De-risking strategies in pension plans

De-risking strategies in pension plans are currently much discussed by corporate management and pension plan fiduciaries. These strategies may include adopting a liability driven investment (LDI) strategy or purchasing participating annuity contracts (buy-in contracts) on the asset side to decrease volatility and manage cash flow. Strategies becoming common on the liability side may include offerings of lump-sum cash payouts and/or purchasing non-participating contracts (buy-out contracts) to reduce and/or transfer risk. Finally, the ultimate de-risking strategy is plan termination, which eliminates all risk for plan sponsors.

From the inception of the defined benefit plan, generally all risk lay within the plan and ultimately the employer sponsoring the pension plan. Participants were not burdened with longevity or performance risk as their benefit was defined and it would last as long as they lived.

The financial crisis of 2007 and 2008 greatly impacted pension plan performance and their funding status. At the same time, the increased funding requirements were effectively in play mandated by the passing of the Pension Protection Act of 2006, pension funds in the nation were at record high underfunded status by the close of 2009. Pension plan obligations began to be a sharp thorn in the side of many corporate balance sheets as compliance to the legacy Financial Standards Board Statement No.158 required sponsors to report their funded status on their company’s financial statements.

It seems the implementation of liability driven investment strategies or asset liability matching (ALM) became the flavor of choice for many pension plan investment managers and plan fiduciaries immediately following the 2008 crisis. LDI or ALM is a risk-conscious investment strategy to ensure current assets will generate sufficient income to meet future obligations for plan participants. This de-risking strategy provided better management of the relationship between assets and liabilities. Plan sponsors were trading the potential of greater returns for less volatility. But de-risking was not an implementation of only the asset side.

Moving Ahead in Progress in the 21st Century (MAP 21) was signed into law by President Obama in July 2012. It provided relief for plan sponsors in respect to interest rates with the use of a segmented vs. average rate in pension plans where applicable, but it also addressed insurance premiums paid to the Pension Benefit Guaranty Corporation (PBGC). Under MAP 21, premiums paid by pension plans to the PBGC would increase and the increase would escalate until 2016 with increases for inflation adjustments thereafter. These premiums include both fixed and variable increases based on participant counts and funded status, respectively. As a result, administrative, insurance, and investment costs in pension plans continued to weigh heavy on sponsors with no end in sight.

In April 2012, Ford Motor Company implemented a de-risking strategy that addressed the liability side of the equation by opening a window for 90,000 salaried retirees and former employees to take an option to receive their current or future monthly annuity as a lump-sum cash payment. In June of the same year, General Motors Company (GM) implemented a two-step program by purchasing non-participating group annuity contracts for a certain class of retirees and opening a window offering lump-sum cash payments to a certain other class of retirees. The GM program reduced their pension plan obligation on their balance sheet by approximately $28 billion. The major automakers believe that the transfer of risk and reduction in liabilities provided for a higher level of focus for the corporations to build cars and trucks.

Other major corporations in the nation have followed this trend including Verizon Communications, Sears Holdings, Lockhead-Martin, and PepsiCo and there is no doubt many more will follow.

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