Managing a Defined Benefit Pension Plan as A Separate Line of Business Provides Clear Sight Line to Making Informed Decisions
Businesses create strategic plans for all of their business units. Often, a decision to close or curtail an operation occurs. Imagine a large division that complicates your balance sheet, P&L situation, and cash flow, and is no longer a core part of your business, it is a point of distraction (picture a wasting EPA site). A business would never permit this to persist. Why then are pension plans any different?
In the very near term, companies with calendar-year defined benefit (DB) pension plans will be preparing a variety of filings and reviewing their funded status, expense levels, and future contributions. Has anything really changed much? Have we taken action to reduce the underfunded size of a pension plan - that is essentially debt? There is an increasing view among corporate CEOs and CFOs that pension debt is a riskier form of debt than traditional debt, because pension debt carries additional volatility. As such, there should be a premium associated with managing that risk, and companies are weighing this risk alongside others. This
is a fact, regardless of whether or not the DB pension plan is a strategic part of a Company’s Total Compensation offerings.
Creating a detailed business plan to manage this issue, like one would for any other line of business, is the most practical way to solve this problem. Who is ultimately responsible for running a pension plan – frozen or active? Many parts of a business touch these plans: from accounting, finance, legal, and HR to technology. Getting focused on this approach is the only way to solve this issue.
In our experience, many companies say that, in addition to curtailing pension benefits, they are focused on managing the risks posed by their DB pension plans. Specifically, they are concerned with reducing the volatility of their funded status reported on balance sheets and the level of required contributions. This trend is a result of:
- Accounting transparency mandated by the Financial Accounting Standards Board (FASB)
- Pension Protection Act (PPA) time-frame squeezes on addressing funding gaps
- Phase out of temporary funding relief programs provided by Congress
- Lack of a significant enough rise in interest rates or improvement in market conditions
- Updated mortality tables released by the Society of Actuaries magnifying longevity risk (These tables have been widely adopted for accounting purposes and are now forming the basis for determining minimum funding, Pension Benefit Guaranty Corporation (PBGC) premiums, and lump-sum payments.)
One of the objections to de-risking is: Why not simply wait for market conditions to improve? Would we take this approach with any other line of business? Relying on improvements in market conditions to close funding gaps is a risky proposition, because equity markets and interest rates can be volatile and are unpredictable. Plan sponsors may also be misjudging the risk they are taking based on the belief that the recent rise in short-term rates will assist in improving funded status. Actually, an interest rate increase for long-duration investment-grade corporate bonds would benefit plan sponsors more than an increase for shorter-duration bonds. This is because DB pension plans are required to discount future liabilities based on the prevailing rates on investment-grade corporate bonds that match the duration of their plans’ liabilities. Moreover, a rise in interest rates for these bonds will not benefit the typical plan sponsor, if it coincides with an equity market decline.
The impact of an unfunded pension plan on a company’s bond rating can be significant. Bond ratings are reviewed when securing loans, as well as the fact that current loans may be at risk (perhaps in the form of high rates) if certain bond ratings are not maintained. Additionally, financial risks associated with future cash flow based upon the unfunded DB pension plan will play a significant role in the market value of the organization.
As a result, companies have significant incentive to reduce funded status volatility. For some plan sponsors, the prospect of engaging in a pension risk transfer, via the purchase of non- participating annuity contracts for current retirees or offering a lump-sum window for deferred vested participants, may seem cost-prohibitive. The cost of transferring risk is lower than what many sponsors perceive, as the transaction will generate a long-term savings on expenses that the sponsor would otherwise incur, including:
- Administrative Expenses and PBGC Premiums – Plan sponsors incur annual expenses related to participant servicing and plan administration, estimated at $40 – $75 per participant, per year. The per-participant flat-rate premium for plan years beginning in 2019 is $80 for single-employer plans (with indexing thereafter). The PBGC variable rate premium, charged per $1,000 of unfunded vested benefits, is projected to be $42 per $1,000 of unfunded vested benefits in 2019. It should also be noted that there is a per-participant cap on the variable rate premium of $523 times the number of participants with indexing thereafter.
- Investment Management Fees – Plan sponsors incur investment management expenses related to managing the assets within a DB pension plan, which can range from 25–40 basis points per year.
- Mortality Table Changes for Funding – The IRS has issued proposed regulations that identify an update to the mortality tables used for pension funding obligations and PBGC premiums. These changes to the liabilities, for funding purposes, are expected to increase by roughly 3% – 5%, as a result of the new tables, although actual results will depend on plan design and participant demographics. Increased longevity is the primary reason the tables are being updated, as the long-term effect will be people are living longer, thus requiring monies in a DB pension plan to be extended longer for individuals than originally anticipated. Given this, plan sponsors should evaluate the benefits of offering lump-sum windows for deferred vested participants, since it will result in a favorable impact on accounting liabilities.
There are certain obstacles that are often raised when considering a de-risking strategy. Plan sponsors may be concerned with the fact that DB risk-reduction strategies may harm certain financial measures, such as accounting settlement charges. If this non-cash charge is a concern, the settlement charge matter can be effectively managed by periodic settlements that are under the threshold amount, combined with straddling the purchase between plan years.
The Department of Labor crafted specific guidance that plan sponsors must comply with as part of any de-risking strategy. These safeguards include only utilizing highly rated insurance companies, who are focused on handling retiree obligations. The goal of these rules is to offer comfort to retirees and these points should be the focus of any PR and communications plan.
Reducing DB risk will most likely narrow the projected range of cash contributions. In addition, by removing volatility for a portion of the liability, future cash flow will be favorably affected. As most companies are measured on the basis of available cash flow, it would seem that implementing de-risking strategies would be a positive. The first step is to create a plan to manage this part of the operations.
Content provided by Elliot N. Dinkin, President/CEO at Cowden Associates Inc., a Solution Partner in the Connex Partners' network.
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