Recently, I was having a discussion with a client who, like most plan sponsors, was very concerned about the volatility and unpredictability of their pension plan financials and was looking for ways to manage the costs and risks. This client was under the impression that freezing and terminating the plan was the only way to achieve their goal, when in reality, there are many strategies available that address a myriad of sponsor concerns.
Let’s start with a review the top areas of sponsor concern.
As we shared in our Pension Risk Study published earlier this year, we asked plan sponsors to rank their top concerns. The overall burden of funding the plan over the years causes the most unease at 80 percent followed by the chance of investment losses having an adverse impact on the company’s bottom line at 77 percent. And, competitiveness risk — the risk that the benefit as a recruitment and retention tool will lose its appeal, is the third ranked concern at 73 percent.
What are the key drivers of these concerns, and how can they be managed?
There are a variety of elements that impact a plan sponsor’s ability to fund the plan over time, and the value of the plan’s liabilities reported on an employer’s balance sheet including: market performance, interest rates, and employee factors such as longevity, tenure, and compensation. When taking these elements into consideration along with the plan sponsor’s objectives, we need to examine the risks associated with these elements.
The good news is that there are many strategies available to help manage these concerns. For sponsor’s whose top concern is the overall burden of funding the plan, the main objectives will likely be centered on reducing liabilities with plan design strategies and by managing assets to liabilities. Reflecting on a variety of similar conversations with clients, today I’d like to focus in on key plan design de-risking strategies that can make pension costs more predictable and can give plan sponsors peace of mind.
So, how do these strategies work?
As noted earlier, one of the most commonly known pension risk management methods is to freeze the plan. When freezing a plan, the sponsor may choose to close the plan to new entrants, and in some cases, choose to stop further accruals from that date forward.
In these cases, the plan participants retain benefits accrued through the freeze date, thereby not experiencing a reduction in benefits already accrued. What’s more, some plan sponsors will announce that the pension benefits will freeze in the future, which provides a transition period for participants to plan for this change.
Meanwhile, this approach, whether effective as of the current date or a future date, provides an immediate reduction to the accounting balance sheet and costs for the employer’s benefit. More specifically, these approaches reduce liabilities and some of the risks associated with funding the liabilities, which in turn have a positive impact on the employer’s bottom line.
However, freezing the plan also may mean that the employer is no longer offering a competitive defined benefit plan for many of its employees. So, what are the other options?
Reduce compensation risk by moving to a career average pay design
With a traditional final average earnings pension plan design, generally, the liability is calculated on the employee’s last three or five years of pay – the years when employees typically earn more. This is intended to reward high performers, but can also result in additional risk to the plan.
To dampen the impact of higher wages earned in the last three to five years, a career average pay plan type averages the wages over the full career of the employee. This approach dampens the impact of large changes in pay – reducing volatility associated with the plan’s liabilities.
Manage compensation, interest rate, and longevity risk with a cash balance plan option
Because pension liabilities, as defined for determining cash contributions purposes, are based on interest rates as prescribed by the IRS, interest rate risks are important considerations when determining pension liabilities. With cash balance plans, the benefit is stated in dollars and the account accrues interest on the stated balance. This "cash balance" is the liability. Because the liability has been converted to a "cash balance," the impact of future interest rate fluctuations on the liability value is muted. And, since the benefit is often paid as a lump sum, the company is less exposed to longevity risks.
What’s more, participants more readily understand the value of the benefit because it is stated in dollars — a feature which makes cash balance plans a popular choice.
Mitigating the impact of interest rate and longevity risks with pension equity plan
A Pension Equity Plan, commonly referred to as a PEP, preserves some of the desirable features of a traditional pension plan while diminishing the effects of interest rate risk. With this plan type, the benefit's value is determined by a formula based on pay and service, however, the benefit is defined as a lump sum. Because the benefit is defined in terms of a lump sum value, the impact of future interest rate fluctuations is diminished. What’s more, this plan type allows for early retirement subsidies that encourage the orderly retirement of participants.
It is important to note that due to differing plan sponsor objectives, a plan design that may make sense for one plan sponsor would not work for another. With over 70 years of experience helping clients strategically manage pension plan costs and risks, we have a team of actuarial consultants with a deep and broad background who are committed to exemplary service. We would appreciate the opportunity to explore ways to increase the predictability of your plan costs together with you and your advisor and give you peace of mind.
To learn more, please contact us today at DBSales@MassMutual.com or 1-800-874-2502, option #4.