Why Should You De-Risk Your Pension Plan? By: Sean PattonAIF® 2014.05.19

Improvements over the last year in defined benefit plan funding status have plan sponsors and their fiduciaries considering whether now is the time to take action to reduce future volatility. For almost the last five years, post the financial crisis, defined benefit plan sponsors have watched as their funding ratios ride a roller coaster in the wake of 2008. Now that many are closing in on a funded status that is closer to being fully funded, they want to ensure that they do not allow that status to fall back into the 70s and 80’s again. The idea of de-risking, or finding better ways to manage your plan’s pension obligations, should be at the top of most plan sponsor’s priority list.

There are many different ways to accomplish this goal. It seems that many plan sponsors are playing a game of chicken, waiting to see what the Fed’s next move holds. This idea of trying to guess interest rate movements is akin to trying to time the equity markets – it is almost impossible to do. Many pension committee’s feel if they move too soon they will leave money on the table. It is critical that plan sponsors address the many choices they have in de-risking their plan. This can be done all at once or little by little to soothe the effects of what you are trying to accomplish.

There are several reasons why the most proactive investment committees are moving to take action now. The most obvious is the improvement over the last year in funded status. Equity markets in 2013 were robust and interest rates moved up for the first time in many years. For some plans, the increase in funded status allowed them to remove funding restrictions that limit the ability to settle liabilities by paying out lump sums or buying annuities. If you have implemented a glide path strategy in the past, stay disciplined and do not try and time the market. If your committee has not reviewed your asset allocation, then now is a great time to—this will help to ensure you are removing unnecessary risk from your plan. By implementing some basic diversification strategies on the equity side and examining matching the duration of your liabilities with the duration of your fixed income portfolio, you can have real impact on reducing volatility without getting too sophisticated.

The next reason that plan sponsors are being more proactive is that they have some certainty in their plan right now versus the uncertainty that the future holds. Even if you are tempted to wait because you expect interest rates to continue to move higher (therefore lowering your liabilities) know that if you have done any kind of liability matching with your fixed income, higher interest rates will push asset values and liabilities lower so there may not be an advantage to waiting. Also, it is important to remember that if you do wait, lump sum cash-outs and annuity costs will be increasing due to the expected mortality table increases that should go into effect in 2015. If your committee holds a strong view on the direction of interest rates, consider the idea of adding a couple triggers to the glide path implementation—one on funded status and the other on interest rate levels to ease into hedging your portfolio.

Lastly, PBGC premiums are increasing again. Sponsors with underfunded plans will pay additional risk premiums of $14 per $1000 of plan underfunding. This is up from $9 in 2013. This will move to $24 in 2015 and $29 in 2016. Risk premiums will decrease as your funded status increases. Committees that proactively review their pension plan and implement strategies to de-risk should receive the benefit of improved funded status which will reduce these premiums’ impact on your plan over time.
Improvements over the last year in defined benefit plan funding status have plan sponsors and their fiduciaries considering whether now is the time to take action to reduce future volatility. For almost the last five years, post the financial crisis, defined benefit plan sponsors have watched as their funding ratios ride a roller coaster in the wake of 2008. Now that many are closing in on a funded status that is closer to being fully funded, they want to ensure that they do not allow that status to fall back into the 70s and 80’s again. The idea of de-risking, or finding better ways to manage your plan’s pension obligations, should be at the top of most plan sponsor’s priority list.

There are many different ways to accomplish this goal. It seems that many plan sponsors are playing a game of chicken, waiting to see what the Fed’s next move holds. This idea of trying to guess interest rate movements is akin to trying to time the equity markets – it is almost impossible to do. Many pension committee’s feel if they move too soon they will leave money on the table. It is critical that plan sponsors address the many choices they have in de-risking their plan. This can be done all at once or little by little to soothe the effects of what you are trying to accomplish.

There are several reasons why the most proactive investment committees are moving to take action now. The most obvious is the improvement over the last year in funded status. Equity markets in 2013 were robust and interest rates moved up for the first time in many years. For some plans, the increase in funded status allowed them to remove funding restrictions that limit the ability to settle liabilities by paying out lump sums or buying annuities. If you have implemented a glide path strategy in the past, stay disciplined and do not try and time the market. If your committee has not reviewed your asset allocation, then now is a great time to—this will help to ensure you are removing unnecessary risk from your plan. By implementing some basic diversification strategies on the equity side and examining matching the duration of your liabilities with the duration of your fixed income portfolio, you can have real impact on reducing volatility without getting too sophisticated.

The next reason that plan sponsors are being more proactive is that they have some certainty in their plan right now versus the uncertainty that the future holds. Even if you are tempted to wait because you expect interest rates to continue to move higher (therefore lowering your liabilities) know that if you have done any kind of liability matching with your fixed income, higher interest rates will push asset values and liabilities lower so there may not be an advantage to waiting. Also, it is important to remember that if you do wait, lump sum cash-outs and annuity costs will be increasing due to the expected mortality table increases that should go into effect in 2015. If your committee holds a strong view on the direction of interest rates, consider the idea of adding a couple triggers to the glide path implementation—one on funded status and the other on interest rate levels to ease into hedging your portfolio.

Lastly, PBGC premiums are increasing again. Sponsors with underfunded plans will pay additional risk premiums of $14 per $1000 of plan underfunding. This is up from $9 in 2013. This will move to $24 in 2015 and $29 in 2016. Risk premiums will decrease as your funded status increases. Committees that proactively review their pension plan and implement strategies to de-risk should receive the benefit of improved funded status which will reduce these premiums’ impact on your plan over time.

 

Sean D. Patton

Sean is a Founding Partner of Westminster Consulting, where he currently works with corporate, non-profit and foundation clients.

Sean is involved in the local community through his memberships in Rochester Rotary. He is also the Past-President of the Board of Directors for Camp Haccamo, a Rotary...

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