Despite another strong year in 2014 for equity markets, the funded ratio of defined benefit pension plans declined due to historically low interest rates. As a result, the pain continues to mount for plan sponsors. Funding requirements, PBGC premiums, other plan-related costs, and increasing stress on the balance sheet continue to negatively impact the welfare of sponsoring organizations. In order to free themselves of this burden and offer retirement benefits more in-line with the goals, values, and strategies of their organizations, pension plans will continue to “derisk”.
The wave of defined benefit plan derisking began in 2012 when big names like Verizon, General Motors, and Ford offloaded billions of dollars of pension liabilities. Many others followed as the derisking of defined benefit plans became one of the hottest industry trends making plenty of headlines. What many headline readers don’t realize is that derisking comes in many flavors:
- A DB plan redesign can have numerous shapes and sizes but most commonly involves “freezing” the benefit. Following a freeze, existing and newly hired employees are shifted to a defined contribution plan resulting in a reduction in the growth of liabilities and risk.
- Another way to remove risk from the plan is to offer a lump sum distribution If taken up on the offer by the participant, the sponsor simply cuts a check and is then free of their obligation to that former employee.
- There are two derisking strategies that involve purchasing annuities from an insurance company. A buyout involves the purchase of an annuity on behalf of the participant so that the financial commitment and liability shifts from the plan sponsor to the insurer. A buy-in involves the purchase of a bulk annuity on a group of participants in the plan that is held as a liability-matching asset of the plan. In this scenario the plan sponsor pays premiums to the insurance company in exchange for a stream of income that matches the pension liabilities.
- An increasingly utilized approach to managing defined benefit plan assets is through liability-driven investing (LDI). Instead of focusing solely on the risk of the assets in a plan, LDI takes a broader view by also focusing on liability risk. This view allows assets to be matched with liabilities thus smoothing cash contributions and mitigating plan risk.
These are just a few of the ways an organization can derisk their defined benefit plan. If consideration is being made to a derisking strategy, an independent, knowledgeable consultant should be engaged to assist in the process. The burden placed on responsible plan fiduciaries is great so take care to make sure any plan-related decisions are made prudently.