because plans are on the good side of risk now.  Even if a plan is 100% funded, it still may not have the appropriate risk controls in place.

Whether the DB is active or frozen, now is a critical and opportune time for plan sponsors to evaluate the status of their plans and proactively develop strategies to manage the ongoing risks of a DB plan.

What goes up can come down

The increased funded status can easily be threatened if equity performance slides or interest rates decrease.  Additionally, currently scheduled increases in Pension Benefit Guaranty Corporation (PBGC) premiums—double to triple the level from a few years ago—will make it more costly to operate a plan. The premium will be even higher for underfunded plans.  And there is the potential for significant premium increases down the road.     

It was difficult in a low interest rate environment, and especially if a plan was underfunded, to realistically consider some de-risking options, but improved conditions make de-risking a much more viable option.

Here are four steps to help DB sponsors analyze and manage their risks:

1.       Revisit asset allocation decisions – Plan sponsors have discussed liability-driven investing (LDI)  for years, but have used it sparingly. A carefully constructed long-bond strategy on a portion of the allocation as part of a portfolio can help “immunize” or more closely match liability movements.  As funded status increases, moving to this type of strategy under a “glide-path” approach has virtually become a standard method for managing frozen plans.  Make sure there is good coordination between the investment adviser and actuary to assure that DB plan risks are appropriately analyzed and monitored.

 

2.       Consider de-risking transactions – The goal of nearly all frozen plans is to eliminate all risks. These plans typically achieve that by paying out lump sums, purchasing annuities, or a combination of the two strategies.  Any plan, frozen or not, can use these approaches to reduce the size of the liability and the per-head portion of PBGC premiums. Reducing plan risk can also help eliminate the risks of losing benefits for some participants. Plan sponsors who want to de-risk could consider buying annuities for retirees, adding a permanent lump-sum provision, or offering the temporary availability of lump sums for terminated participants.  It is important for plan sponsors to carefully analyze the short- and long-term financial implications of these transactions before taking action.  It is also critical to not overlook the quality of data management and administration which are needed to make sure these transactions are analyzed accurately and implemented efficiently.  The impact of data quality is often overlooked and underestimated.

 

3.       Evaluate plan design – A number of sponsors made DB plan design changes during the past several years in reaction to the pressure on company finances.  It will be much easier to conduct a strategic analysis of how well the overall retirement program is meeting the sponsor’s goals when not forced to make decisions based primarily on the bottom line.  Now is an opportune time to reassess the overall goals for offering a retirement program and the acceptable level of risk the company wants to take.  Then, evaluate plan design options that can help achieve company goals.

 

4.       Inject efficiencies – Make sure to understand the total expenses required to operate the DB plan and where you might be able to save money.  This is a good time to look for efficiencies in providing this very valuable benefit to employees.  One way to streamline cost for sponsors with multiple retirement plans is to streamline administration costs by finding providers who can service more than one plan type. Not only are there efficiencies for the sponsor in outsourcing plan administration, there are also financial benefits when the actuarial service is integrated with investment management. This move also gives employees a more holistic picture of their retirement readiness by providing a consolidated view of retirement benefits all in one statement.    

 

When things are not painful, it is easy to ignore them, but with a DB plan, that could be a costly mistake.  Analyzing and implementing the proper changes now could help reduce the pain in the future and could save DB sponsors millions in running their retirement program.  _____________________________________________________________________________________

Mike Dulaney is a senior consulting actuary at the Principal Financial Group.  Mike consults with defined benefit plan sponsors on the design, financing, and risks associated with their retirement programs.

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.

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