Corporate sponsors of defined benefit (DB) plans have been backing away from these plans for years. Since peaking in1983 at about 26,000, U.S. pensions with over 100 participants had decreased to a few shy of 9,000 by 2014, says the U.S. Department of Labor (DOL). While growth has, admittedly, been seen in the micro end of the market, midsize and large plan sponsors have given up on defined benefit plans. And for good reason—they can be expensive and, when not properly managed, inflict volatility on the sponsor’s financial health.
Still, compared with other plans, DBs offer the superior solution for retirees. “I often say that the worst DB plan is better than the best DC [defined contribution] plan,” notes M. Barton Waring, retired chief investment officer (CIO) for investment strategy and policy at Barclays Global Investors, and author of “Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control.” “A DB plan that is affirmatively stingy by historic standards—but perhaps, then, being more affordable—nonetheless probably does a far better job at providing meaningful retirement income than does a typical DC plan.” While large corporate sponsors may not be starting new defined benefit plans, there are several important tactics at their disposal to help keep their current plans in place.
Two techniques serve to reduce the size of a plan, by removing inactive or retired employees from the liability base. First, many firms have offered buyouts to terminated employees with vested benefits. Those individuals no longer accrue benefits, so their cost is not growing, but removing them from the rolls makes life simpler for the human resources (HR) department. It also reduces premiums owed to the Pension Benefit Guaranty Corporation (PBGC), at a per-head charge that is now $64 and climbing, plus charges based on a plan’s unfunded liability.
“A buyout shrinks both the assets and liabilities, which reduces the potential risk of an adverse move in benefits or the portfolio,” explains Jon Waite, chief actuary at SEI Institutional in Oaks, Pennsylvania. If the plan is underfunded, the tactic can take funded status even lower, he adds, “but, because the plan has become smaller, there’s less impact on the sponsor’s financial position.” Moreover, after the buyout, a plan’s retirees, whose liabilities are more predictable, account for a greater portion of the liability.
A similar reduction in plan-scale effect can be accomplished through a purchase of annuity contracts to satisfy obligations to retirees (see “Annuity Providers,” PLANSPONSOR, November 2016). “Again, you are reducing the size of the plan, and reducing your PBGC premiums as well. Depending on the size of the organization, the cost savings can be pretty big,” Waite says.
However, risk transfers such as buyouts and annuitization create their own problems, asserts Jeremy Gold, a New York City-based consulting actuary. “Paying out large amounts in lump sums, either to terminated employees or to people at retirement, impairs the DB plan’s value in pooling risk,” he says.
The plan’s investment portfolio offers another lever to pull toward reducing volatility of the plan surplus. Liability-driven investing (LDI) loads up on bonds and fixed-income derivatives so portfolio values will move more in sync with changes in liabilities. However, LDI strategies are most effective when a plan is fully funded, or nearly so—the lower returns to fixed income do little to make up a significant funding gap.
A more sweeping change is overhauling the plan’s design: converting a traditional defined benefit plan to a cash balance format (see “Blurring the Lines,” PLANSPONSOR, January 2016). Sponsors contribute a percentage of employee compensation annually, and investment returns are based on results of the markets. “The investment crediting rate moves up and down, and it’s the employee who has to bear that risk,” says Kevin Wagner, senior consulting actuary in the Bloomfield Hills, Michigan, office of consultants Willis Towers Watson. “That’s one reason cash balance plans work for many sponsors.”
Observers all note that DB pension regulation is far too intricate, but they offer little hope for relief. As Gold puts it, “It’s hard to imagine ever unwinding enough of the regulation to create a favorable framework.”
Waite favors defined benefit plans—thinks they are worth preserving—but believes things would improve with a few design changes. “They deliver benefits in a way employees can’t for themselves. Employers can buy annuities economically as a strong base benefit and better manage risk through the law of large numbers,” he observes, “but the types of plans have to change—to present less risk to the sponsor, and share some of the risks with the employees.”
DB Developments of 2016
Sponsors of defined benefit (DB) plans may find the following of interest:
• Actuaries are regarded as guardians of pension benefits and pillars of financial rectitude. Therefore, it was surprising when the Society of Actuaries (SOA) and American Academy of Actuaries tried suppressing a paper, made by their joint pension finance task force, on applying the rules of financial economics to public retirement liabilities.
Using the low market rates of interest that financial economics calls for would have revealed, and did, that the finances of many public plans are even weaker than they look using the actuaries’ favored higher discount rates. Logic would suggest that the actuarial community would encourage the most solid funding standards, but, instead, for public plans, they stick to high discount rates, which translate into minimal funding.
The document made its way into the public domain nonetheless, and the societies’ move drew widespread negative publicity. The groups reversed course and released it, but not before stripping out the authors’ names. “Responsible actuaries, writing the nearly suppressed report, should be applauded for their courage in standing up to those who continue to insist on current weak funding methods,” observes pension scholar M. Barton Waring. He adds, “Millions of pension beneficiaries trusted the actuarial community to use sober, responsible standards for ensuring adequate funding of their pensions.”
• A propos of public plan defined benefit investment strategy, several state pension funds moved to eliminate or scale back their allocations to hedge funds, for reasons of disappointing performance, high fees or both. For the hedge fund industry as a whole, eVestment of Marietta, Georgia, reports that third quarter 2016 brought a fourth consecutive quarter of redemptions, raising the year-to-date total to $59.9 billion and leaving the total assets in hedge funds at just over $3 trillion.
• A third remarkable defined benefit development for the year, notes Kevin Wagner of Willis Towers Watson, was more of a nonevent, arising in the firm’s annual review of the defined benefit ecosystem for companies in the Fortune 100. “We’ve been looking at large corporate DB plans for about 25 years,” he says, “and this year, for the first time, there wasn’t a decrease in the number of plans.” That is hardly a sign of recovery, however. “There are just 2% or 3% of Fortune 100 sponsors offering newly hired employees the pension plans we knew as kids, and the rest are in DC [defined contribution] or cash balance plans,” Wagner adds. “We may be at the end of the movement away from the traditional pension concept, but there is no hint at all that we are going back.”