Opinions April 21, 2014

De-risking Corporate Defined Benefit Pension Plans

April 21, 2014 (PLANSPONSOR.com) - The funded status of corporate defined benefit (DB) pension plans has been experiencing unprecedented volatility since 2000 and, for plan sponsors, it’s been a high-speed roller coaster ride.
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The chart in below tells the story. It shows the history of the Milliman 100 Monthly Pension Funding Index, which measures the funded status of the 100 largest U.S. corporate defined benefit pension plans.

Milliman byline Pension Funding Index

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When Milliman established the Index in 2000, DB plans were in a surplus position. The Milliman 100 pension plans fell to a deficit position in the wake of the dot-com crisis and the 9/11 terrorist attacks of 2001. An all too brief economic and funded-status recovery followed in 2007 and early 2008, but those gains were obliterated before the start of 2009 because of the real estate crisis and recession. Deficits in funded status have existed from late 2008 through today, the first quarter of 2014.

Now a surplus position is approaching for the third time. Investment returns for the Milliman 100 plans exceeded expectations in 2013, as they have done for four of the last five years. A strong rally in U.S. equities led the way, as the S&P 500 Index advanced 29.6%. Overall, Milliman 100 plans produced a 2013 investment return of 11.2%, as the negative performance of fixed income investments tempered total returns.

This is an alert to plan sponsors of a strategic opportunity: Assuming that a pension plan reaches a surplus position, a variety of tools exist that can maintain that surplus into the future, reducing the risk that the plan will go into deficit again. Every plan sponsor should at least consider risk reduction measures as their plans approach a fully funded position. It is also incumbent upon plan advisers to discuss de-risking tactics with their clients. In general, these discussions can be structured as an introduction to a three-step process.

The first step in a de-risking program is to understand the plan’s risk exposure. This is a matter of systematically working through the different categories of pension risk. In each case, the plan sponsor needs to analyze how its plan’s specific exposure to risk impacts the balance sheet, pension expense, and cash contributions.

The second step involves determining the plan sponsor’s risk tolerance. What is the plan sponsor most concerned with and to what extent—interest rate risk, investment risk, administrative risk? Plan sponsors need to prioritize the risks they wish to mitigate. Keep in mind different de-risking strategies will be implemented depending on whether the top priority is managing cash flow, the balance sheet, or volatility. Costs are also a factor; there may be some trade-off between what de-risking measures a plan sponsor would like to implement and what is affordable given budget constraints.

The third step views pension risk in the context of the enterprise’s acceptable risk tolerance, and deals with bringing the pension plan’s risk exposure within an acceptable tolerance level as defined by the enterprise. What could cause the company to fail? How do total compensation and benefits strategies impact the company’s long-term health? This is easiest to see in an extreme example such as General Motors (GM). Some analysts commented that GM’s balance sheet looked more like an insurance company, which was due to the magnitude of its pension obligations. GM’s de-risking measures were taken to reduce the size of the footprint its pension plan had on its balance sheet, offloading liabilities despite paying a heavy premium to a third party for taking on its pension risk.

However, on many companies’ balance sheets, the pension plan does not show up as a first-order-of-magnitude line item. Therefore, the enterprise risk is correspondingly lower, which implies less justification for pursuing costly strategies such as pension risk transfers as the first option.

In subsequent articles, we will cover topics in greater detail: The major risks facing DB plans today; managing and mitigating risk, which will catalog the key options on both the liability and the asset sides of the equation; and moving risk and the risks of de-risking, which will look at third-party risk transfers—and what can go wrong.

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.
Reader Responses April 21, 2014

SURVEY SAYS: Use of Safe Harbor IRAs

April 21, 2014 (PLANSPONSOR.com) - Participant mobility and the increasing use of automatic enrollment in retirement plans may result in many small balances in different plans.
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For plan sponsors, this could be an administrative and cost concern. Regulations have been enacted allowing plans to automatically distribute small account balances. The law now requires that if a plan issues mandatory distributions of balances less than $5,000, retirement plan mandatory distributions of $1,000 to $5,000 must be automatically rolled into an IRA (safe harbor IRA) instead of being paid out in cash, unless the participant elects otherwise.  

There isn’t much information available about adoption of mandatory distribution policies and usage of safe harbor IRAs.

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So last week, I asked NewsDash readers whether their current firms automatically roll over small plan balances of $5,000 or less into a safe harbor IRA, and why or why not?

Seventy-eight percent of respondents work for a plan sponsor and 22% work for a TPA/recordkeepeer/investment manager. All responding readers reported they do not have a defined contribution (DC) plan account balance of less than $5,000 in a former employer’s plan. In addition, all reported they have not had an account balance of less than $5,000 automatically rolled into a safe harbor IRA by a previous employer?

Slightly more than 17% of respondents indicated their firms do not have a mandatory distribution policy for balances less than $5,000, so don’t use safe harbor IRAs. However, among those whose firms do have such a policy, 53% said their firms did so because they wanted to reduce cost from additional participants or participant balances, and 47% said it was because they wanted to reduce complexity/administration of tracking too many terminated, non-cashed-out participants. Nearly 24% wanted to reduce responsibility for investment of those balances, and 11.8% indicated they do not know why their firms chose to adopt the policy. One participant said his or her firm wanted to keep the participant count below the level for which the plan audit requirement is triggered.

Readers were also asked if their mandatory distribution policy includes the use of safe harbor IRAs to roll over balances of $1,000 or less. Nearly 6% said yes, while slightly more than 88% said they automatically cash out those balances. Nearly 6% indicated they have no mandatory distribution policy for balances of any size.

Among those whose firms that have not implemented a mandatory distribution policy using safe harbor IRAs to cash out balances less than $5,000, 43% said they haven't considered the policy, or discussed it with the plan committee. More than 28% indicated they do not have a problem with a lot of small balances, and 14.3% each said they "want to allow participants to take advantage of plan investments/costs" or they’ve "considered it, but haven’t implemented it yet." However, the majority (57.1%) specified another reason for not adopting such a policy, including not being aware of the option, the CEO not approving it, and wanting to avoid the administrative burden of rolling over the small balances.

Asked how likely it is their firms will adopt such a policy in the future, half of participants said they do not know. One-quarter reported it is unlikely because their firms do not have a problem with a lot of small balances or do not see many advantages for such a policy. The remainder of those responding to the question (12.5% each) either said it is likely because they have discussed such a policy and see advantages for administration and cost, or it is very unlikely because their firms have already decided not to implement such a policy for one or more of the reasons listed in the previous question.

Among the few verbatim comments were a couple more important considerations for adopting a policy to distribute small plan balances. Editor’s Choice goes to the reader who said: “Hmmm, I would submit that if I answered 'yes' to the lead question [about having a small plan balance in another employer’s plan] I shouldn't be in this business.”

Thank you to those who responded to the survey!

 

Verbatim

It's all about the cost of small accounts.

Moving terminated participants out quickly is much easier than trying to find them once they reach 70 1/2.

Administratively a wise thing to do!

Hmmm, I would submit that if I answered "yes" to the lead question I shouldn't be in this business.

There is a concern that these small balances do not cover administration fees. We are looking for ways to handle that problem. Auto Rollover usually means the participant will pay even MORE expenses than within the plan. Need to solve the fair distribution of expenses rather than force people out.

 

 

NOTE: Responses reflect the opinions of individual readers and not necessarily the stance of Asset International or its affiliates.

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