The rampaging stock market and a recent rise in interest rates have greatly improved the funded status for employer-sponsored defined-benefit (DB) pension plans. One result is a stampede of sponsors looking to de-risk their investments of plan assets.
Responding to a recent Towers Watson survey of 180 large U.S. companies that sponsor at least one DB plan, 75 percent said they have either implemented a “journey plan” — a formal document detailing actions the sponsor will take to de-risk its pension plan — or are planning or considering the move.
Towers Watson didn’t have available a comparison to an earlier time period. But as recently as three years ago, the number of large pension-plan sponsors at least considering whether to create a journey plan was likely “almost none,” according to Michael Archer, a senior retirement consultant for the firm. Some took de-risking actions, but not for all plan assets like many sponsors are doing or thinking about doing now.
DB plan sponsors are shedding risk even though there are still likely to be opportunities associated with staying in equities, Archer notes. “Even with interest rates still relatively low, they’re saying ‘We don’t care, we just don’t want to take this risk any longer.’ Instead they’re buying bonds, even though that may be expensive.”
Other than buying bonds, the main de-risking strategies are: making other long-term, fixed-income investments; getting into alternative investments like private equity, commodities and reinsurance, which carry some risk but not nearly as much as public equities; purchasing annuities from insurance companies; and offering to plan participants lump-sum buyouts of their future plan benefits, which makes the plan smaller and therefore less risky.
A majority of employer-sponsored DB plans were significantly underfunded (i.e., did not have enough assets to pay currently estimated future liabilities) in recent years, so much so that many saw little hope of climbing out of the hole without staying in equities and hoping the markets would catch fire.
That has turned around quickly in 2013, with equity markets having gained by about 20 percent this year and interest rates finally budging upward. With their plans rather suddenly in good shape, sponsors are looking to shed risk so they can stop worrying about their funded status.
“Some companies will look at an underfunded position and say, ‘We can either contribute our way out of it or try to earn our way out of it’ through investment gains,” says Archer. “The latter has paid off for many employers this year, and they are now in a better position to lock down and take less risk.”
It’s worth asking whether the lower-risk regime will hold if the stock markets descend from their current giddy height. After all, some observers consider current equity values to be artificially high, given the large portion of corporate profits that in recent years have been achieved through cost-cutting rather than business growth or execution.
To Archer, it depends on the company. “Is a company that is far down the liability-driven investment path — with, say, 80 or 90 percent of pension-plan assets in long-dated fixed income — going to re-risk if equity markets fall? I don’t think so,” he says. “They have already made a philosophical statement about the way they want to manage their plan.”
On the other hand, take a company that has 55 percent of plan assets allocated to equities and is only 85 percent funded. “If there’s a big equity drop, and all of a sudden that sponsor finds itself 70 percent funded, it might increase its equity risk because it’s further away from a fully funded state where it can take significant action without putting a lot of cash in,” Archer says.
Pension-funding targets were established by the Pension Protection Act of 2006. The formula for a plan’s funded status is plan assets minus credit balances divided by plan liabilities. So, a plan with $175 million of assets and accrued liabilities of $200 million would be 87.5 percent funded.
When a plan’s funded status is below 80 percent, lump-sum payments can total just 50 percent of a participant’s accrued benefit, and there can be no amendments to increase benefits if the plan is at least five years old. If a plan five or more years old has a funded status below 60 percent, no lump sums can be paid and all benefit accruals must be frozen.