De-Risking Pension Plans: Evaluating Plan Sponsors Options and Obligations

Identifying and mitigating risk across an organization is a core tenet of sound corporate financial management. For companies that maintain a defined benefit (DB) pension plan, these liabilities can represent one of a company’s greatest sources of risk.
 
Against a backdrop of longer life expectancies, rising Pension Benefit Guaranty Corporation (PBGC) premiums and other administrative costs, as well as volatile equity markets, many plan sponsors are looking for ways to reduce or eliminate risk entirely with their pension plans. As a result, de-risking has become increasingly popular among the shrinking number of companies that maintain DB plans.
 
De-risking DB plans is a way for plan sponsors to modify plans to mitigate obligation risk or to transfer the risks associated with current and future liabilities to a third party. In fact, a January 2019 survey by MetLife found that 76 percent of the plan sponsors that intend to de-risk expect to completely divest all DB plan liabilities.
 
While de-risking can be an effective way for organizations to focus on core business objectives instead of nagging pension issues, there are many decisions involved in determining an appropriate de-risking strategy.

Mounting Headwinds for Pensions

For decades, pension plans provided assurances to employers and employees. For many employers, DB plans have been a great retention and workforce management tool. Pensions are designed to allow qualifying employees to focus on their jobs without having to worry about managing investments, contributions and account balances like today’s defined contribution plan participants.
 
Over time, volatility in financial markets, strict federal funding rules, mounting administrative costs and rising life expectancies have made DB plans increasingly difficult for employers to maintain. For example, plans are required to pay an annual premium to the PBGC, the federal insurance agency that backstops DB plans. The PBGC charged single-employer sponsors of pension plans $35 per participant in 2012; that same rate ballooned to $80 per participant in 2019. In addition to this per-participant charge, any plan that is not 100 percent funded pays an additional premium based on the total dollar value of underfunding. This started at $9 per $1,000 of underfunding in 2012 and is now $43 per $1,000 for 2019 (capped at $541 per participant). This means PBGC premiums have increased by two to four times for most sponsors in just seven years.
 
In addition to PBGC costs, other expenses like investment management fees, actuarial, legal, accounting and other administrative charges can add to a plan’s overall liability. In fact, it has gotten to the point where the investment returns on some plans do not cover these administrative costs.
 
Even though 2018 wasn’t a good year for equity investors, rising interest rates helped many DB plans improve their funded status. Still, the prospect of the nearly decade-long bull market ending, coupled with uncertainty about the pace of interest rate increases, present major challenges for sponsors of DB plans. While plan sponsors may see some relief in funding obligations this year, they may want to evaluate whether there are opportunities to minimize or eliminate risk in their DB plans.

De-Risking Options for Plan Sponsors

Plan sponsors have several de-risking options, so it’s important to evaluate which strategy—or combination of strategies—might work best for the organization.
 
One option is to take participants off the balance sheet by offering lump-sum payouts. While this may have a higher short-term cost, it is an effective way to reduce the number of terminated vested participants while also reducing the plan’s overall obligation. Many participants like it because they are able to use or invest that money as they see fit.
 
A similar option may be an annuity buyout. In this strategy, participants are still given an annuity payout, but that obligation gets shifted to an insurance company. Unlike a lump-sum payout, retirees earning a benefit may be considered in this strategy. According to the MetLife survey, 67 percent of plan sponsors that plan to de-risk expect to do so by using an annuity buyout, while 50 percent expect to use a combination of the two alternatives.
 
Liability Driven Investing (LDI) may serve plan sponsors who want to keep participants in the plan, while mitigating the plan’s overall risk. With LDI, the investment portfolio is closely matched with the duration of the pension liability. In other words, the goal of the fund is to earn enough on returns without bearing too much risk so the fund is able to meet its obligations to participants over time. Again, plan sponsors need to take care in this strategy that they make appropriate adjustments for the high administrative costs of the plan.

BDO Insight: Consider De-Risking Decisions From All Angles

As with any strategy, plan sponsors have many factors to evaluate when it comes to de-risking a pension plan. First, plan sponsors should look at how de-risking will affect the organization’s goals and objectives, particularly in terms of retaining a motivated workforce. If de-risking makes sense, plan sponsors need to decide which option or combination of options will be best to meet the objectives and how that strategy would affect the company’s cash flows.
 
In addition to these financial considerations, plan sponsors need to think about how de-risking might affect the company culture. Once a decision to de-risk has been made, plan sponsors must begin thinking about how they will communicate the decision to their employees. Developing a plan to educate employees about their options and providing them resources about how the de-risking will impact them is especially important.
 
Rising interest rates, renewed equity market volatility and an expanding field of annuity providers may make de-risking options more attractive to plan sponsors today. Your BDO representative can help explain the various choices as well as the outcomes they can provide for your organization.

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