Pension investment strategy in light of new law
New pension funding stabilization legislation should prompt plan sponsors to assess their investment strategies
By Jonathan Barry and Richard McEvoy | August 29, 2012 8:30 am
Defined benefit plan sponsors in the U.S. now have the flexibility to reduce pension contributions to their plans in the near term, thanks to recently enacted pension funding stabilization legislation that allows plan sponsors to use a 25-year average of interest rates to calculate pension obligations. The average results in a higher discount rate than current market conditions, which lowers plan liabilities and resulting contribution requirements.
In addition, Pension Benefit Guaranty Corp. flat-rate premiums will increase significantly, while the annual PBGC levy on unfunded liabilities will move from 0.9% to 1.8% over the next few years. This creates a trade-off to be considered between any savings achieved by pension contribution deferral and the associated PBGC costs, as well as higher accounting costs as lower contributions levels will result in a reduction in the expected-return-on-assets component of pension expense.
In addition to pension contribution considerations, this is a good time for plan sponsors to assess their investment strategies. Considerable attention has been paid in recent years to liability-driven investment strategies, through which defined benefit plan assets are invested in a way to match the movements in the liabilities (the net effect is to reduce funded status volatility).
The LDI strategy often includes two elements: A move to long-duration bonds; and a reduction in equity allocation, which is often linked to an improvement in funded status.
For sponsors implementing LDI strategies, long bonds are considered a low-risk asset, as their values change broadly in line with plan liabilities. However, the 25-year smoothing of the discount rate results in far less liability sensitivity to interest rates over the short term. This means that pension contribution volatility in the short term with an existing LDI strategy could be higher than it would be without an LDI approach in place.
However, LDI strategies are still effective in reducing volatility of accounting costs and volatility of pension contribution costs over the longer term, when funding stabilization is effectively phased out. In addition, the legislation has not changed the fundamental economics of investing DB plan assets to meet future obligations.
Here are some key considerations for evaluating whether a plan sponsor should maintain or modify its investment policy:
Sponsors that are sensitive specifically to short-term pension contribution volatility might wish to adapt their existing LDI strategies or slow down the transition to LDI over the next few years to minimize the volatility of contributions. Where contribution volatility is a key concern, the new rules may afford more flexibility to take advantage of short-term investment opportunities as the interest-rate sensitivity of contributions is mitigated.
Funding stabilization does not change the underlying economic risks that would need to be addressed through additional pension contributions when the relief is effectively phased out. If sponsors reduce their “hedge ratios” in the short term, any change in their deficit resulting from interest rate movements over the next few years will still likely need to be paid for later. Therefore, while short-term contribution volatility may be lessened, or tactical investment opportunities put to work by changes to a sponsor's LDI strategy, this should be measured in the context of any resulting longer term volatility and potential cost.
Unlike pension contribution costs, accounting requirements are unchanged by the legislation. The pension plan directly affects a plan sponsor through the balance sheet and income statement that are measured in line with U.S. GAAP rules. For many sponsors, these financial metrics are even more important than cash funding measures, and we often see sponsors develop their investment strategies to reduce the volatility of these key accounting measures. Therefore, while pension funding reform may offer some near-term opportunities for managing cash, a change in LDI strategy or reduced contribution levels would likely come at the expense of increasing volatility of accounting costs.
Any significant changes to a plan sponsor's existing LDI strategy would likely require a corresponding gradual return to the original LDI approach. This “round trip” approach would require a high degree of oversight and proactive management, and sponsors should consider the high level of expertise required.
While the composition of the hedge portfolio is an important consideration, given the change in the minimum contribution outlook, plan sponsors might wish to evaluate their broader risk budget in terms of the balance between growth and hedging assets. For example, for cash-strapped sponsors, a move to hedging assets from growth might be more effective than changing the composition of their hedge portfolios.
There are also dynamic derisking strategies, by which pension plans establish a “glidepath” approach to altering investment risk over time. And an increasing number of plans are looking to the end game, by transferring their liability to participants in the form of lump-sum payouts, which in theory, carry no default risk, no investment management fees, and lower administrative and PBGC premium costs.
Do these approaches still work in the world of funding stabilization? It certainly remains the case that equities in the portfolio produce funded status volatility. Therefore, a strategy to remove equity risk is still relevant under pension funding stabilization. However, for plan sponsors that defer contributions as a result of funding stabilization, the lower contribution amounts will likely lengthen the amount of time to hit funded status triggers that drive asset allocation changes. Therefore, it might be prudent for plan sponsors with glidepath strategies to revisit them and determine whether triggers need to be refined to maintain the same pace of risk reduction as originally desired.
The increase in the PBGC flat-rate premiums does present plan sponsors with an additional incentive to consider lump-sum cash-outs to participants, and plan sponsors that have been on the fence about implementing a cash-out program might want to take another look a the economics of such a program. While it is true the benefit paid out to participants will be greater than the liability held on a funding stabilization basis, the true economics of the transaction make a compelling argument to consider a cash-out.
We anticipate that while some cash-strapped plan sponsors might change their LDI strategy or transition speed, others may use the shorter-term flexibility afforded by the legislation to avail themselves of tactical opportunities. Given some of the long-term economic, governance and accounting considerations, many will also stay the course with their existing approach.
Regardless of the path chosen, the implications and trade-offs should be evaluated fully so sponsors are not surprised by unintended risks.
Clearly, pension funding stabilization presents many complex issues; it's crucial for sponsors to work through them in a deliberate and coordinated manner.
Jonathan Barry and Richard McEvoy are partners with Mercer. Mr. Barry leads Mercer's defined benefit risk consulting efforts for the U.S. retirement risk and finance business; Mr. McEvoy leads Mercer's financial strategy group in the U.S.