Managing Pension Risks Comes at a Cost

When it comes to many financial decisions, there’s no such thing as a free lunch. It’s especially true for pension risk management.

Lately, the market buzz is about reducing pension risk (high and/or volatile accounting results) in favor of greater financial stability. To reason otherwise feels like arguing against “Mom and apple pie.”  But you don’t simply elect stability; you pay for it in some way. Often, the cost is well worth the risk reduction tradeoff (as is the case with buying insurance). However, if anyone is presenting these strategies as cost free, be cautious and probe further.

Generally, for pension plans, the financial “risk” to banks, credit unions and most insurance companies can be divided in two categories: higher than warranted profit-and-loss (P&L) costs or higher-than-manageable volatility in the plan’s year-over-year results. Financial institutions have a unique ability to manage both of these risks, due to high capital reserves with limits on how these reserves can be invested outside the plan. For these organizations, the real science behind risk reduction lays in understanding the organization’s risk tolerance. That is, the difference between a financial inconvenience (rain storm) and a financial risk (lighting storm) specifically for the organization.

The Federal Reserve in March boosted interest rates by 25 basis points, the first of three such predicted increases for 2017. This, combined with a strong stock market, is expected to provide relief from recent accounting results. Stronger pension returns also present a chance to refresh some financial management strategies for two reasons:

• It’s worthwhile to consider “locking in gains” once they have occurred, and
• Lower unamortized losses (OCI) will mean lower accounting settlement charges.

Financial institutions may mitigate their pension plan risks by positioning assets to better “shadow” liabilities—referred to as liability-driven investing (LDI)—along with using plan assets to strategically settle tranches of the plan’s inactive participant liabilities:

• Moving, over time, from an equity-centric portfolio (return seeking) to a liability-centric (liability hedging) portfolio through the use of a glidepath approach or dynamic investment policy statement (IPS). As a plan becomes better funded, protecting against the downside may become more important than “reaching for” upside gains. However, keep in mind that as the allocation changes, so too will the expected return for P&L purposes. Generally, a more conservative allocation results in a lower expected return and a potentially higher prospective P&L expense.
• Dividing retirees into groups based on the benefit amounts and analyzing the accounting impact of currently buying annuities for a portion of the retiree population. This has several benefits, including reducing or eliminating immediate settlement charges and taking out the participants with the “biggest bang for the buck”—those with the highest relative fixed costs (PBGC premiums, etc.). Plan sponsors also leave a pool of retirees for any future annuity strategies or needs. This is especially important for a plan that’s going to be terminated and fully settled in the next few years. Generally, insurance companies prefer bidding on retirees only but will accommodate a small pool of deferred annuities. Therefore, if there isn’t also a pool of retirees, it may be problematic to get bids on a pool of deferred annuities.
• Offering lump-sum settlements to the plan’s vested, terminated participants. These are former employees who have not yet begun to receive their annuity payments. As with the retiree strategy, plan sponsors should consider the possibility of dividing these participants into groups based on the benefit amounts for reducing or eliminating settlement charges as noted above.

Again, it’s important to remember that there is no free lunch. If your goal is greater predictability, it comes with a cost. For example, let’s look at a plan with $86.8 million in assets with a portfolio that is expected to earn 7% per year with $100 million in liabilities. The liability is also expected to grow, but at 4% per year (the liability is a discounted measure expected to grow for passage of time). Therefore, the best estimate is that the plan will be 100% funded in five years. However, this is only an estimate with a wide range of potential results. For example, if the assets net a zero return over the five years, the plan will be short $34.9 million.

The plan currently has an opportunity to settle $40 million of liabilities by paying out $40 million of plan assets. Assuming the sponsor acts on this opportunity, there is now $46.8 million in assets and $60 million in liabilities. The best estimate is now that in five years the plan will be 90% funded and short $7.4 million dollars. This could be viewed as the cost of this stability approach. However, the benefit is that the dollar variances in the possible outcomes are now reduced. Looking at the zero return outcome, the plan would be short $26.2 million (rather than $34.9 million).

This, by no means, makes settling some liabilities a bad alternative to consider. However, in doing so, it’s advisable to work with advisers, actuaries and other experts who fully understand defined benefit plans and their unique financial operation within your organization. You want to get a full 360 degree view, including the potential “opportunity cost” of removing or realigning assets.

Bottom line: make sure you understand the true costs/benefits behind whatever risk mitigation strategy that you are considering. That is, understand if you are running the risk of getting struck by lightning or simply the inconvenience of getting wet.