Several Strategies Help DB Plan Sponsors Manage Financial Risks

As employers wrestle with how to best mitigate the financial risks associated with sponsoring defined benefit (DB) pension plans, they should weigh the relative benefits of limiting versus eliminating those risks over time, according to a new white paper from MassMutual, “Key Decisions for De-Risking Your Pension Plan.”

There are four main strategies, according to MassMutual: hibernating risks, establishing glide paths, hedging risks by re-allocating investment assets and shifting pension obligations to a life insurer by purchasing annuities.

“There are several different risk strategies for employers to contemplate when managing pension risks over both the short and long term,” says Neil Drzewiecki, head of pension risk transfer for MassMutual. “More employers are concluding that transferring those risks to a life insurer is in the best interest of the company and its employees.

Drzewiecki says that annuities might be the most preferable approach because they help employers shift pension risks off their balance sheets, reduce their long-term financial liabilities and costs, and enables them to maintain long-term financial security and service to plan participants.

“The growing popularity of PRT [pension risk transfer] is good news for both plan sponsors and participants,” Drzewiecki says. “When a plan participant receives a notice in the mail that his or her pension benefit will be paid by a financially secure, experienced life insurer with great service, it’s great news.”

In fact, annuities are the only way to eliminate pension obligations under current law, MassMutual notes. In 2018, pension buy-out transactions totaled $26.4 billion, up demonstrably from $3.84 billion in 2013, according to the LIMRA Secure Retirement Institute.

Another approach to de-risking a DB plan is to “hibernate risks,” i.e. close the plan to any new entrants and to stop accruals for participants who are still accruing benefits. This is also known as freezing a plan. The goal of the hibernation strategy is to limit the financial risks of the plan while the sponsor continues to manage the plan.

A plan with a hibernation strategy will typically establish a glide path in which investments are increasingly allocated to fixed income as its funded status improves. This is done for two reasons. First, assets can’t revert to the plan sponsor, so as a plan approaches being 100% funded, the risk/reward associated with equities starts to diminish.

Second, fixed income assets offer a hedging effect on pension liabilities because interest rates affect fixed income assets and pension liabilities in a similar manner. MassMutual says that on the positive side of the equation, this approach protects against the risk of unanticipated benefits increases. It also saves money for the employer and reduces their risks before eventually executing a pension buyout.

However, plans are still exposed to many other risks, especially interest rate risk. Even though in hibernation, the plan must still be managed to some degree, and, therefore, continues to incur costs, including investment management expenses, actuarial consulting costs, recordkeeping fees and reporting fees.

Another approach DB plans can take is to hedge risks by investing fixed income assets to match the plan’s liability sensitivity to interest rate movements, known as “duration,” to offset changes in the plan’s liabilities. When interest rates decrease, the asset portfolio will increase in value in an amount to close to the increase in liabilities.

On the plus side, this can reduce the plan’s investment risks—but it does not eliminate the risk. While the hedging lowers market risk and makes it less volatile, market risk still exists, MassMutual says. And the assets and liabilities of the DB plan still remain on the sponsor’s balance sheet.

Finally, MassMutual explores annuitizing the plan. Besides the benefits noted above, MassMutual notes that annuities provide income for life, and are guaranteed and fixed. In some cases, income from an annuity can increase over time, providing much-needed inflation protection. However, inflation protection is not provided by all annuities.

Finally, the annuitant can decide when to begin taking payments and they are often offered a death benefit. Typical death benefits pay 100%, 75% or 50% of the initial annuity payment. The higher the death benefit percentage, the lower the initial income payment at the start of the annuitant’s retirement.

MassMutual also underscores the importance of the employer performing due diligence on the insurer before the process begins. They need to look at its ratings provided by insurance rating agencies. They need to look at the quality and diversification of their investment portfolio, and the size of the insurer relative to the annuity purchase.

They need to explore the level of capital and surplus held by the insurer, and the insurer’s other lines of business and liabilities that they are exposed to. Finally, employers need to thoroughly examine the structure and terms of the annuity contract. MassMutual recommends that employers turn to experts to conduct this analysis, as well as to assess quotes for annuity purchases.