Mercer Encourages DB Sponsors to Act on Funded Status Improvements

Most defined benefit (DB) plan sponsors enjoyed significant funded status improvements in the first three quarters of 2018. According to Mercer, the continued bull market, coupled with a significant rise in discount rates, drove up the aggregate funded ratio of pension plan sponsors in the S&P 1500 from 84% to 92% by the end of September—the highest level in the past five years.

However, the beginning of the fourth quarter reminded plan sponsors of the potential equity volatility inherent to plan funded status performance and continued equity risk moving forward, including concerns of a potentially less accommodative Federal Reserve. Mercer says this highlights the question, “When is the right time to bank on funded status improvements?”

In its “Top 10 Defined Benefit Areas of Focus for 2019,” Mercer suggests that whether a DB plan has a formal glide path in place or not, plan sponsors should take a fresh look at their current situation and risk posture and consider monitoring funded status more frequently to ensure opportunities are not missed; reviewing the plan situation to determine or reconfirm the plan sponsor’s ultimate intended destination for the plan and the conditions that should drive changes in the structure of the investment portfolio or to initiate a transfer of plan obligations and risk off balance sheet (in part or in full); and putting the appropriate governance in place so plan sponsors can move quickly to take advantage of market opportunities as they are presented.

According to Mercer, developing a “journey plan” that outlines the strategic policy choices to move a plan to its ultimate destination is a step many plan sponsors have undertaken. The three primary elements of a journey plan are investments, funding and risk transfer strategies (for some plans, plan design may also be an option). Mercer says it is important that these strategies are coordinated where appropriate, for example by linking the investment policy with planned risk transfer activity, to manage cost and risk. As another example, where the journey plan calls for annuitizing a portion of the liability, adjusting the investment policy to account for financing the transaction by transferring assets-in-kind can reduce premium costs.

Mercer also suggests DB plan sponsors assess pension risk transfer strategies. It notes that there are emerging solutions gaining increased attention for 2019. For one, while organizations may pay lump sums to terminated, vested participants, plan sponsors can structure a transaction to offer lump sums to active employees with frozen benefits, although Mercer notes this is slightly more complex. The firm notes that such an offer can shed liability, reduce Pension Benefit Guaranty Corporation (PBGC) premiums and allow employees to roll their lump sum into their defined contribution (DC) plan, though the cost may not always be attractive. Other strategies to consider for 2019 are to implement a pension buy-in—the plan sponsor purchases an annuity as an asset that it holds and which provides cash flows to pay benefits—rather than a pension buy-out, and a full plan termination, which settles all liabilities through a combination of lump sums and annuity buyouts.

If plan sponsors are currently navigating the plan termination process, Mercer says it is time to focus on the investment risk hedging strategy and critical drivers of termination costs, such as the plan’s lump sum stability and look-back periods and the impact that the lump sum rate-lock date will have on the total plan termination liability duration. Mercer offers details about changes to contemplate for a plan’s liability hedging portfolio, as well as considerations for bond capacity, re-evaluating growth portfolio construction and alternatives, and managing the growth portfolio’s liquidity along a plan’s glide path.

Looking ahead to possibly more volatile market activity, Mercer notes that protection strategies always reduce return as they reduce risk if the strategy is held for a long period. “The key to options, and most protection strategies, is to use them when there is something in particular to protect against, and it can’t be the same thing everyone else wants to protect against. An option strategy to protect a portfolio from a loss prior to a planned buyout or lump sum can be effective, as might an interest rate strategy that takes in a premium for accepting the risk of buying bonds after rates rise,” the firm says.

Finally, Mercer recommends assessing opportunities to improve investment governance. “Understanding why plan sponsors have made the decision to shift to the OCIO [outsourced chief investment officer] approach, and whether these decision drivers are applicable to your organization, is critical,” it says.