In our introductory article last week, “De-risking corporate defined benefitpension plans,” we stated that the current, relatively well-funded status of DB plans presents an opportunity to lower the risk level. It’s important to recognize that the risks involved cover a full spectrum that extends well beyond the problems that result from underfunding. This article explains the six major types of risk that plan sponsors face.

Investment risk has been making its presence felt since 2000 and, until recently, equity returns have been lower than both historical averages and plan sponsor expectations. Interest rates have lingered at or near record lows. Volatility has been high at times, with extreme “tail-risk” events coming with unusual frequency. And increasingly high correlations between asset classes have left investors with no safe place to hide.

During the great recession of 2008, all asset classes declined together. Diversification, the traditional primary tool for managing investment risk, failed to protect investments from significant declines. As a result, plan sponsors face great uncertainty over how much of their pension liabilities can be funded in the future from investment returns; they face the alternative of using the corporation’s operating cash to maintain or improve their plans’ funded status.

Interest rate risk really came to light because of the declines in interest rates since 2008, reaching historic lows in 2012. The calculation of the value of pension liabilities is similar to bonds, with present values increasing when interest rates decline. In addition, the Pension Protection Act of 2006 (PPA) imposes strict funding schedules and heavy penalties for plans that are significantly underfunded. By an unhappy coincidence, PPA technical calculations went into effect in the same year (2008) that the great recession led to the collapse of financial markets and pension asset values. While remedial legislation passed by Congress relieved some of the pressure on these cash funding requirements, GAAP (generally accepted accounting principles) accounting rules still require pension liabilities to be “marked to market” using current interest rates. This means plan sponsors are still dealing with high pension liabilities on their balance sheets and an extremely complex regulatory environment. Bottom line: Interest rate risk is still a major source of uncertainty.

Longevity risk is becoming more of an issue for pension plans as retirees enjoy longer life expectancies. Mortality tables that use projection scales are required by both auditors and the PPA. Specifically, the Internal Revenue Service (IRS) mandated the use of mortality tables with projection scale AA as part of the PPA. The Society of Actuaries continues to update its recommended scales on a regular basis. In the near future, we may transition to table “MP-2014,” a unique two-dimensional table that takes into account both age and calendar year of death. Depending on actuarial assumptions, participant age, and gender, this could result in liabilities that are significantly higher than under current mortality table assumptions.

Legislative and regulatory risk can be summarized succinctly: Pension complexity and, in turn, fees are likely to increase. The PPA turned the pension fund world upside down with its application in 2008 as liabilities were measured on a “mark to market” basis and asset smoothing was limited. Coming at the end of that year, the great recession created the need for statutory funding relief and the result was the Moving Ahead for Progress in the 21st Century Act (MAP-21) legislation. Until MAP-21, interest rates smoothing was only allowed for a maximum period of 24 months.

While bringing some cash funding relief for plan sponsors, MAP-21 also increased the insurance premiums that are paid by plan sponsors to the Pension Benefit Guaranty Corporation (PBGC). Moreover, with the November 2013 budget accord, even higher PBGC premiums have been etched into pension law for the next several years. The higher premiums produce more for the federal budget even though they are unrelated to federal spending, attracting legislators looking for ways to fund increased spending. With PBGC officials constantly speaking about their need for more revenue, the real dollar cost for plan sponsors with underfunded plans will almost certainly increase in the future.

Administrative risk stems from the possibility of litigation over plan interpretation and plan administration. One nettlesome issue is late retirements. Here, plan sponsors are at risk over suspensions of benefits, mandatory commencements at age 70.5, and potential Voluntary Correction Program (VCP) issues. A second area fraught with hazards falls under the Defense of Marriage Act’s extension of benefits for same-sex spouses. A third danger zone focuses around lump sum offerings, where problems can arise over potential discrimination, subsidies, anti-selection, and liquidity issues.

Clearly, pension plan administration is complicated, and our society is litigious. That’s a volatile combination, which can prove costly to pension funds. As a result, many companies have looked to outsource their pension administration to third parties, a trend that will probably continue in the future.

Other demographic risk refers to any adverse unexpected experience among the participant population (other than longevity risk, already referenced above). Since the great recession, there has been a significant increase in disability claims and terminations. While the overall trend is toward delayed retirement, many participants who were laid off during the recession and couldn’t find reemployment have opted to commence their pension benefits early. There is also embedded anti-selection risk in plans where participants have the option to choose from various subsidized benefit forms.

Discussing and evaluating these six types of risk are the key first step in any de-risking process. Next week we’ll explain some of the major strategies plan sponsors can employ to address the fund’s assets, liabilities, and funded status.

 

John Ehrhardt and Zorast Wadia, principals and consulting actuaries with Milliman in New York  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.   

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.