By Steve Richards
One might think DB plan sponsors looking to terminate their frozen plans are feeling increasingly sanguine after a great year of stock market performance. However, the funded status of plans has barely budged over the last year with the Milliman index increasing a scant .3% to 84.1% from 83.8% since the beginning of 2017. This would seem to beg the question: If you can’t get ahead with a raging stock market, how are things going to look if things go south? This is the essence of de-risking and why many plan sponsors are planning to terminate, or at least take a big chunk out of their risk profile through partial buyouts.
This all brings with it a timely occasion to review what de-risking is all about, and take a look at the red-headed step child of DB plan hazards: Operational Risk.
Why de-risk or terminate a frozen plan? Pension plans expose sponsors to many risks, not least of which are unpredictable, even uncontrollable costs. Most of which we are all too familiar. The two BIG risks that all keep their eye on? Market performance and interest rates.
Market Risk has a direct impact on funding levels and rising equities in 2017 were great for the funded levels for many plans. Fixed income assets held steady last year though many are predicting the end of the bull market in treasuries, and with it the corporate bond values that are a fixture in most plan portfolios. Of course, much the same has been predicted for the better part of the last decade.
Interest Rate Risk relates to unknown future crediting rates and changes to liability discount rates. Bond pundits are expecting that with the end of the bull market in treasuries that interest rates will finally begin to “normalize” though gradual it may be. Rising rates would usher in falling liabilities, but falling fixed income asset values as well.
Then there are the other risks. Regulatory Risk includes changing regulations surrounding pension plans like the PPA (Pension Protection Act). Demographic Risk includes increasing longevity, early retirements, etc. For those thinking long term these are important risks, especially as they pertain to new mortality tables, as we have recently seen.
Which leads us to a most prominent risk which is usually off the radar as compared to the big two (interest rate and market): Operational Risk includes changing administration costs, PBGC premiums, etc. Nothing has generated more de-risking angst over the recent past than rising PBGC premiums, and going up they are. Furthermore, the new RP-2014 Mortality Table Report is increasing costs in all sorts of ways for de-risking/terminating plan sponsors. Estimates are that contributions are going up as much as 11% annually with PBGC premiums increasing 10% (or more) annually, as far as the eye can see. Additionally, the cost of lump sums to plan participants who choose them are also going up by as much as 3%-5%.
What are the risks going forward? Well, the operational risks are now baked in. Is the new tax act good or bad for pension funding given the lower value of deductions? Let’s say it’s all good as it also means more after-tax profit to make contributions or buyout a plan, full or partial. Market and interest rate risks are always front and center. Demographic risks? We’ll assume mortality will decrease over time as the new table predicts.
Bottom line? There are A LOT of moving parts in trying to figure whether this is a good time or not to de-risk/terminate. But if this is as good as it gets insofar as asset performance goes, the default strategy of “Wait & Hope” seems like wishful thinking.
For those plan sponsors who have been at this a while, most should realize it can get a whole lot worse. Either way, a review of termination proposals are mostly outdated with projected cash flows needing to be refigured.
Fascinating DB plan de-risking articles you may have missed:
Pension Risk Transfers Target the Small Fry - Treasury & Risk (December 2017)
SOA Measures Mortality ‘Anomaly’ in 2016 - Plan Sponsor (January 2018)