For nearly 30 years, institutional investors have lived within a regime of falling interest rates. In the 1980s, U.S. 10-year Treasury bond interest rates peaked at 14%. In 2012, they reached new lows, falling below 2%. On the upside, this secular trend helped fuel one of the most powerful bull markets—for both stocks and bonds—in history.
On the downside, it can be argued that low rates have helped fuel a cycle of booms and busts, centered on technology stocks and real estate, since the year 2000. What’s certain is that falling interest rates caused the valuation of defined benefit (DB) pension plan liabilities to soar. This is simply a function of the formula used to calculate plan liabilities: Lower assumed interest rates result in higher liabilities. As a result, the average funded percentage of DB plans sank to a low of 70.5% during 2012, down from a comfortable surplus in excess of 130% in 2000, as measured by the Milliman 100 Pension Funding Index.
Tired of financial market volatility and funded status risk, many pension plan sponsors have already “frozen” their DB plan and considered the possibility of terminating their plan when interest rates increase significantly (thereby decreasing liabilities). That inflection point appears to be on the horizon. Just past the halfway point in 2013, interest rates have increased by over 70 basis points since the start of the year. Correspondingly, the Milliman 100 Pension Funding Index improved from 77% as of the beginning of the year to 90% as of the end of July.
This raises the question of whether or not it’s a good idea to go ahead and terminate a DB plan. To evaluate the arguments systematically, we’ll provide a brief overview of the reasons why plan sponsors have chosen to freeze DB plans. Then we’ll look at the costs and benefits of plan termination. Finally, we’ll examine a range of alternatives including liability-driven investing strategies (LDI), lump sum payouts, and equity hedging strategies.
The fate of the DB plan in the 21st Century
For two decades, from 1980-1999, sponsors of pension funds lived in a “golden age” as U.S. equities returned 18% per year on average (as measured by the S&P 500 Index) and bonds returned 10% per year on average (as measured by the Barclays Aggregate Bond Index). Well-managed funds helped pension plans maintain surpluses year after year. Plan sponsors took contribution holidays and enjoyed pension income as opposed to pension expense. Some plan sponsors went more than 20 years without making a contribution to their plans, as funding surpluses continued to be built while statutory minimum-required contributions were zero. Maximizing alpha was the name of the game as taking on investment risk seemed an easy way to boost income on the corporate balance sheet.
However, since the year 2000, declining rates became a mixed blessing at best. As mentioned above, the sudden bursting of the bubbles in technology and real estate led to dramatic losses in the world financial markets. The U.S. Federal Reserve (and other central banks around the world) saw maintaining liquidity as a necessity—so short-term rates continued their decline. For DB plan sponsors, this was the worst of all worlds. Staggering losses reminded them that investment risk can, and does, have dire consequences. Just prior to the financial crisis and subsequent deterioration of funding ratios, Congress enacted the Pension Protection Act of 2006 (PPA), defining timelines and penalties for underfunded DB plans. The PPA fundamentally changed rules for determining minimum and maximum plan sponsor contributions, with plan liabilities now tied to current interest rates as opposed to rates based on long-term expectations of asset returns. New FASB regulations stipulated that funding status needed to be shown on financial statements, not “hidden” in the footnotes.
In extreme cases, offering a DB plan was seen as an enterprise-level risk. It was said of some of our older blue chip companies, like General Motors, that their real function had become the provision of retiree benefits, not manufacturing. An exaggeration perhaps, but not without an element of truth.
In order to avoid the risks posed by market volatility and uncertain ongoing pension liabilities, a significant number of companies chose to freeze their pension plans during the 10-year period from 2003 to 2012. Freezes come in two types: soft and hard. A soft freeze closes the DB plan to new employees, while those already participating continue to accrue benefits. A hard freeze stops the accrual of all future benefits to current and future participants. In many cases, employers chose to move the affected employees into Defined Contribution (DC) plans.
The economics of termination
Generally speaking, a soft freeze is a strategy for a decades-long transition to a DC plan. The hard freeze, presumably, will lead to plan termination as soon as the employer can afford to do so. It’s important to understand that the costs of administering and funding the liabilities of a DB plan do not go away just because it has been frozen. All pension promises that existed prior to the freeze still must be honored.
For example, a plan with a hard freeze that is only 70% funded will have to make up the 30 % deficit before the employer can stop making contributions. And, as long as the plan is underfunded, the employer must bear the burden of higher PBGC premiums and continued contribution requirements each year until full funding is reached. In addition, any frozen DB plan still has administrative expenses, including fees for actuarial services, accounting, and investment management—regardless of the funding level.
While 100% funding is the target for regulatory purposes, practically speaking, a DB plan needs to reach approximately 115 to 120% funding in order to terminate. That’s due to the cost of annuities. Insurance companies have their own methods of determining discount rates and mortality assumptions for valuing liabilities, and these are very conservative. Typically, the annuity valuation is 15 to 20% higher than the balance sheet liability. The high cost of terminating a DB plan explains why sponsors have been watching interest rates so closely.
There are alternatives to plan termination that may make sense for some employers. These include some very compelling asset strategies, methods for reducing liabilities, and combined approaches that address the big picture.
Potential lifetime income for the balance sheet
Here’s the key question for plan sponsors: After going to the trouble and expense of funding your DB plan at more than 100%, is there more value to the enterprise in unloading it to an insurance company or in keeping it as an ongoing asset that generates income on the balance sheet—at significantly reduced risk?
Sponsors can achieve this outcome—the creation of a lifetime income-generating asset—by transitioning to an LDI strategy. Typically, the pension plans buys a portfolio of high-quality bonds with durations matching those of plan liabilities. This way, the sensitivity of the market value of assets to interest rate changes closely matches that of the liabilities. The investments and liabilities move in tandem, and the net funded status stays relatively consistent from year to year.
Matching up the fund’s assets and liabilities effectively eliminates funded status risk and minimizes interest rate and investment risk. We can’t talk about eliminating investment risk, because the portfolio clearly has exposure to the bond market. In addition, LDI strategies generally maintain a small allocation to equities, since a perfect duration match between plan liabilities and investments is not possible to achieve in the real world. Sponsors wishing to control the risk of this remaining equity exposure can employ an equity hedge. For example, Milliman’s Managed Risk Strategy offers dynamic hedging capabilities. The Strategy showed its effectiveness for some of the world’s largest insurers during the 2008 market downturn. This leaves only mortality risk, which can also be addressed, if desired, with customized hedging techniques.
In addition to risk control, this approach provides another substantial benefit—surpluses. Even a moderately overfunded plan with an LDI strategy in place can produce pension income under US GAAP accounting as the expected return on assets will exceed the interest cost on frozen liabilities by more than anticipated plan expenses. Every year, the financial statement can show income from the pension plan; and every year, that surplus can show up directly on the balance sheet
Optimizing the plan design
How does a pension fund transition to a surplus-funded approach? There are several options.
First, it makes sense to look at the liabilities. Some companies find it beneficial to reduce liabilities by offering a lump sum settlement to a portion of the active and/or inactive (terminated vested) population. Current statutory minimum lump sum interest rates are close to US GAAP interest rates, so the net balance sheet impact can be minimal. Some CFOs adopt this approach in order to control the absolute size of the fund. The reduction in headcount also lowers the expense of PBGC premiums.
That said, this downsizing strategy is basically a way to get liabilities out of the pension plan and off the balance sheet without the cost of an annuity purchase, which can be quite expensive in comparison. Another variation of the lump sum strategy is to only offer limited lump sums (less than $50,000, for example, depending on the size of the accrued benefits in a particular plan). Of course, before implementing this strategy, consideration should be given to the expected financial aspects of the transaction (should a lump sum subsidy exist?) and human resource implications (which participants will be eligible for lump sums and of those eligible, how many will actually opt to take them?).
After any potential lump sum strategy has been employed, the next step is to adopt a schedule to achieve a funding surplus. For example, think of a plan that was 80% funded at the beginning of 2013. Thanks to the interest rate increases and robust market returns experienced so far, its funding ratio may have improved to 87% by the middle of the year, based on the Milliman 100 Pension Funding Index. At this point, the pension committee decides to adopt a surplus funding/LDI strategy. They commit to moving more plan assets to bonds as the funded percentage improves, developing specific target goals. Every time the target is reached, they will transition a stated percentage of assets from equity investments to fixed income investments. This is called a glide path approach towards adopting a LDI strategy and it might look like this:
The company starts with a 60%/40% allocation to stocks and bonds on June 30. On July 1, they take on an LDI investment strategy. Then, when they reach a 90 % funded status, they move to a 50% stocks and 50% fixed income allocation. At 100 % funded, the allocation may shifts to a 30% stocks, 70% fixed income allocation. And when they achieve the desired surplus of 115%, they phase out of equities completely to remove any further market risk and adopt a full LDI strategy (also known as immunization) to further eliminate future interest rate risk. Once the plan’s ultimate surplus-funded position is achieved, the idea is to lock in and remove any further market and interest rate risk.
Flexibility of a surplus-funded plan
Sponsoring an overfunded pension plan gives the employer a number of options to use the surplus. For example, in a year when cash is tight, the company could choose to temporarily suspend its match to a 401(k) plan, and pay an accrual (similar to a cash balance plan accrual which can mimic a 401(k) match) to participants through the defined benefit plan instead. This can be accomplished without a cash contribution, by using the overfunding to provide for benefits. Of course, this will serve to lower the funded status of the pension plan but it still may be worth it depending on the DB plan’s surplus level and the fact that the benefit will be less costly to the employer when offered through a DB plan compared to a DC plan. Alternatively, the excess could be used to pay for service provider expenses. These include the fees of actuaries, lawyers, attorneys, auditors, and record keepers. Depending on the size of the surplus, it is possible to pay for these fees as well and still generate income on the balance sheet. Furthermore, the plan’s minimum contribution requirement will also be zero given a plan’s surplus position.
In every case, the advantages of maintaining an overfunded DB plan will depend on the size of the fund, the specifics of the employee population, the financial impact on a plan sponsor’s balance sheet, and the goals and level of risk tolerance of the plan sponsor. For employers who cannot afford to have any pension risk (zero risk tolerance), the extra costs of plan termination and purchasing annuities from an insurance company may make sense. For other plan sponsors who may be more comfortable dealing with a specific level of pension risk, there may be some merit in maintaining the plan (that is, once the pension risk is properly brought within the plan sponsor’s desired risk tolerance level). Detailed discussions of costs, benefits and risk tolerance with the plan’s actuary would be essential for the company’s pension committee before deciding the future strategy for the fund.
That said, it’s certainly an avenue worth investigating. There’s no way around the fact that terminating a DB plan requires overfunding it. And once that funding is in place, it’s a serious economic question whether or not the company balance sheet would benefit from having a lifetime surplus locked in. The alternative is paying a premium to a life insurance company to take on the plan’s liabilities. We think it’s an attractive concept to consider: restoring DB plans to a benefiting order again, as in the not-so-distant 1990s— when pensions were appreciated as an asset, rather than a liability, to the corporation.
William Most (
