Helping defined benefit plan sponsors be more successful
The best plan sponsor is an educated plan sponsor. Teach your sponsors these seven easy to employ practices listed below, and they will surely be the smartest ones in the room at their next retirement committee meeting. Plus you, as their adviser, will appear really, really smart.
1. Understand the impact of interest rates on your plan’s liabilities
The liabilities of a typical DB plan move inversely by 10 to 15% for each one percent change in the interest rate used to discount future benefit payments. Corporate bond rates have been low for a long time now, but measurable rate increases would reduce plan liabilities significantly. This would introduce valuable opportunities to hedge your plan’s pension risk through liability driven investment (LDI) strategies or transfer it through annuity purchases or lump sums.
The sensitivity of a specific plan’s liabilities to interest rate movement depends on the design and demographics of the plan:
- 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.
- Note that different types of benefits with different durations can exist within a single plan as well.
2. Factor the plan’s funding ratio into asset allocation decisions
The lower the market value funding ratio, the more logical it is 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 becomes more important than chasing overall returns.
The only way to know your plan’s position is to get periodic reporting of liabilities at current interest rates versus 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:
- More return focused at lower ratios.
- Greater emphasis on LDI hedging at higher ratios
3. Consider a lump sum window
Offering a temporary lump sum “window” to terminated vested employees (no longer employed but not yet receiving a pension) has been gaining popularity for several years now. This approach offers a way to transfer risk directly to individuals without adding an expensive, permanent feature to the plan.
"Teach your sponsors these seven easy to employ practices ... and they will surely be the smartest ones in the room at their next retirement committee meeting."
The impending adoption of longer mortality assumptions by the Internal Revenue Service (IRS) in 2017 for calculating minimum lump sums has added additional urgency. That’s because paying out in 2016 could save 5 percent to 10 percent of the overall cost. (Though future interest rate movement should also be considered.) Aggressive Pension Benefit Guaranty Corporation (PBGC) premium increases have added additional fuel to the lump sum window fire.
No two plans are the same, so an analysis of a lump sum window’s impact on plan funding, accounting and PBGC premium levels should be done before proceeding. You better get moving quickly, though, if you want to get the payouts administered by year end.
4. Ponder mortality
You don’t have to go all Hamlet, but it is important to understand the impact that mortality (more specifically, less of it) has on your plan.
The Society of Actuaries released its new generational mortality assumptions in 2014, and they updated the improvement scales last year. Generally, assuming longer lives means more benefit payments and higher liabilities, although the precise impact of the change varies greatly based on the demographic composition of your plan.
You’ve probably already booked a significant accounting liability for this change. But the impact to minimum plan funding, lump sum conversions and PBGC premiums won’t occur until 2017. We still don’t know exactly which tables the IRS will use, but you may want to request estimates from your actuary now.
5. Reduce PBGC premiums
The Bipartisan Budget Act of 2015 included the third major increase to PBGC premiums in three years. Since premiums paid to the PBGC have no benefit to your plan (unless you’re going to declare bankruptcy) you should do everything in your power to minimize your assessment.
There are ways to potentially reduce premiums that you should discuss with your actuary if you haven’t already:
- Make additional contributions.
- Assign contributions as “receivables” to the prior plan year.
- Switch from the “alternative” to “standard” filing method.
- Offer a lump sum window to reduce head coun
6. Set a funding policy
Many plan sponsors have historically used the ERISA minimum contribution requirement as a default funding policy. But three rounds of 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) you should 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 get you where you want to go. Keep your eye on the appropriate target when planning your annual contribution.
7. Search for administrative efficiencies
A significant number of DB plans still utilize “in-house” staff to provide many plan services, absorbing large chunks of valuable human resources time and exposing plan sponsors to the risk of miscalculation and non-compliance. Plan sponsors should consider the benefits of outsourcing their DB plan administration to improve both the employee and plan sponsor experience.
Outsourcing to a provider with extensive 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.
A version of this blog originally ran on The Principal blog.
The subject matter in this communication is provided with the understanding that The Principal® is not rendering legal, accounting or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax or accounting obligations and requirements. Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group (The Principal), Des Moines, IA 50392.