Investment Strategies are Among the PRT Alternatives

Current conditions, including improved plan funding status, support pension risk transfers. However, sponsors that still offer defined benefit  pensions can consider options besides PRTs to reduce their plan’s risk exposures. One option, funding a cash balance plan with a DB plan’s overfunded surplus, drew headlines last November. IBM announced plans to replace its 5% matching contributions and 1% automatic contribution to employees’ 401(k) plan accounts with a 5% contribution to a cash balance “retirement benefit account.”

“The ingenuity of that shift in retirement benefits vehicles was that this generated a tremendous cash savings because to make the 401(k) matching contribution that was a 6% of pay cash cost,” says Zorast Wadia, principal and consulting actuary with Milliman. “If you’re providing that similar level of benefit accruals in the defined benefit plan, [and] if your plan is already at a surplus level, it’s not going to take a cash action. So, they went from a massive cash contribution to zero, potentially saving several billions of dollars, presumably, over the next several years to the extent that they can maintain the defined benefit plan surplus.”

Copycats Expected?

IBM has a history of making significant changes to its retirement plans, including using hard and soft freezes and completing one of the largest U.S. PRTs. Given IBM’s role as a plan innovator, will other sponsors follow the company’s most recent move? Perhaps, but it’s likely to be a select few.

The Center for Retirement Research at Boston College identified seven other companies whose plans’ financial metrics were similar to IBM’s and conducive to a similar move. Milliman examined the 100 largest U.S. DB plan sponsors and found 34 companies that could adopt IBM’s change. Wadia said he would not be surprised to see some companies following IBM’s lead soon. “When a trendsetter like IBM basically goes first, that opens the door for other employers to consider the same thing,” he says. “I think that several are in serious discussions as we speak, and we could learn of several more by the end of this year. It also has to do with competitors, industry standards, and recruitment and benefits strategy. But I wouldn’t be surprised if we see more companies follow that pattern.”

Seeking Alternatives

Improvements in a DB plan’s funded status also enhance alternatives for de-risking the plan without a PRT. For example, Wadia cites the hibernation option. “This is when you naturally let the plan wind down its balance sheet footprint as a result of participant terminations and eventual deaths,” he explains. “And then, at some point, if it becomes small enough, you pursue annuitization.”

Glide path management and liability-driven investing strategies also can be alternatives to PRTs. With glide paths, Wadia notes that higher interest rates are prompting DB sponsors to reduce their equity exposures and increase fixed-income allocations. The 2023 year-end average fixed income allocation in the Milliman 2024 Corporate Pension Funding Study was 53.5%, versus the 51.1% level at year-end 2022.

Russ Kamp, managing director with Ryan ALM Inc., believes sponsors should consider bifurcating their plan’s assets into liquidity and growth or alpha buckets. The liquidity bucket holds a defeased bond portfolio using investment-grade bonds, creating a sinking fund for the plan’s liabilities. These assets ensure the plan can pay benefits and expenses while allowing the alpha assets to grow long-term.

“Now you’ve bought time, which is a critical variable,” says Kamp. “When you give somebody 10 years and get away from these quarter-to-quarter cycles, you’re going to dramatically enhance the probability of success. That’s what we need to do—we need to give the alpha assets time to grow and what they produce will meet future liability growth.”

Duration matching and cash-flow matching are two frequently used LDI strategies. Kamp explains that numerous plans have used duration-matching strategies, either buying long-duration bonds to match portfolio duration or using derivatives to establish an interest rate hedge.

Because duration-matching strategies typically use average duration or key rates along the Treasury yield curve, Kamp advocates for cash-flow matching. “With cash-flow matching, you are matching durations every month of that mandate,” he says. “So, if you have a 10-year assignment, that’s 120 bespoke duration matches.”

Kamp adds that cash-flow matching is a viable alternative for smaller and mid-sized pension plans. Bonds are available in small lots, allowing these plans to match their unique liabilities. “You have to make sure that it’s done in a separate account because each entity’s liabilities are going to be unique,” says Kamp. “But you can build a cash-flow matching assignment for small and mid-size pension plans and it’s easily done.”