The improvement of the funded status of corporate defined benefit plans offers plan sponsors and plan advisers a real opportunity to quantify and downsize risk.
Unfortunately, hedging longevity and actuarial assumption risks, such as changes in assumed retirement rates, is virtually impossible.
Even plan sponsors with completely frozen, fully funded and fully hedged plans should be prepared to fund mortality improvements and actuarial experience risk.
These risks might erode what has been an improving funded status.
The aggregate funded status of the 100 largest U.S. pension plans has improved to 95% at the end of December from 74% in early 2009, according to Milliman Inc.
Designing and implementing a derisking strategy now can help plan sponsors lock in that strong funded position. Such derisking would help them sidestep the balance sheet volatility of the past five years and avoid potentially large cash contributions as pension relief under MAP-21 erodes over the next few years.
Most plan sponsors are well aware of the risks defined benefit plans face today: interest rate risk, equity risk, and other non-interest-rate investment risk, such as liquidity risk, as well as longevity risk, actuarial assumption risk and regulatory risk. But few truly understand the magnitude of these risks. Plan sponsors should quantify these risks and determine risk tolerances.
For defined benefit plans, investment risk tolerance is best measured not in terms of expected asset returns and volatility but rather based on the impact on funded status, the asset-to-liability surplus or deficit, cash contributions and/or pension expense. After all, what matters to a plan sponsor is not asset returns either in absolute terms or relative to the financial markets, but rather the change in funded status or these other plan-specific characteristics. Thus, plan sponsors need to understand how the two biggest levers they can manipulate — the degree of interest rate hedging and the amount of equity exposure — affect both assets and liabilities, and the plan overall. Plan sponsors should consider how their pension plans would evolve under different blends of liability-hedging and return-seeking strategies in various market environments.
But some risks, such as longevity and actuarial assumption risks, cannot be hedged. While longevity swaps may eventually become a hedging option for large U.S. plans, in the near-term plan sponsors should expect annual liability growth of up to 0.2% to 0.4% due to improving mortality. Of course individual plan experience will vary, and this projected upswing is where actuarial advice is crucial.
As for actuarial experience, plan sponsors should be aware of the early, or late retirement subsidies inherent in their plans and the impact of economic conditions. As an example of a subsidy, the actuarial value of a benefit taken at age 64, considered early retirement, might be higher than the actuarial value of that benefit at age 65, considered normal retirement age. Many if not most plans include them, in part to encourage participants to retire early. As for the impact of changing economic conditions, during the recession, for example, a plan might experience fewer participants retiring than actuarial assumptions implied and therefore accruing greater benefits than expected. This deviation from actuarial assumptions had, at one particular plan, for example, a 3% to 5% increase in the liabilities. This increase simply cannot be hedged. However, knowing this kind of possibility would help the plan sponsors budget for contributions.
Thus, even plan sponsors that appear to be fully derisked with completely frozen, fully funded and fully hedged plans with respect to interest rate risk should be prepared to fund mortality improvements and actuarial experience risk. Plan sponsors that know the potential costs of these risks can determine how much of the risk to accept in the form of future contributions, or possibly mitigate it by taking on a relatively small amount of equity risk however imperfect that might be, or transfer it through annuity purchases or lump-sum distributions. If equities outperform liability-hedging assets, then the extra return can fund mortality improvement and adverse experience risk.
For well-funded pension clients, partial lump-sum payouts or annuity purchases can be an effective way to completely divest all associated risks, reduce the size of the plan and lower operating expenses, including elimination of Pensions Benefit Guaranty Corp. premiums associated with those participants in the buyouts There are many nuances associated with risk transfer and the advantages should be considered along with drawbacks, such as potentially higher costs, especially in the case of annuity purchases and settlement accounting.
A plan sponsor that determines the risks and costs of its plan and analyzes them in light of the sponsor's risk tolerance and contribution ability can establish a framework for ongoing analysis and a roadmap for managing the plan. Often that roadmap is a glidepath that outlines derisking steps based on one or more criteria, such as the plan's funded status, the level of interest rates, the size of the plan relative to the balance sheet and the overall health of the company.
Even with a recent downturn in funded status, many plan sponsors will find their plans are in the best funded position since 2008, thanks to both rising interest rates and strong equity returns. To ensure improving pension plan health, plan sponsors should evaluate the risks that might erode that strong funded status, develop a framework for future analysis and establish a disciplined, long-term derisking process.
Alex Pekker and Meghan Elwell are vice presidents for quantitative analysis and research at Sage Advisory Services Ltd. Co., Austin, Texas.