Opportunities exist in 2019 for plan sponsors to continue to lower the costs and risks of their defined benefit plans. (Photo: Shutterstock)

Having the right pension risk management strategy at the right time has been a key to success for pension plan sponsors during this decade. Sponsors have used lump sum windows and annuity purchases to improve their balance sheet, shrink their participant base, lower their administrative costs and lower the risk their pension plan may pose to their organization.

Plans have also systematically reduced their interest rate exposure through more allocations to liability matching investments. So what can pension plan sponsors do during 2019 to keep working toward their goals?

2018 in quick review

2018 gave sponsors quite a ride on the economic roller coaster. The good news is that the FTSE discount rate ended the year up 61 basis points (0.61%). For a typical pension plan, liabilities should have been around 10% lower than they would have been at the prior year's rates.

The bad news is that a rough December led to equities being down for the year; the S&P 500 was down over 4%, the Russell 2000 was down over 11%, and international strategies were down almost 17%.

For most sponsors the asset losses will more than offset the liability gains, resulting in a slight decrease in funded status absent new contributions in 2018.

In other news; PBGC premiums continued to rise.  The per head cost in 2018 was $74 for every participant is now $80 in 2019. The variable premium rate was 4.1% of every dollar of unfunded liability up to the dollar cap and has increased to 4.3% in 2019.

If you hit the cap then you "only" paid $597 for each of these participants (including the $74 fixed per head premium), that has now bumped up to $621.

2019 pension risk mitigation actions

Below are some actions pension plan sponsors can take during 2019 to keep working toward their goals.

1. Revisit lump sums. Rates rose significantly last year which means the cost of lump sums has dropped. Below we discuss how the direction of rates during 2019 will inform sponsors on whether to do a window this year or wait until 2020.

2. Look at another round of retiree annuities.  Many plan sponsors have annuitized their "small" benefit retirees, saving significant PBGC premiums. The retirees with larger benefits have been kept to preserve assets in order to potentially earn favorable investment returns or avoid settlement accounting.  Rising PBGC premiums and higher interest rates means that the definition of a "small" retiree has become bigger.

3. Revisit your investment glide path. Higher bond rates could be inviting for increasing your allocation to LDI assets.  Lower funding may mean you want to consider taking on more risk.  New tools for managing your glide path have emerged.  Sponsors should address these considerations.

4. Consider strategic plan restructuring.  For the right sponsors there are a number of ways of restructuring your plan(s) that can significantly reduce PBGC cost.  We discuss some of these ideas below as well.

Lump sum windows in 2019

Many plan sponsors have implemented at least one lump sum window for terminated participants.  Many of these windows were offered before 2018 to pay out lump sums prior to the effective date for mandated up-to-date mortality tables.

Since the lump sum rates for a given year are typically set at the beginning of each plan year (often with a look back to an earlier month) plan sponsors  still have  the potential for arbitrage by  paying lump sums using higher-than-market interest rates in plan years where interest rates decline.

2019 is likely to provide sponsors with a lump sum arbitrage opportunity. Plans can typically offer lump sums using interest rates looking back to rates in the five months prior to the start of the year; in 2019 a calendar year plan could pay lump sums using interest rates from October or November of 2018 when rates peaked.

Since rates fell in December 2018 and are down even more since the beginning of 2019, any such lump sums would be paid out at below the value current rates would produce.  If rates continue to fall in 2019, the savings on each lump sum paid would increase.

Conversely, rates could rise in 2019, wiping out the arbitrage, and removing the financial incentive to sponsors to offer 2019 lump sums but making lump sum offers more enticing for sponsors in 2020.

Action plan: Monitor rates. Sponsors should monitor rates during the first half of the year and be ready to implement a window if conditions remain favorable. Below are the three different scenarios for interest rate movements and what plan sponsors should consider:

1. Steady rates. If rates stay level sponsors may want to consider a modest lump sum offering with a relatively low maximum lump sum (e.g. $25,000). In this scenario sponsors minimize the risk of a sudden upward swing in rates but still reduce participant counts and lower PBGC premiums in the future.

2. Dropping rates. Further drops in interest rates in early-to-mid 2019 would point towards including a larger group of terminated participants (perhaps all of them) in a lump sum window.

3. Rising rates. Should rates rise 25+ basis points in in the first half of 2019, then waiting until 2020 to take advantage of even higher rates than we saw in 2018 could be the optimal strategy.

Retiree annuities in 2019

With higher rates, like lump sums, retiree annuity purchases should be considered in 2019. Many plan sponsors have implemented one or two purchases already focusing on retirees with smaller benefits.

Paying PBGC premiums for retirees with small benefits just does not make economic sense.  There are a number of reasons why another purchase may make sense in 2019.

1. Increasing PBGC costs.  PBGC premiums keep rising with no end in sight. Plus, after a relatively poor year for assets for most plans, the variable rate premium cap could very well apply to plans that thought they were fairly well funded.  Saving $621+ (or even $80+) per person per year can make the savings add up quickly.

2. Better annuity prices. The rise in rates during 2018 means annuities are now priced as inexpensively as they have been in a number of years.  In addition there are a few new insurers that have entered the market, making the competition for these annuities that much greater which results in better pricing.

3. "Perfect hedge." Retiree annuities costs are close to a plan's accounting liability.  Instead of hedging the retiree liabilities with a duration matched bond portfolio, sponsors can deploy the same assets to transfer participants over to an insurer eliminating the interest rate risk, as well as other risks such as mortality and regulatory risks.

4.  Accounting strategy.  Assuming the plan sponsor uses a spot market discount rate and mortality tables that reflect the plan's demographics for calculating their accounting liabilities, the annuity purchase price is quite close to those accounting liabilities.  Small purchases, below the settlement accounting threshold, will essentially be a non-event. Larger purchases above the settlement threshold may allow sponsors to manage down that annoying AOCI.

Importantly, with the advent of ASU 2017-7, any settlement expenses are now treated as "below-the-line" expenses, removing a barrier that has prevented many sponsors from proceeding with larger risk transfer events. Plans following IAS 19R could even see small settlement gains due to an annuity purchase.

5. Timing is important.  "Hurry, Act Now." Insurers have more capacity early in the calendar year and may be a bit more aggressive in their pricing.  By the time the fourth quarter rolls around many insurers have used up their capacity and have constrained their resources to bid or take on new placements.

By beating the year-end rush, you'll maximize the number of competitive bidders.  The competition among insurers is at a high point, with as many as 16 high quality insurers looking to take on these annuities; double what was available only a few years ago.  This competition is good for sellers but may not last.

Revisit liability-driven investments

Entering 2019 we are experiencing increased volatility in equity markets and a fall in longer term interest rates which can materially change a plan's funded status day to day.  This is a good time to review your investment strategy, both in terms of today and planning into the future.

There are key questions to ask:  Is the hedging portfolio working?  Are we comfortable with the risk vs. expected return trade-off of our growth portfolio?  Do we need to take a different action?

Unfortunately most glide paths and de-risking strategies don't protect against equity swings for the portion of assets still invested in the equity market.   Plan sponsors have typically lowered equity allocations if they weren't comfortable with the risk, but this also lowers the expected return.  A lower expected return means higher pension accounting expense and either a longer expected time horizon until the plan is expected to become sufficiently funded or higher contributions to get there.

A solution plan sponsors should consider is to maintain or even increase their growth portfolio but deploy equity derivative strategies to protect their position.  This approach will maintain or even increase a plan's expected return while still preserving the sponsor's interest rate hedge.

Many plan sponsors have an asset allocation plan in place that was developed a several years ago.  With the market volatility, increased costs of maintaining an unfunded plan, and liability transfer options available, we strongly recommend a review of a plan and consideration of new investment strategies to help manage the plan going forward.

Strategic plan restructuring

There are several strategic approaches that sponsors can look at which can lower risk and lower costs.  The highlights of a few to consider follow (the authors would be happy to provide more details):

1.   "Spin term." Under a spin term, smaller benefits are spun off into a separate plan.  That plan is then terminated.  This can allow a frozen plan with a number of actively employed participants with small benefits to settle the benefits for those participants thus saving PBGC premiums and shrinking the costs.  If the spun-off plan is kept to under 3% of assets this process can be relatively simple.

2.   Strategic plan split.  Similar to a "spin term" but going one step further.  A plan that is subject to the variable premium is split into two plans.  One plan has the larger benefits and fewer participants.  The other plan has the bulk of the participants with smaller benefits.

The nature of asset allocation rules will typically leave the smaller plan much better funded such that a relatively small contribution eliminates the PBGC variable premium for those participants.  The bigger benefit plan will be set to hit the cap.  This technique has reduced PBGC premiums anywhere from 25% to 50%.

3.   Cash balance plans. If you sponsor a cash balance plan with a floor crediting rate or a relatively high crediting rate basis, it may be a win/win for you and your participants to provide the opportunity for active participants to get the same contribution in a defined contribution plan and roll their cash balance account into the DC plan.  This could be neutral or better on an accounting basis, and you eliminate those pesky PBGC premiums.

Now is the time to decide

Opportunities exist in 2019 for plan sponsors to continue to lower the costs and risks of their defined benefit plans.  With the New Year upon us now is the time to decide which strategies will work best this year.

Charlie Cahill is Managing Director and Consulting Actuary with River and Mercantile and currently heads River and Mercantile Solutions' actuarial team and leads the US business. He has served clients and their retirement plans for over 30 years and has extensive experience with all aspects of post-employment benefit plans including qualified and non-qualified defined benefit and defined contribution plans, multi-employer plans and post-retirement medical benefit programs. [email protected]

Michael Clark is Director and Consulting Actuary with River and Mercantile and consults on all aspects of financial risk management for defined benefit plans as well as retiree medical plans and defined contribution plans. He also has led numerous clients through pension risk transfers as well as other complex, strategic pension projects. Michael leads River and Mercantile Solutions' business in the West as well as Business Development for the US. He currently serves as President-Elect for the Conference of Consulting Actuaries. [email protected]