What’s in Your DB Plan Toolbox?

August 5, 2014 (PLANSPONSOR.com) - In the first decade of the millennium, we saw market crashes that wiped billions of dollars from the collective funding levels of defined benefit (DB) pension plans across the country.
By PS

At the end of 2007, the average pension plan was in surplus, but the credit crisis again left plan sponsors concerned with the challenges of running a DB plan. The real question for plan sponsors now is how to best manage their DB plans, given their specific goals and objectives. Let’s look at some of the options within the toolbox.

One Tool: Liability-Driven Investing

Liability-driven investing (LDI) is the concept of measuring the performance of the assets relative to the liabilities. Typically, pension payments stretch out many years into the future and have characteristics similar to a long-duration bond. Therefore, for many plan sponsors, moving a portion of their assets to long bonds helps reduce the volatility between the two while also maintaining a similar level or slightly higher than expected return—a win-win. LDI version 1.0 considered shifting bond assets already held (mainly core aggregate bonds) to long-duration bonds (potentially a mixture of long Treasury STRIPS, other long government bonds, long corporate bonds and possibly Treasury futures or swaps).

Many plan sponsors, however, weren’t ready to close their funding gap through additional contributions. Instead, they put in place an asset de-risking roadmap—helping to lock in funded status improvements by shifting asset allocations as certain funded status (or interest rate) triggers were hit. With the more recent run-up in equity markets (as well as interest rate rises), this so-called dynamic de-risking has resulted in asset allocations with declining allocations to equities (and other growth assets), and a higher proportion in liability-matching, long-duration bonds. Of course, the ultimate question for the plan sponsor is what is their target end-game objective?

Other Tools with Increased Opportunity and Complexity

The journey (conceivably LDI version 2.0) considers the range of possible tools and resources available to assist plan sponsors with managing their pension plans. 

For some, maintaining an open pension plan will be a human resources (HR) employee attraction tool, imposing a comparatively small financial liability relative to the market capitalization of the company, with a predictable, manageable company contribution rate.

For others, their frozen DB plan is a legacy issue that provides little value from an HR perspective for current employees or new hires, but still needs appropriate fiduciary management. It is an ongoing distraction for finance staff and creates unwelcome volatility to the company balance sheet. Solutions to the last of these features can be achieved through asset allocation de-risking. A reduction in administrative burden can also create value for employers—from both cost and time perspectives.

This evolution has led to significant increased interest in risk transfer opportunities, which are distinct from investment risk reduction strategies. Risk transfer considers the future pension liabilities and explores whether there may be appropriate ways to relieve the sponsoring employer of the risks associated with funding those obligations. One example is offering terminated vested employees a lump-sum cash-out option. Many ex-employees are looking to consolidate their pension benefits. By transferring the benefit as a lump sum, the plan sponsor is also relieved of the duty to maintain funding for the future payment of those benefits—a solution for both parties.

Another tool that plan sponsors may consider is using assets other than cash—such as employer stock, real property or interests in subsidiaries—to fund their DB plans. Sometimes these “in-kind contributions” are used to satisfy minimum funding requirements. Other sponsors use them as voluntary additional contributions to accelerate progress to full funding or to avoid the benefit limitations that result when funding levels dip below certain legislated standards. These transactions must be carefully structured to meet Employee Retirement Income Security Act (ERISA) standards. Also, an independent fiduciary typically represents the plan in deciding whether, and on what terms, to accept the asset, and to manage it once it becomes a plan asset.

Independent Experience and Advice

The important consideration for plan sponsors and fiduciary committees is the determination of the appropriate target solution for their specific circumstances. Whether to offer, maintain, freeze or terminate a DB plan is a plan design decision for the plan sponsor. Therefore, under ERISA, it is a so-called “settlor” decision not subject to ERISA’s fiduciary standards.

Asset allocation, manager selection and ongoing monitoring for a current plan (where the plan sponsor retains the pension risk), or lump-sum cash-outs and/or plan termination (where the pension risk is transferred) may be other considerations. If they are, sound independent advice and guidance will ensure that the broad range of available options are considered and deliberated in a manner consistent with ERISA’s demanding standards. 

Plan sponsors should work to differentiate between strategic decisions versus implementation themes. Staff, committees and boards have limited time and resources and should consider if their efforts are being focused in the right areas. Independent fiduciaries and outsourced chief investment officer (CIO) arrangements can provide additional resources as an extension of staff in order to facilitate due diligence and implementation in a timely and robust fashion.

 

Nick Davies is area president at the Institutional Investment and Fiduciary Services practice of Arthur J. Gallagher & Co. (Gallagher Fiduciary Advisors, LLC). As area president, Davies is responsible for guiding development and delivery of the firm’s capabilities across the full range of Gallagher’s investment advisory and independent fiduciary services. Davies is a member of the firm’s management committee. He is also a defined benefit risk expert providing specialty asset/liability consulting and journey planning advice to clients.  

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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