Reasons NOT to Offload DB Plans

One-third of respondents to a 2017 survey conducted by CFO Research in cooperation with Prudential Financial chose each of the following factors driving corporations to implement a pension risk transfer by purchasing an annuity from an insurance company: Desire to manage the total costs of the organization’s pension plan; desire to mitigate the impact of changing actuarial mortality assumptions, including potential future changes; and desire to mitigate the impact of rising Pension Benefit Guaranty Corporation (PBGC) premiums, including potential future increases.

“Desire to reduce the pension plan’s asset-related volatility” was chosen by 31% of respondents, while “desire to focus the organization on its core business (rather than on pension issues)” and “desire to reduce the number of smaller-benefit payments being made” were each chosen by 25% of respondents.

However, John Lowell, Atlanta-based partner and actuary for October Three Consulting LLC, contends the exit from traditional defined benefit (DB) plans is in part a result of a “follow-the-leader” mentality.

“Clearly, once plan sponsors started to exit from DB plans it became a trend,” Lowell says. “If a few large companies are doing something, everyone tends to follow the leader, just like when everyone started moving to high-deductible health plans.”  

Unless companies see a compelling reason to keep their DB plan, someone internally in management says, “Why do we have this thing?” Lowell says. “Unless someone has the answers thought out, it’s not an easy question to answer.” He adds that chief financial officers (CFOs) see maintaining a DB plan as a big issue, but human resources staff generally do not view it as a negative; they either view it neutrally or positively.

What Led to a Negative View of DB Plans?

Lowell says the reason plan sponsors want out of DB plan administration goes back to the 1980s. In 1985, the Financial Accounting Standards Board (FASB) released its Statement No. 87 which affected return on asset assumptions and discount rates used to calculate pension expenses and obligations. Then, two years later, Congress passed the Omnibus Budget Reconciliation Act of 1987, which requires employers to provide full pension service credits for participants who work beyond normal retirement age. “What they did is bring in an accounting and funding regime, each of which introduced volatility which had not been previously inherent in pensions. Some say volatility is not inherently bad, but all CEOs think it is bad,” Lowell says.

In his opinion, the next big thing that happened is—following the 1990s, when asset performance was great—the tech boom of 2000 to 2002 caused interest rates to fall, and companies suddenly had to make large unbudgeted contributions to their DB plans. “That, to me, really started the race to the exits,” Lowell says. “Once people saw peer companies doing it, they thought, ‘Why don’t we do it?’”

Then the Pension Protection Act (PPA) of 2006 took what had been gradually increasing PBGC premiums “and really spiked them upward,” he says. “The maximum amount of PBGC premiums plan sponsors could be paying for the 2020 plan year is $600 to $700 per person,” Lowell explains. “Suppose a plan sponsor has someone getting a relatively small benefit. Paying a provider $640 per year to write checks totaling $1,200, makes it think ‘Why not write one check to that person and get rid of them?’”

Are the Costs to Maintain the Plan Really That Bad?

Perceived costs are a big driver of plan sponsors’ move to offload their DB plans. But SEI Institutional’s interactive white paper “5 Myths to Terminating Your DB Plan,”  explains how ideas about the cost to maintain plans could be misguided. According to the paper, the five myths are:

• Annuitization strategies are financially favorable transactions and cost less than maintaining the pension plan;
• PBGC premiums are a large financial burden for the pension plan sponsor, and contributions that reduce those costs are positive uses of capital;
• Making contributions to fund up the plan reduces the plan’s risk and is a good use of capital;
• The pension plan is a large financial burden and needs to be solved in the near term; and
• Termination is the best way to end the frustration of managing a pension.

Tom Harvey, director of institutional advice at SEI Investments Co.in Oaks, Pennsylvania, has been with SEI for nine years and now works with plan sponsors on their pension strategies with a view of how the pension plan fits in with a company’s overall financial situation. He says plan sponsors know enough about DB plans but are not experts. All the rules are complicated and different from the other things they do in their companies. “They have difficulty parsing through available strategies, and I try to educate them about how to think about them,” he says.

Harvey says the biggest challenge is that plan sponsors approach their pensions in a silo. “When they consider strategies for their DB plan, they focus on its assets and liabilities. But it’s important to consider the plan in context of the plan sponsor’s overall strategic position,” he explains. “How big is the plan relative to the plan sponsor? For example, how big are DB plan payouts relative to the plan sponsor’s overall cash flow and other expenses? When we look into these things, they get a different view of their plan.”

“For example, for a hospital looking at plan termination, the first thing I look at is benefit payments of $1.5 million a year, which is just deferred compensation, in the context of salaries and benefits of $300 million annually. The hospital would have to come out of pocket $60 million to eliminate an annual liability that is a fraction of what they are spending on compensation and benefits every year.” he says.

“Many times just that comparison is enough. Plan sponsors wrestle with spending money to terminate the plan when the cost of the plan is relatively minor,” Harvey says.

He adds that DB plans were designed for plan sponsors to put money in and have that money earn investment returns over a long time period. A lot of what SEI calls “pension fatigue” comes from not making the progress in building plan assets that plan sponsors would have liked. Harvey says plan sponsors need to remember that paying to get rid of the plan now is more expensive than paying benefits out of plan assets over 20 years.

Harvey concedes that for clients with large plans that represent 30% or more of a plan sponsor’s market capitalization, offloading some liability—through a lump-sum payment window or partial risk transfer, for example—would be valuable. But, he says, the average plan sponsor can easily manage the risk. “If a plan sponsor can write a big check now to pay an insurance company to handle the risk, it is basically saying it can handle the risk,” Harvey says.

Another way to look at it is, if the risk forward would be $2 to $4 million annually, but the plan sponsor is willing to write a check today for $60 million to get rid of the plan, Harvey says, the math doesn’t make sense. “The plan sponsor will be losing interest on, or missing out on another purpose for, cash.”

As for the urgent need to offload pension risk in the near term, Harvey says, “Most payments will happen long after people currently at the table are gone, so why do they have to solve for risk now? Just like any other expenditure, plan sponsors should think of the DB plan in the context of the overall business. Paying now is more expensive than paying later.”

He also points out that PBGC premiums are fairly tangible in terms of the cost of managing a plan. They have increased and the way they are determined is by a percent of underfunding. This could be a meaningful dollar value, but Harvey says, rather than focus on how premiums are calculated, plan sponsors should focus on the payment the plan makes to the PBGC out of asset returns. “The drag on assets on a percent basis is smaller than in the context of managing the plan,” he says.

If plan sponsors look at how items are paid, not calculated, then the decisionmaking is really about how to allocate capital. Harvey warns that plan actuaries tend to look at this differently.

Another Reason to Keep the DB Plan

Lowell notes that Millennials are hearing about problems older generations are having with retirement readiness and are worried as a group about lifetime income. He says recent surveys have shown they don’t want to be the job hoppers they’ve been viewed as or that Generation X has been.

So, if the next generation wants to find a company to stay with and from which they will retire, they need benefits that assuage their worries. Lowell says offering a DB plan will attract employees and make them more productive, which in turn will increase the productivity of the company.

“DB plans can be designed to get rid of almost all of the volatility; DB plans don’t have to be evil things for a company,” Lowell says. “Before they follow everyone else, plan sponsors should look at the short-term and long-term pros and cons, and make a decision that is prudent for their companies. That’s the discussion they should try to have.”