Some sponsors are thinking about de-risking their defined benefit plans. Before deciding on a pension risk management strategy, plan sponsors should understand the financial implications associated with each approach. Zorast Wadia examines lump-sum windows, plan overfunding, and replacement benefits in his article “The risks of de-risking pension plans.”
This excerpt highlights the risks presented by lump-sum windows:
In the past couple of years quite a few plan sponsors have expressed interest in reducing their pension footprints. Several implemented lump sum windows during 2012 and 2013, giving former employees with vested benefits a one-time opportunity to receive single sum distributions. Once a lump sum distribution is taken by a participant, the plan sponsor no longer bears future pension risk with respect to that participant’s benefit. Besides risk reduction, there are also other good reasons for this de-risking technique, such as lowering flat-rate Pension Benefit Guaranty Corporation (PBGC) insurance premiums and reducing future plan administration costs. However, plan sponsors must consider the opportunity costs associated with implementing a lump sum window. These costs include:
• Missing out on investment gains as assets leave the plan upon a lump sum cash out
• Anti-selection from participants
• Higher plan contributions
Regarding plan overfunding, Wadia says:
With the announced rises in PBGC premiums over the next several years, many plans sponsors have attempted to de-risk their plans of the rise in premiums by accelerating funding.
…For plans that have achieved full funding positions, they will certainly have the advantage of showing pension surpluses on their balance sheets and recording pension income on P&L statements, all the while having the ability to take contribution holidays. However, should we experience another interest rate rebound as we did during 2013, or a sudden spike in interest rates should unemployment figures dramatically improve, several plans will find themselves greatly overfunded.
… A plan’s overfunding does not get returned to the plan sponsor, unless the plan is terminated, and even then, there is still the payment of a large premium to an insurance company for taking on the pension risk, not to mention a hefty 50% excise tax. Therefore, while it is prudent to fully fund a plan, the risk of overfunding does exist and plan sponsors must carefully plan out funded status lock-in strategies when their ultimate funding goals are reached.