7 questions defined benefit plan sponsors should be able to answer
Question 1: Do you understand the impact of interest rates on your defined benefit plan’s liabilities?
Answer: The liabilities of a typical defined benefit (DB) plan can shift in the opposite direction 10 to 15% for each 1% change in the interest rate. That fact can be used to your advantage. For example, if corporate bond rates increase, that could be a good opportunity to hedge or transfer your plan’s pension risk.
Options for managing pension plan risk
- Handle the risk in-house, via liability driven investment (LDI) strategies
- Transfer the risk to another party, via an annuity purchase or offering participants a lump sum
The sensitivity of your plan’s liabilities to changes in interest rates depends on the plan’s design and demographics:
- Longer duration plans—those with younger populations and traditional monthly paid benefits—are more sensitive to interest rate movements.
- Older populations and cash balance plans tend to have shorter durations and react less to rate changes.
What is investment duration?
In investing terms, duration is a measure of how sensitive the price (aka, the principal value) of a fixed-income investment is to changes in interest rates. Duration is expressed in years. The longer the duration, generally the higher the sensitivity to interest rate changes.
Remember: Different types of benefits with different durations can exist within a single plan as well.
Question 2: How does your plan’s funding ratio factor into your asset allocation decisions?
Answer: The lower your funding ratio, the more logical it may be to take additional risk to generate returns. But as a plan approaches full funding on a market value basis (particularly frozen plans looking to terminate), hedging against downside risk can become more important than chasing overall returns.
What is a funding ratio?
Expressed as a percentage, the market value funding ratio is the current market value of your DB plan’s assets compared to its liabilities. The higher the funding ratio, the more closely plan assets match liabilities.
The only way to know your plan’s funding ratio is to get periodic reporting of liabilities at current interest rates vs. the market value of plan assets. Many plan sponsors have adopted dynamic asset allocation (DAA) strategies that formally adjust the plan allocation based on the funding ratio to place:
- More focus on gaining returns at lower ratios
- Greater emphasis on LDI hedging at higher ratios
Question 3: Would it benefit your pension plan to offer a lump sum window?
Answer: Offering a temporary lump sum “window” to employees who have already left the plan with a vested benefit has been a popular way to transfer risk directly to individuals without adding an expensive, permanent feature to the plan.
In addition, aggressive premium increases from the Pension Benefit Guaranty Corporation (PBGC) and longer mortality assumptions for calculating minimum lump sums have inspired more plan sponsors to take action.
No 2 plans are the same, so analysis of a lump sum window’s impact on plan funding, accounting, and PBGC premium levels should be done before proceeding.
Question 4: What impact could increasing lifespans have on your DB plan?
Answer: It’s important to understand the impact that mortality has on your plan. Generally, longer lives mean more benefit payments and higher liabilities although the precise impact of changing mortality assumptions varies greatly based on the demographic makeup of your plan.
Question 5: What’s your plan for reducing PBGC premiums?
Answer: The PBGC has increased its premiums annually since 2015, and is scheduled to do so through 2019. Since premiums paid to the PBGC have no benefit to your plan (unless you’re going to declare bankruptcy) you’d be wise to minimize your assessment.
Each plan is different, but there are ways to potentially reduce premiums that you should discuss with your actuary if you haven’t already, including:
- Making additional contributions
- Assigning contributions as “receivables” to the prior plan year
- Switching between the “alternative” to “standard” filing methods
- Offering a lump sum window to reduce head count*
*No two plans are the same, so analysis of a lump sum window’s impact on plan funding, accounting, and PBGC premium levels should be done before proceeding.
Question 6: Have you set a funding policy?
Answer: Many plan sponsors have historically used the ERISA minimum contribution requirement as a default funding policy. But pension funding relief laws have reduced minimum contributions almost to the point of insignificance, forcing plan sponsors to consider what funding is actually appropriate rather than just required.
Before blindly accepting government-offered funding holidays (which they consider tax revenue generators) consider the long-term objectives of your plan. Market value (or termination) liabilities are significantly higher than the liability used in the minimum funding calculation, so minimum funding may not meet your goals. Keep your eye on the appropriate target when planning your annual contribution.
Question 7: How efficient is the administration of your DB plan?
Answer: A significant number of pension plans still have in-house staff provide many plan services, absorbing large chunks of valuable personnel time and exposing plan sponsors to risk of miscalculation and non-compliance. Instead, consider the benefits of outsourcing DB plan administrative services.
Outsourcing to a provider with strong DB expertise may increase hard dollar costs, but the addition of call centers, web access and education resources can provide significant value. The soft-dollar costs of freeing up internal staff time should also be taken into account.
We can help
The good news is that you can successfully manage your DB plan with the tips above and with the right team. We can help you and your financial professional objectively evaluate your options, make an educated decision, and propose action steps you can use to help you reach your unique goals. Give us a call at 800-952-3343, ext. 22681 or contact your advisor to get started.