Employer Retirement Plan Priorities -- Cut Risks and Costs Says Survey

This morning, I opened up my daily NewsDash email from Plan Sponsor and found an article telling me that employers that sponsor retirement plans (almost all employers of more than a few people do) are looking to curb risks and cut costs. While it's nice to know that a survey confirms prevailing opinion, this is not exactly a revelation.

As disclosures have become more comprehensive, two elements of retirement plans that have gotten particular scrutiny from outside observers are unnecessary risks and unnecessary costs. Interestingly, if a company chooses to make a generous retirement program part of its overall broad-based rewards program, outside observers generally have no problem with this.

Risk in this case is usually measured in terms of volatility. However, just plain old volatility should not be a concern. What should be a concern is volatility in plan costs as it relates to some useful metric or metrics.

Consider a hypothetical company (HC) with free cash flow of $100 million. Suppose the volatility that they are looking at is in pension contributions and that HC is expecting (baseline deterministic scenario) to have to make a contribution in 2015 of $500,000. In looking at forecasts provided by its actuary, HC notices that the 95th percentile of required pension contributions is $2 million. While that is a big increase in relative terms, it may not be enough to have any meaningful effects on the way HC runs its business (it may, depending on circumstances, but in this hypothetical situation, it does not). Depending upon HC's tolerance for risk, this may be a situation where no action needs to be taken.

On the other hand, Failing Business (FB) has a legacy frozen pension plan with expected 2016 required pension contributions of $50 million. FB has significant debt and if it contributes the full $50 million, it will just barely be able to run its operations and service its debt. If that number hits $52 million, FB will default on its largest loan.

What should FB do?

There are several schools of thought here. One is to mitigate pension contribution risk to the extent possible thereby ensuring that the ominous $52 million pension contribution number will not be reached. But, is that really a good strategy? Or is it just part of a spiral to a lingering death? The other school of thought says that FB is an ideal candidate to take on risk for potential reward. If the risk turns out to produce bad results, FB may go out of business, but it looks like whether that happens or not is only a matter of time. On the other hand, if taking the risk generates a big upside, FB will be in a much better position to revive its business.

FB is purely hypothetical and we don't know all the facts here. But, my point is that just because the trend says to do something doesn't mean its right for your company.

On the defined contribution (DC) side, the analysis is a bit different. Today, most companies (I don't have a percentage for you) offer 401(k) plans with some level of employer matching contributions. In this scenario, many companies have thought about the costs, but few have thought about the financial risks.

What are the costs that companies are thinking about? Here are a few:

• The cost of plan administration (recordkeeper, custodial, legal, accounting)
• The fund management fees
• Institutional class versus retail class
• Passive versus active management
• Open architecture versus proprietary

Generally, these are costs that a plan sponsor can control by careful selection of vendors and evaluation of options. Take a look. It may be that your current providers have let their fees to you creep up while their service to you has gone down.

Then, there's the risk. 

One of the other concerns in the DC industry is that employees are not saving enough money. So, many employers are taking steps to encourage their employees to defer more. However, if they defer more, the cost of matching contributions will increase. In my experience, almost no companies actually consider this risk, but I have seen a few CFOs who have been really upset when those matching contributions got big enough that they affected the company's financials.

There are plan designs that can help to control this. Perhaps you should consider one.

Click this link if you want to ask me how.

There's More to Risk than Just Risk

Risk is a four-letter word. There is even a book with that title (I've never read it and I'm neither recommending it nor panning it). Every CFO will tell you that they hate risk. Most large companies in today's world have large departments whose sole function is to deal with risk. They are tasked with identifying risk, measuring risk, and mitigating risk.

So, John, you're telling me there is more?

I'm afraid there is. When you have fairly constant risk, you can develop a plan to measure it and often to control it. On the other hand, when your risk is volatile, that feels worse.

Consider a hypothetical element of risk related to some sort of performance. Let's say that the mean performance is denoted by 0 and that good performance is denoted by a positive number and poor performance is denoted by a negative number.

Which series of outcomes would you rather have?

• 1, -1, 1, -1, 1, -1, 1, -1, 1, -1
• 0, 7, -4, -8, 6, -3, -11, 5, 8, 0

I suspect that 100% of my readers like the first scenario better. Why? Each has mean and thus expected cumulative outcome 0. But, in the first scenario, the expected downside is (negative) 0.5. In the second scenario, it's (negative) 6.5. 

I developed those results by determining the probability (based on each data set separately) of achieving a sub-par performance and multiplying that by the average negative score in all years in which the score was negative. 

Suppose I want to insure or hedge against this risk. In the first case, it seems like I would be safe insuring against a risk of 1. Suppose I can afford to actually lose (and cover out of assets) 0.5, then I need to purchase insurance or a hedge to cover the other 0.5 each year. 

In the second case, however, it's not so easy. If I know that my loss could be 11, does that mean that I need to insure or hedge 10.5? At the very least, I need to be able to cover my expected downside (for years in which I have sub-par performance. So, in no event can I consider hedging or insuring less than 6.0. 

While the relationship may not be linear, it is probably not a bad approximation. So, in this case, depending upon my view of the situation, I need to insure or hedge somewhere between 13 (this possibly is a linear model and is 6.5/0.5) times as much and 21 (costs less than 21 times as much and developed as 10.5/0.5) times as much. 

That additional cost and it is likely very significant in this case is the cost of volatility. And, that's just the financial cost. There is also the headache cost, the reputational cost, and lots of other associated costs. 

So, when somebody tells you that some riskier strategy is better because it has more upside potential, look at it the other way. Nobody ever lost sleep over an upside. 

Think about it a different way. Consider yourself a golfer. On the 18th green, you have a 5 foot putt that affects a bet you have made. If you are a millionaire and the bet is for $1, you probably don't care all that much (other than for ego and pride) whether you make it or not. You can afford to lose or not win $1. On the other hand, suppose you have $50 to your name and the putt is for $5,000. If you're like most people I know, you will be petrified. You can't stand that kind of risk.

Business works the same way.

Think about it.