Conditions are ripe for employers to derisk their pension plan
Elliot Dinkin believes that plan sponsors should manage their pension plans like they would any separate line of business, paying attention to their impact on the balance sheet, tax floor and profit and loss, among other things. The problem is, most don’t look at it that way.
Instead, employers don’t put enough money into their plans to keep them solvent and are then forced to take drastic action when they realize what a drain the plan is on their balance sheet, says Dinkin, president and CEO of Cowden Associates in Pittsburgh. “If plan sponsors are proactive in trying to manage it, they may take a longer-term approach and understand what the issues and opportunities are before it’s too late,” he says.
Many have frozen their plans to new hires to stop the bleeding, but others have tried to offload some of the liability through lump-sum payouts or annuity purchases for those who have already retired and are taking money from the plan.
Federal Express just purchased an annuity to reduce the amount of former employees to whom it will have to pay benefits. It is the single largest annuity purchase since 2012, when General Motors and Verizon made big headlines by engaging in very large annuity transactions, says Justin Owens, director of plan strategy and research at Russell Investments.
“For some of these organizations, the pension plan has become quite large relative to the organization itself,” he says. “The plans have been around for many years — 60 or 70 years and beyond. Most of the participants in the plan are not currently working for the company, [but] the company is still obligated to pay the benefits for former employees.”
An annuity purchase is one way to make the plan smaller in order to better manage a company’s expenses and risk, he adds.
Removing 40,000 retirees from Federal Express plan saves the company $3 million a year in premiums the company must pay to the Pension Benefit Guaranty Corporation. It also saves on other administrative costs.
“There’s no reduction in benefits. Most retirees will not even notice this change, as far as the amount and the extent they are required. The insurers are required to pay the same benefit as the pension plan would have offered,” Owens says.
Plan sponsors considering an annuity purchase should take into consideration what the pension plan will look like afterward, he says.
“The plan after an annuity purchase could actually be a more risky group. Retirees are a fairly straightforward group. They have the same benefit each month,” Owen says. Their benefits are already being paid out. For active plan members and terminated vested participants, there’s a lot of uncertainty about when their benefits will start.
Owens says plan sponsors also need to reevaluate their plan’s investment strategy once an annuity purchase takes place. The people still left in the plan may have a different risk tolerance than the retirees who were just shifted out of the plan.
Many corporate pension plans are underfunded. Government-sponsored plans are also having a hard time staying on top of their pension obligations.
Milliman’s Public Pension Funding Study, which explores the funded status of the 100 largest U.S. public pension plans, estimated that the total pension liability at the end of June 2017 would be $4.87 trillion, up from $4.43 trillion the prior fiscal year. The aggregate funded ratio of these plans was estimated to be 70.7%, according to Milliman.
“Underfunding doesn’t mean they aren’t meeting their current obligations,” says Dinkin.
What it does mean is that companies that make their quarterly payments may not have enough money to invest in their businesses, and investment returns usually won’t be enough to help a company’s funded status.
The Pension Benefit Guaranty Corporation, the agency that steps in to take over failed pension plans, has already said it will run out of funds by 2025 if nothing is done to solve the problem.
“The PBGC has taken steps to increase insurance requirements, but it is not going to be enough,” says Dinkin. “We won’t get there with insurance premiums. It makes people look to get rid of their plans faster. They are getting rid of the head count in their plans because they don’t want to pay the high premiums.”
Owens agrees, saying that if a pension plan fails, as has happened to some companies in the past, the PBGC will then pay the benefits for those plans. When an annuity transaction occurs, the guaranty is removed from the PBGC and is put on the insurance guarantee organizations, which are held at the state level.
“I would argue that there’s no reduced security in the benefits. In fact, there are more examples of pension plans failing than a large insurer failing by far,” he says. “The requirements to keep the annuity fully funded are much more stringent with an insurer.”
Many companies with pension plans are evaluating the benefits of de-risking their plans. The rise in interest rates since the beginning of the year has been good for the funded status of pension plans.
“Anything that increases the funded status — strong market performance, an increase in rates, contributions — all of these will lead to more plans taking steps to reduce their expenses and the risk in their plans,” Owens says.
Dinkin urges plan sponsors to take a proactive approach to their DB plans. To come up with more ‘what if’ scenarios so they understand fully what is happening with their plans and aren’t waiting for a problem to arise.
“If they are being proactive in trying to manage it, they may take a longer-term approach,” he says. “They understand what the issues and opportunities are before it’s too late.”
It is still very rare for a company to just terminate its plan. Plan termination involves not only purchasing annuities for retirees, but cashing out or buying annuities for all active participants and terminated vested participants.
Most companies are using annuity purchases and lump-sum buyouts for current retirees to shift some of that liability off their books. Others are freezing their defined benefit plans to new hires and offering defined contribution plans instead.
“The premium to take over those obligations is quite high. The process for a full plan termination is daunting,” says Owens. “There are plan terminations happening, but very few in the larger end of the market.”