What’s Next for Defined Benefit Plan Sponsors?

Contributor:  Richard Berger
Posted:  05/07/2012  12:00:00 AM EDT
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Spring is in the air - and so is pension relief, once again. A provision has been attached to a Senate-passed transportation bill, to set a floor and a ceiling on the interest rates used to calculate the funding target and annual contributions. (The funding target is the present value of benefits earned to date, and varies according to the interest rate used to discount future payments. The higher the interest rate, the lower are the liabilities and vice versa.) The floor is to be based on a 25-year average of bond rates, which would include the much higher rates of the 1980s and early 1990s; the average is likely to be in the range of about 7.5%. The floor for 2012 year plans is to be 90% of the average, with the floor dropping 5% per year until it reaches 70% in 2016. For 2012 this would set a floor of 6.7%, trending down to 5.25% in 2016. Given current smoothed rates around 5.25%, these lower floors would reduce the pressure on plan sponsors for the next few years. It would also increase tax revenues, because it would reduce tax deductions for pension contributions. Unfortunately, the prospects for passage of this measure are hostage to fundamental arguments about the highway bill to which it is attached and its immediate prospects seem to have dimmed.

The short history of current pension funding rules

The Pension Protection Act was passed in 2006, during a period of rising markets and stable interest rates. The basic principle was simple: to measure liabilities on a market basis, funding benefits in the year earned and any shortfalls in accrued benefits over seven years. When the main funding provisions became effective in 2008 however, the financial crisis had begun to bite. The IRS allowed plan sponsors to make one-year elections of interest rates, to keep liabilities down and to help manage funding levels and contribution requirements. In 2010, an additional round of relief allowed the extension of amortization periods and the use of prefunding balances.

Pension relief has once again come to the fore. The relentless pressure of the Federal Reserve on interest rates, combined with a lackluster market in 2011, has worsened contributions and funding status at the beginning of 2012. As an additional inducement to Congress, pension relief would also raise tax revenues by reducing deductions.

The following chart shows the results for a plan that was fairly typical:

This plan has fared better than many. Still, there has been a steady deterioration in funding, despite good asset returns in 2009 and 2010, and a significant level of contributions. The falling effective rate (the overall rate at which the future benefit streams are discounted) has resulted in falling funding percentages and an expanded shortfall. Since the beginning of 2012, rates have continued to drop. Most plan sponsors have welcomed past relief measures, and will continue to do so in the future. But pension relief is temporary and the basic PPA requirements remain unchanged. Reducing funding requirements now means that more contributions will likely be needed later.

The choices for plan sponsors

Although some plans are well funded, it is common to find plans with funding percentages in the low 60s to mid-70s at the start of 2012. Moreover, these plans are likely to have invested a significant share of their assets in equities, even though long corporate bonds are a better match for the plans’ liabilities. With sizeable funding shortfalls, plan sponsors are unwilling to move their investment allocations to bonds. They realize that such a switch would reduce their potential yield and lock in an underfunding that can only be eliminated by making contributions. They are basically hoping that markets will maintain their 2012 gains, and that the Fed will gradually let interest rates rise to “normal” levels. Their hopes might be realized – but matters could go also awry, as they have done several times since 2007.

Although plan sponsors are reluctant to reduce the size of their funding hole by filling it in with contributions, they realize that only a fixed income strategy can control unsettling volatility. So they may seek a compromise approach. Enter “de-risking,” whereby the plan reduces its risk systematically, as its funding position improves. The general idea is that the plan reduces its exposure to equities and increases its long term bond allocation until it reaches close to 100% funding.

Another variation entails the purchase of annuities when prices are right. An older flavor, called a nonparticipating annuity, allowed the plan to irrevocably transfer the risk of participant benefits to an insurer, in exchange for a cash premium. That structure was known as a buy-out; the new flavor is called a buy-in, logically enough. The buy-in allows the plan to provisionally transfer the risk to the insurer, but it is revocable.

The prices of annuities are largely tied to rates on high quality fixed income investments. Since interest rates on these are low and prices are therefore high, the prices of annuities are generally high as well. The relatively high annuity prices are reflected in the low level of market demand. Annuity purchase activity has not picked up since the late 1990s, and the buy-in annuity has not yet fulfilled its promise.

The role of fixed income in DB plans

The general goal of a de-risking strategy is to gradually reduce the volatility which plagues DB plan funding and accounting expense. By the time that the plan’s assets are equal to funding liabilities, it will likely have a nearly total fixed income allocation. Once that point is reached, is it likely that a plan would ever reallocate a significant portion of its assets to equities?

Many plans are frozen. They will likely go through a formal termination process to settle all benefit obligations, at which point the plans will go out of existence. These sponsors are unlikely to move away from fixed income, because their termination liabilities will be very similar to the funding liabilities that they have targeted.

Some plans that are not frozen will continue. Are they likely to reintroduce the volatility that has proven so troublesome, by increasing their equity allocations? It is certainly possible that strategies involving overfunding or development of prefunding balances could be used to manage volatility, at least on the funding side. Safety and security, however, would still be powerful reasons to stick with fixed income.

To some extent, plans have reverted to a DB investing strategy that was common in the 1970s and earlier. A plan sponsor purchased a deferred annuity for each participant as the benefits were earned, so that the benefit was guaranteed and the costs were known. Beginning in the 1980s, plans moved to include large equity allocations. The reversion to greater fixed income investment is similar to the old deferred annuity approach.

Suppose DB plans move from equities to largely fixed income investments. That transition would reverse an observed phenomenon, that DB plans earn higher rates of return than participant-investors in savings plans. In other words, DC plans could ultimately provide a higher level of benefits than DB plans, by undertaking more risk for more reward. That would indeed be a curious result of the Pension Protection Act!

The time for action

While some plans have doubtless begun to implement a de-risking strategy, most are taking a wait and see approach. Interest rates are still hovering at low level, although markets moved sharply higher in the first quarter of 2012. The Fed has publicly stated that its goal is to keep interest rates low for the near future.

Two contingencies may trigger de-risking strategies:

• Rising equity markets might improve funding levels sufficiently that a swap of equity for fixed income becomes palatable
• Interest rates might rise, lowering liabilities, and fixed income investments might become more attractive (which should also make annuitization more attractive)

Is a bell going to ring, telling plan sponsors to get going? It is likely that either of these events will start a trickle, which might develop into a steady flow. Once events move, there could be a rush by plan sponsors. The moral is that, even though the moment for action might not yet be at hand, it is already time for putting together contingency plans. You do need to be ready to act quickly when that bell sounds.

Richard Berger Contributor:   Richard Berger




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