Thursday, July 23, 2015

Derisking Your Defined Benefit Plan or Not

Every couple of years, there is a new trend in the remaining corporate defined benefit plans. Lately, it has been derisking in one sense or another. In fact, the Mercer/CFO Research 2015 Pension Risk Survey says that plan sponsors have been spurred by a perfect storm of events.

I'm not going to argue with there having been a perfect storm of events, but I think that everyone else's idea of what constituted the perfect storm is a bit specific and technical. They focus on falling interest rates, a volatile equity market, and a newly (last year) released mortality table. Instead, I would tend to focus on constantly changing pension rules both in the law and in financial accounting requirements that give plan sponsors a constantly moving target.

But, all that said, the study tells us that 80%-90% of plan sponsors are pleased with the risk management actions they have taken to date. What makes them pleased? Is it that they have cleaned up their balance sheets? Is it that their funding requirements have decreased? Has the derisking decision helped them to better focus on or run their businesses?

Isn't that last one what should be at the crux of the matter? The fact is that 2014 was not a good year to offer lump sum payments to individuals with vested benefits if what you were looking to do was to pay out those lump sums when the amounts would be low. Underlying discount rates were very low meaning that lump sums would be larger. Similarly, the cost of annuities was high, but many chose to purchase annuities for substantial parts of their terminated and retired participants.

What all of these plan sponsors did was to decrease future volatility in pension costs (however they choose to think of cost). For many, that truly was a good thing. But, at what cost?

For some, that cost was significant. For others, it was not.

Defined benefit pension plans used to be viewed as having a degree of permanence. That is, when funding them, calculations assumed that the plan would go on forever. While we know that forever is a very long time, we also know that plans with benefits that are based on participants' pay in the last years of their careers are wise to consider the amounts that they are likely to have to pay out in the future as compared to the amounts that would be paid out if everybody quit today. That is not reality. There used to be what are known as actuarial cost methods that allowed sponsors to do that and frankly, they resulted in larger current required contributions. But, those larger current contributions tended to be very steady as a percentage of payroll and that was something that CFOs were comfortable with.

But, the wise minds in Congress with the advice of some key government workers determined that this was not the right way to fund pension plans. Actually, their real reasons for doing so were to reduce tax deductions for pension plan funding thereby helping to balance the budget.

Sounds stupid, doesn't it? It is stupid if what you are doing is making sponsorship of a pension plan untenable for most corporations.

Risk truly became a 4-letter word for pension plan sponsors. As time went by, it became important for sponsors to find new ways to mitigate that risk.

Unfortunately, many of them have been so eager to do that over the last few years that they likely overspent in their derisking efforts. For others, it was clearly the prudent thing to do.

My advice is this if you are considering your first or some further tranche of derisking. Consider the costs. Consider how much risk you mitigate. Make the prudent business decision. What would your shareholders want you to do?

Then decide whether you should derisk.

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