Managing and Mitigating DB Plan Risk

In this article, we’ll focus on the first two: managing risk by reviewing plan designs and considering liability-based solutions, and mitigating risk via asset-based solutions that target the funded status of the plan.

Managing risk 

The approach of managing risk starts with a careful examination of opportunities to control plan liabilities through changes to the plan design. After reviewing pay and service definitions, the plan formula, and the accrual pattern, actuaries can make recommendations to meet a sponsor’s de-risking objectives.

Costly features of some plans may include:

• Using final average pay (FAP) in the benefit formula rather than career average pay (CAP); FAP leverages employees’ highest earnings years throughout their retirement and offers a maximum level of preretirement inflation protection;
• Offering automatic cost-of-living adjustments (COLAs) combats post-retirement inflation. These features are more prevalent in public pensions than in private pensions. There were many more ad hoc COLAs in the ’80s and ’90s; and
• Subsidizing early retirement benefits and optional forms of benefits such as Joint and Survivor (J&S) annuities.

While it’s easy enough to prospectively amend features such as COLAs and subsidized options, switching to a new plan design is a bigger undertaking. Rather than transition directly from FAP to CAP, many employers choose to adopt hybrid plans with or without lump sum payout features.

Here are a few of the most frequently used plan designs and strategies:

Cash balance plans. A cash balance plan looks like a defined contribution (DC) plan, because the employee receives an annual credit as a percentage of pay, say 5%. In fact, it’s a DB plan because the plan sponsor retains the investment risk while crediting the participant accounts with a specified return, tied to a financial benchmark such as the 10-year Treasury rate. This strategy provides participants with a guaranteed rate of return, accelerated vesting, and benefits portability. Employers like cash balance plans because they eliminate the leveraging of the FAP formula. The accrual pattern is level, and funding can be made predictable through funding strategies that mitigate interest rate risk and market risk.

Variable annuity plans. Like a cash balance plan, a variable annuity plan credits the participant with a percentage of annual pay. But instead of tying return to a fixed-income benchmark, participants’ annual returns are tied to those of a variable annuity. Thus, balances can go up or down. There is a floor, however, protecting retirees from extreme downside risk. And because of longevity pooling, participants are guaranteed not to outlive their benefits. Employers gain from predictable costs, which are cheaper than they would be under a FAP formula. There is also a greater degree of risk sharing between employer and employee under this design than under a cash balance plan.

CAPs with ad hoc updates. Employers can adopt a CAP design with periodic benefit updates. This gives the plan sponsor the option to increase payouts, when markets are strong, to levels approaching FAP—but not the obligation to do so when markets and the economy are weak.

Lump sums. Some employers encourage future retirees to leave the plan by offering attractive incentives for taking a lump-sum payout. The idea is to reduce both the plan’s total liabilities and its longevity risk, and, at the same time, to lower the cost of Pension Benefit Guaranty Corporation (PBGC) flat-rate premiums, calculated on a per-participant basis. The downside is that assets also leave the plan along with the liabilities. This reduces the fund’s upside ability to benefit from future investment gains and could potentially worsen the plan’s funded status, causing PBGC variable-rate premiums—based on unfunded vested benefits—to go up.

Mitigating risk 

The second “M” stands for mitigation strategies, where the focus is on asset strategies designed to maintain and protect the plan’s funded status. The following three risk mitigation strategies are discussed below: liability-driven investing (LDI), dynamic asset allocation, and equity tail risk hedging.

Liability-driven investment (LDI) strategies. LDI strategies are designed to significantly reduce the volatility of both a plan’s funded status and its contribution requirements. The goal is to match the duration of the plan’s liabilities with an asset portfolio composed of fixed income investments. Once fully implemented, the value of the plan’s assets and liabilities will respond the same way to changes in interest rates and significantly reduce the sponsor’s interest rate risk. If some equity exposure is required for growth, that risk can be managed using tail risk strategies as described later.

Dynamic asset allocation. These strategies are often described as “target-date funds for pension plans” because both employ a self-adjusting glide path to reduce risk while achieving an investment goal. The goal of dynamic asset allocation for DB plans is not to target a level of risk or return; instead, it is designed to reach a specific funded status that the plan sponsor selects. As shown in the table below, the glide path is defined by a series of triggers: Each increment in funding percentage triggers a change in asset allocation. Equity risk is gradually removed and replaced with larger commitments to a fixed income portfolio that is dedicated to LDI. Note that the ultimate plan sponsor funding target can be as high as 110%, or even 120%, for an ongoing plan. The surplus allows the plan to deal with future liability growth through service and pay accruals, and to absorb market movements.

Note: Dynamic asset allocation should be customized for each particular plan. The above table is a sample.

Tail risk management. A sponsor that chooses to forgo LDI strategies and maintain a significant allocation to equities will be exposed to equity risk and tail risk. Tail risk is the risk of an asset or portfolio moving more than three standard deviations from its current price. Essentially, it’s the risk associated with low-probability events that can spark uncontrolled volatility in the financial markets.

Tail risk management involves some form of hedging and may include the buying or selling of options or replication of options. For example, Milliman’s Managed Risk Strategy synthetically replicates a put option (i.e., an instrument that pays off when the underlying asset falls in value) and is accomplished through the purchase of future contracts. Historically, the Milliman Strategy has a track record of eliminating 75% of downside risk while giving up only 20% of the upside. That’s the type of downside protection that plan sponsors having significant equity positions in their pension portfolios need.

This is the third article in a series. Please also see “De-risking Corporate DefinedBenefit Pension Plans” and “Major Risks Facing DB Plans Today.”  

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.