Weighing the Pros and Cons of De-Risking Strategies

August 28, 2012 (PLANSPONSOR.com) – Now seems like a popular time to offer lump sums, but according to a white paper from Goldman Sachs Asset Management, there is no one-size-fits-all de-risking strategy.

In the spring, de-risking “took a new turn” with General Motors’ lump sum offering and annuity purchase involving more than 100,000 participants, according to the white paper titled “Halftime Highlights: Corporate Pension Plans Face Ongoing Stresses.” It was not the first time a plan sponsor had offered a lump or entered into an annuity buy-out, but the size of the action was unparalleled. 

General Motors’ move underscored that there are many different de-risking strategies. Some plans may prefer lump sum and annuity strategies as they reduce their gross pension obligation. For other plans, the potential accounting costs and cash flow requirements may outweigh the benefits, the white paper said.

“There are different tools in the toolbox,” Michael Moran, pension strategist at Goldman Sachs Asset Management and author of the white paper, told PLANSPONSOR. “These discussions are really going on within every DB plan right now in the United States.”

Moran explained several de-risking strategies and the pros and cons of each:

Lump Sum 

Lump sums can lower the gross pension obligation, but also potentially lower the funded percentage. There is also a risk of adverse selection, meaning participants who are in poor health may be more likely to take the lump sum, but those who are healthy may take the annuity, Moran said. The lump sum strategy could also trigger the income statement recognition of a portion of unrecognized losses that are related to plan liabilities being settled.  Typically these losses are amortized over a period of time, but settlement of the liabilities through a lump sum may result in immediate recognition of the losses.  This option could also be disruptive to asset allocation, given that the payment of lumps sums may require the plan sponsor to liquidate certain existing plan asset holdings.

Annuity (Buy-In) 

Purchasing an annuity in the plan (buy-in), in which the annuity becomes an asset of the plan, does not reduce the obligation, but there is no settlement loss recognition. A buy-in results in an ongoing amortization of losses. There is also the potential for lower expected return on assets (EROA) because the expected return on the annuity may be below the overall rate currently assumed for the plan.

Liability-Driven Investment (LDI)  

LDI has been the de-risking choice for many plan sponsors, although now some plans are taking more aggressive steps such as with lump sums and annuity terminations, Moran said. This option results in no settlement loss recognition or reduction in pension obligation. Like the buy-in, it results in an ongoing amortization of losses. LDI strategies do provide a much better liability match, Moran said, thereby making them attractive to some plan sponsors.

Full or Partial Termination (Buy-Out)  

This option lowers the gross pension obligation and transfers the risk to a third party, thereby making it potentially attractive to some plan sponsors.  It comes at a cost, however, because the insurer must be compensated for taking on the risk, and cash contributions may be required in order to effectuate the transaction.  In addition, as with lump sums, it may trigger settlement accounting and potentially lower the funded percentage.

The funding relief recently passed by Congress has raised questions about whether this legislation will slow down or potentially reverse de-risking activities and the implementation of LDI strategies, but Moran said while the relief may slow some de-risking activities, it likely does not end them (see “Despite Funding Relief, DB Contributions May Stay Above Minimum”). He added that the relief is essentially temporary and the ability to use higher discount rates than before the funding relief was passed will likely diminish.

The white paper is available here.