Contributor: Richard Berger
Posted: 10/19/2010 12:00:00 AM EDT | 0
The past few years have not been fun for defined benefit plan sponsors. When the new Pension Protection Act (PPA) funding rules went into effect in 2008, employers struggled to understand and comply with them. Plan assets headed south in 2008, contributions went up and funding ratios dropped in 2009. Pension relief measures allowed some tactical management of contributions, but 2010 arrived and the final rules are in effect. Now is a good time to step back, to review the situation and set a long-term course of action.
For starters, plan sponsors must now comply with funding rules that were never intended to make their lives easier or more predictable. The new rules are actually designed to leave a tidy corpse, ready to be euthanized by the plan sponsor, or entrusted to an extended life in the care of the Pension Benefit Guaranty Corporation (PBGC) established in 1974 by the Employee Retirement Income Security Act (ERISA).
Many plan sponsors have frozen their plans, and once a plan has been frozen, odds are that its days are numbered. These pension lame ducks will only reach the finish line when the assets are sufficient to settle all benefit obligations, either through purchasing annuities for promised benefits or offering lump sum payments. Right now, the finish line is out of reach for most plans, because the prices for lump sums and annuities are high, and plan assets have only partially recovered from their plunge in 2008. There is no quick exit for frozen plans, so plan sponsors must focus on the medium to long haul. Frozen or not, the funding problem remains.
A moving target
In financial economics, “the law of one price” means that identical securities should have identical prices. If they deviate from that price, it creates an arbitrage opportunity to buy low and sell high, and thereby earn a sure profit. Because the future expected cash flows (benefit payments) from a pension plan are like bond payments, this arbitrage principle has been interpreted to mean that the value of pension liabilities should be determined like the market price of a bond.
You might argue that funding a pension plan based on market rates is a lot like flying a plane from New York to Seattle, hugging the ground, climbing steeply at the Continental Divide and diving again after crossing the mountains! Yet the PPA funding rules accept this view of pension liabilities, and the IRS publishes monthly discount rates that are based on high quality corporate bond rates. These discount rates are used to compute the value of your plan’s liabilities. Month by month, pension liabilities move with the corporate bond market. As a result, those who try to fully fund a pension plan are aiming at a moving target.
Traditional pension strategy has been to invest, say, 60% in equities and 40% in fixed income and other investments (or maybe to split asset classes 50/50), refined for maximum return for a given level of risk. Those who continue to follow this strategy may do well, particularly if equity markets and bond interest rates rise. But what if equity markets fall, while interest rates hold steady or decrease further? And who can fully understand what actual deflation, a real fall in the price level, would mean?
The traditional strategy could turn out badly, with higher liabilities, assets lagging, dropping funding ratios and rising contributions. Because of this danger, plan sponsors may be strongly inclined to modify their investment strategy to lessen the risk. This would likely imply a shift in allocation to appropriate fixed income investments, which move in closer coordination with plan liabilities.
The downside would be that these investments have lower expected returns, with less potential for growing out of underfunding through superior returns. Many plan sponsors will be reluctant to abandon hope that the underfunding can be cured by asset performance. The only other way to remedy the underfunding is by increased contributions.
Tradeoffs – what do you do?
If your pension plan is not frozen, new participants are still becoming eligible, and new benefits are still being earned each year. In that case, you can adjust your benefit formula to take into account the higher costs that may be incurred with a safer investment strategy. If your plan is already frozen, you have to determine the tradeoffs between risk and reward, safety and cost.
In either event, you need to evaluate the interaction between future returns and future bond yields, to quantify your exposure. Until your plan is terminated and all benefits are settled, you cannot entirely avoid risk. You will be better served by knowing the risk, and taking steps to address it, rather than crossing your fingers and hoping for the best.
Beyond simple projections for next year’s budget, plan sponsors need to examine longer-term forecasts to understand what is feasible and what the downside risks are to continuing the traditional investment strategy. A simple deterministic projection (for example, assuming that assets earn a given percentage per year and discount rates remain the same going forward) will often reveal how long it will take to put a frozen plan in a position to be terminated, or what the long-term costs of a continuing plan will be.
Such projections can provide a simple sanity check, to understand what is possible or likely. An asset liability study, which models market behavior of assets and liabilities, can give valuable information about risks and the costs of the traditional investment, versus predominantly fixed income allocations. Forecasts are not tools to predict the future, but can be very useful for evaluating the implications of alternative scenarios.
The last few years have forced defined benefit sponsors to improvise and react to rules and events. Now is a good time to take the longer, active view so that you can take the initiative, instead of simply reacting to what tomorrow brings.
Contributor: Richard Berger