For years, low interest rates have resulted in higher pension plan liabilities. As the cost of funding defined benefit (DB) plans has increased, many plan sponsors have frozen their plans. Some sponsors have even considered terminating their pensions upon interest rates rising again. The time for that decision may be on the horizon as interest rates have increased by over 70 basis points since the start of 2013.
Instead of terminating DB plans, Milliman’s Bill Most and Zorast Wadia believe sponsors should consider restoring pensions back to a corporate asset. In their new article, “Rising interest rates redefine options for frozen DB plans,” the two actuaries examine the cost of plan termination. In addition, they discuss alternative de-risking strategies that can turn a pension into an ongoing asset that generates income on the balance sheet.
Here is an excerpt:
Here’s the key question for plan sponsors: After going to the trouble and expense of funding your DB plan at more than 100%, is there more value to the enterprise in unloading it to an insurance company or in keeping it as an ongoing asset that generates income on the balance sheet—at significantly reduced risk?
Sponsors can achieve this outcome—the creation of a lifetime income-generating asset—by transitioning to an LDI strategy. Typically, the pension plans buys a portfolio of high-quality bonds with durations matching those of plan liabilities. This way, the sensitivity of the market value of assets to interest rate changes closely matches that of the liabilities. The investments and liabilities move in tandem, and the net funded status stays relatively consistent from year to year.
Matching up the fund’s assets and liabilities effectively eliminates funded status risk and minimizes interest rate and investment risk. We can’t talk about eliminating investment risk, because the portfolio clearly has exposure to the bond market. In addition, LDI strategies generally maintain a small allocation to equities, since a perfect duration match between plan liabilities and investments is not possible to achieve in the real world. Sponsors wishing to control the risk of this remaining equity exposure can employ an equity hedge. For example, Milliman’s Managed Risk Strategy offers dynamic hedging capabilities. The Strategy showed its effectiveness for some of the world’s largest insurers during the 2008 market downturn. This leaves only mortality risk, which can also be addressed, if desired, with customized hedging techniques.
In addition to risk control, this approach provides another substantial benefit—surpluses. Even a moderately overfunded plan with an LDI strategy in place can produce pension income under US GAAP accounting as the expected return on assets will exceed the interest cost on frozen liabilities by more than anticipated plan expenses. Every year, the financial statement can show income from the pension plan; and every year, that surplus can show up directly on the balance sheet.
Pensions offer an effective solution for potential shortfalls in retirement savings and advantages to employers. For more perspective read Richard Pavley’s article “Why defined benefit plans are still relevant.”