10 New Year’s resolutions for pension plan sponsors
A new decade is a great time for DB plan sponsors to resolve to set objectives for their plans, understand their risks, and deploy the right tactics.
The New Year and, even better, a new decade is a great time for a fresh start on resolutions. The past year and decade created quantum shifts for defined benefits plan sponsors that brings the need for fresh resolve as we head into the 20’s. Below we present our Top 10 DB resolutions for plan sponsors.
2019 was a two-sided coin for DB plans and both sides of the coin grew; interest rates plummeted over 1.00% to near record lows driving liabilities up while the investment markets boomed driving assets up.
The Decade of the “Teens” changed the way DB plans are managed. Declining interest rates and new mortality tables drove liabilities substantially higher. Funding relief took some pressure off contribution requirements. Steeply escalating PBGC premiums drove up the cost of maintaining DB plans. These factors made Pension Risk Transfers (PRT) the big idea; lump sum windows and annuity purchases transferred risk off balance sheets and reduced costs. Investing assets became more sophisticated as sponsors focused more on risk; Liability Driven Investment (LDI), glide paths, alternative asset classes and derivatives became important parts of sponsors’ investing tool kit.
With all that has happened over the last 10 years, now is the time to set resolutions for your DB plan for the next year and the decade ahead.
Big resolutions: What every plan sponsor needs to do
1. Revisit plan goals and objectives. Setting goals for DB plans provides necessary context for revisiting funding and investment policies, updating administrative approaches and tackling cost saving initiatives. For instance, frozen plans should set goals for reaching full funding and whether they will terminate or hibernate the plan when they get there. Similarly ongoing plans should set goals around funding levels, benefit levels, and costs.
2. Understand your risks. Once goals for the plan are set, understanding the underlying risk profile of the plan allows plan sponsors to set policies to meet those goals. Understanding how changes in discount rates and investment markets will impact the balance sheet, contribution requirements and administrative costs provides sponsors an understanding of what risks they can take and what risks they need to manage.
Investment resolutions: Review your investment policy
3. Review your glide path. With a new understanding of goals and risk plan sponsors should revisit their investment glide path to make sure it is designed to get where they are planning to go, when they plan to get there, and at a manageable level of risk. Given the advances in glide path construction, plan sponsors should review their glide paths. Items like interest rate swaptions and equity options can enhance a glide path while decreasing risk. (See our article on the next generation of glide paths.)
4. Optimize your expected return on assets (EROA). Many plan sponsors want to maintain their EROA and its impact on pension expense. Sponsors are rightfully concerned with declining expected equity returns as markets are at all-time highs and bond rates are at historic lows. Reviewing your asset allocation and considering the use of equity options can allow a sponsor to maintain more equity exposure at similar risk levels or decrease risk. (See our article.)
5. Re-evaluate your interest rate hedge. Strong investment returns prevented a material decrease in funded status during 2019 that could have resulted from falling discount rates. However, lower interest rates increase sensitivity to further rate drops and make changes in the yield curve more impactful. Plan sponsors should review their interest rate hedge ratios and the structure of their portfolio to make sure they are in line with desired risk levels and protect the plan from unexpected surprises.
Contribution resolutions: Know what’s coming
6. Understand future contribution requirements. While the last decade saw relief on required contributions, this decade may not be so kind. The last round of funding relief is set to start phasing out in 2021. Plan sponsors that have been well-funded on a minimum funding basis may quickly find themselves underfunded with substantial increases in their contribution requirements. Forecasting contributions will allow sponsors to avoid surprises and develop a contribution policy that could smooth out the future steep increase.
7. Take advantage of low borrowing costs. Another benefit of the low interest rate environment that we currently are in is that many companies are able to issue debt at extremely low rates as well. When considering that any unfunded liability is subject to a 4%+ tax by way of PBGC variable rate premiums, the economics can certainly work to a plan sponsors advantage. Simply stated, if you can borrow at under 8% then this is a tactic to consider particularly if you are a tax payer.
Liability resolutions: Manage your costs
8. Implement strategies to lower PBGC premiums. Annual PBGC premiums are now over $80 per participant plus 4.5% of the PBGC unfunded liability. The total premium is, thankfully, capped at $644 per participant in 2020, but that is a high cost to cover each participant. Plan sponsors should continue to assess the viability of PRT opportunities and implement them when the timing is right to reduce participant counts and thereby premiums. Sponsors should also look at ways of restructuring their plans that can significantly reduce premium cost. (See our article regarding spin-terminations)
9. Review your participant data. Maintaining pension data can be a big challenge. Plan sponsors who spend the time cleaning up that data can reduce costs when they find that they have been holding onto participants that are no longer around.
Two examples: Plans often have vested terminated participants (VTs) that are beyond their Normal Retirement Date and even past their requirement minimum distribution dates. Often the old VTs have already passed away adding unnecessary cost and liabilities. Also keeping track of beneficiaries of current retirees is difficult but useful. For retirees that elected a joint and survivor annuity where the beneficiary has already pre-deceased the retiree, there can be a liability reduction by simply valuing the ongoing benefit as a single life annuity. Both of these strategies can be accomplished by running death searches on the participant population.
Plan administrative resolution: it’s time to take a fresh look
10. Audit forms and procedures. The ongoing administration of the plan is routinely overlooked by many plan sponsors. Plan sponsors need to regularly take a fresh look at their administrative forms and procedures to ensure compliance with ERISA as rules change and procedures become stale. A surprising number of plans are not using compliant forms nor following the required processes for completing the forms. Those plan sponsors that don’t audit themselves will surely be audited at some point by Uncle Sam, with inevitably negative consequences.
A new decade is a great time for DB plan sponsors to resolve to set objectives for their plans, understand their risks, and deploy the right tactics to achieve their objectives and control their risk.
