More firms freezing, closing DB plans
The move away from corporate pension plans continued in 2015, with the number of corporations that have frozen their defined benefit pension plans up 6 percentage points (to 37%) and the number of closed plans (34%) up 9 percentage points from 2012. And the number of plans that are still open dropped 13 percentage points in that same time frame, new research finds.
According to Vanguard’s latest “Survey of Defined Benefit Plan Sponsors,” “a number of market and regulatory factors have driven DB funding ratios lower and plan maintenance costs higher. Interest rates remain stubbornly low. New mortality assumptions reflecting longer life spans have increased liability value and duration for most plans.”
Many of these companies have moved to defined contribution plans, where employees take a more active role in their own retirement savings. The biggest reason is that plan sponsors are interested in getting that liability off of their balance sheet and income statement, says Chris Philips, head of advisory services for Vanguard Institutional Group.
The plan’s liability acts like a bond and because of that, if interest rates are falling, the liability itself increases. If interest rates go up, liability decreases.
If plan sponsors want to mitigate their risk because their liability is increasing, what is coming out of the company’s pockets will have to go up, he says.
If a sponsor wants to “immunize” their plan, they have to have an asset portfolio that has similar interest rate sensitivity to the plan’s liabilities. The only way to do that is through fixed income securities.
Philips points out that the funded status of most corporate plans has improved slightly, even though they took a hit during the last year or so because of interest rate moves and a recalculation of mortality assumptions.
“You are effectively paying out through someone’s death. It costs the plan more if people are living longer,” he says.
“In the immediate sense, funding rates improved because interest rates moved up the last two weeks. There are also a large number of plans that do contribute meaningful amounts out of pocket to their defined benefit plan,” Philips says. “They are motivated to get that off their balance sheet.”
Plan sponsors who want to eventually terminate their DB plans need to get their plan to a target funded status of 90% to 100%. That makes it easier for them to close the remaining gap and offload the liabilities either through a lump sum payout to plan participants or by offloading the plan’s assets to an insurance provider.
And although corporate DB plans are going away, the public sector continues to offer them.
“We don’t see those going away anytime soon because they are so underfunded, it would be a massive taxpayer liability to fully fund them today,” he says. Not to mention the interaction between unions and governments and public entities. Having a DB plan is “very much a recruiting tool as well as a core part of their benefits. As long as that dynamic exists, they may be starting DC plans but DB is not going away,” he says.
On the corporate side, there are a number of professional service firms, like doctors, lawyers and dentists, who are creating cash balance plans, which are considered a hybrid between DC and DB. They are owned by the employee but funded by the employer.
“Most of those are still operating very much like a DB plan,” Philips says. “They have an expected rate of return for those assets and a payout in the end, where the company makes a distribution to the employee.”
As the number of plans that were frozen last year rose, many plans moved their asset allocations to fixed income and reduced their allocation to alternatives and equities.
“You still hear about the expected return on assets being relatively high to what the market projections will be,” he says. “That fact they are moving away from equity is counter to their return expectations.”
Thirty percent of plans who were surveyed by Vanguard expected an average 8% annual return, when the forecasts for the next 10 to 30 years are closer to a 7% annual rate of return.
“In order to get 8% or 9%, you need to be heavy in risk assets,” he says.
Philips believes that plan sponsors are trying to immunize their asset portfolio in anticipation of a rise in interest rates, but many stay in equities and alternatives, at levels that are very risky, in an attempt to build up assets quickly and thus reduce the amount of money they have to put into the plan to fully fund it.