Risk Management

Pension Sponsors Juggle Derisking Strategies

With many pension plans too low-funded to justify aggressive fixed-income investment, lump-sum buyouts and annuities are popular derisking strategies.
David McCannApril 4, 2016
Pension Sponsors Juggle Derisking Strategies

As we reported last Thursday, steeply rising Pension Benefit Guaranty Corp. premiums are forcing pension plan sponsors to get more serious than ever about funding their plans.

ThinkstockPhotos-507637310One result of moving closer to a fully funded plan is that the sponsor can afford to derisk a greater portion of the plan’s assets. Investing in fixed-income instruments is the most straightforward way to do that, but a plan with a low funded status probably has to retain significant risk.

For example, if only 70% of a plan’s future liabilities are funded, it may never get out of that hole by investing strictly in fixed-income instruments.

On the other hand, such a plan could be rescued in relatively short order, if interest rates were to rise quickly while equity markets remained strong. Sponsors of plans surpassing a certain funded-status level then could mostly or completely derisk their assets and be secure in their ability to pay off on future liabilities.

Plans that are 85% to 90% funded are in the sweet spot for getting aggressive with derisking, says Bradley Smith, a partner at investment adviser NEPC.

An example of such a plan is the hourly workers pension plan maintained by General Motors, which was approximately 84% funded at the end of last year. GM plans to issue $2 billion in unsecured debt this year and allocate the proceeds to a contribution to the plan that will consist entirely of fixed-income investments.

Unfortunately, few plan sponsors took advantage of golden opportunities to derisk within relatively recent memory, on occasions when many plans were fully funded as markets soared high. Instead they behaved (as did many individual investors) as if they thought the superlative returns they were experiencing would continue indefinitely.

Will they avoid that trap if and when they again get the chance? “You might find that this time there would be a big trend of plans moving quickly to liability-driven investing (LDI),” says Bob Collie, chief research strategist, Americas institutional, for Russell Investments. “A lot of them are saying that they wished they’d done that in 2000 or 2007. If they get back to fully funded a third time, they will take risk off the table.”

Even plan sponsors saddled with massive future liabilities have been moving — albeit slowly, for the above-stated reasons — to derisk their plans in the fixed-income markets. Collectively, the 20 companies that sponsor plans that had at least $20 billion in liabilities at the end of 2015 had allocated 40% of assets to fixed income, up from 33% five years earlier, according to Russell Investments.

If the scenario Collie suggested actually came to pass, with essentially the entire universe of large corporate pension plans stampeding on a course of derisking, it could present a macroeconomic roadblock for many plans.

“It’s probably a good thing [derisking with fixed-income investments] is a slow trend, because if it picked up substantially there would be questions about the availability in the market of enough bonds to support the large pension plans,” says Ari Jacobs, global retirement solutions leader for human capital consulting firm Aon Hewitt.

The Many Faces of Derisking

Of course, no one knows how long interest rates will stay low or what the equity markets will do, even in the very short term. That’s why plan sponsors continue to derisk with strategies other than aggressive allocations to fixed income.

An increasingly popular one since 2012 has been offering lump-sum buyouts to some groups of pension plan participants. Most often the offers are extended to those with account balances below certain thresholds, like $100,000 or $50,000.

“The carrying costs of pension plans are generally per capita costs,” says Jacobs. “It costs the plan almost as much to carry a liability of $10,000 for one participant as for another one with a $200,000 account. So it’s massively more economically wise to do this for those with smaller accounts.”

Jacobs characterized the lump-sum-offer trend as “nearly at its peak” — for now. A new wave could come after the IRS approves new mortality tables for use in the actuarial calculations for such offers. That’s scheduled to take effect on Jan. 1, 2017, but Jacobs expressed doubt that the IRS will meet that deadline.

Shortly after the legislation ratcheting up PBGC premiums was finalized last fall, NEPC conducted a poll of 37 of its corporate pension sponsor clients. Just as many of them, 32%, were considering making a lump sum offer as were considering making an elective contribution to their plan. Seventeen percent said they were considering a third strategy, transferring risk to insurance companies by buying annuities for plan participants.

“What was interesting was that many clients weren’t thinking about pulling just one derisking lever,” says Smith. “While 45% were focused on one of those derisking strategies, 35% were looking at two of them, and about 10% were looking to pull three or more levers.”

The trend toward buying insurance annuities for plan participants — often retirees — is another surging one. Among large U.S. insurers responding to Aon Hewitt’s most recent annual survey of them, there were 225 such transactions worth $3.8 billion in 2013, 293 deals worth $8.6 billion in 2014, and 339 transactions totaling $13.4 billion last year.

For many companies, derisking activity isn’t only about being fiscally prudent. The stakes are higher than that.

“Earnings volatility associated with plan obligations and fluctuations can become so large that they overshadow the operating business, its growth prospects, and even its strategic direction,” says Robert Scharff, senior executive benefits consultant with The Todd Organization, a retirement plan services provider.