Alternatives to traditional pension de-risking
Are you looking to further de-risk your defined benefit pension plan, while improving the bottom line at the same time? If so, in this note we explore de-risking ideas that are potentially more profitable than simply shifting assets from equities to bonds, which can help maintain your expected return in the process.
Many pension plan sponsors take advantage of improvements in their pension plan’s funded position to reduce funded status risk. The most common way to do this is to sell growth assets (typically public equity holdings) and to purchase more hedging assets (typically long maturity fixed income). There are, however, some excellent alternatives to this form of de-risking that should be evaluated before an asset allocation change.
Some alternative solutions are:
- Offer active employees over age 59.5 a lump sum option for their benefit. This is similar to the common concept of offering lump sums to vested participants who have terminated employment. With the passage of SECURE Act, a plan can now be amended to allow active employees to receive their benefit as early as age 59.5 without terminating employment. This can be combined with a temporary lump sum offer to strategically remove participants from a plan without negatively impacting your workforce. The savings in PBGC premiums for plan sponsors can be very significant, and funded status risk is also reduced.
- Offer lump sums to vested terminated participants, especially if this has not been previously done. This in isolation is not unique. However, if you integrate the offer with a subsequent annuity purchase strategy to remove deferred annuitants with small benefits it can enhance the outcome. Communicating the integrated process to participants helps to encourage decision making and the overall lump sum response rate.
- Implement an annuity buyout for a portion of retirees. Pricing for retiree annuities can be very attractive relative to how plan liability values are carried on a balance sheet. There can be significant PBGC premium savings and funded status risk will be reduced.
- Utilize interest rate options, or “swaptions” to reduce funded status risk while maintaining higher expected returns on assets. Swaptions can help protect the plan from decreases in liability discount rates, while maintaining potential upside should discount rates rise. Significant risk reduction can be accomplished without selling growth assets to buy hedging assets.
- Offer lump sums to active participants under age 59.5 (not just the older active participants as described in Solution 1 above). We have developed a way to accomplish this and have helped plan sponsors implement it with positive results. As with other lump sum distribution campaigns, the savings of PBGC premiums and reduction in risk can be significant.
- Utilize equity derivatives to control risk while maintaining expected returns. Selling growth assets to buy hedging assets creates an either/or problem: if you want to de-risk, then you must reduce expected returns. It doesn’t have to be this way, and using tools such as equity derivatives (swaps, futures, puts and/or calls), can provide ways of reducing funded status risk while maintaining expected returns.
In many cases, the benefit of using the de-risking tools highlighted above will be much greater than the benefit of moving assets from the growth portfolio to the hedging portfolio. For example, removing liabilities also removes the risk permanently, and may result in significant reductions in costs, improving reported profitability, while traditional de-risking strategies retain residual risk and may actually reduce reported profitability. Plan sponsors can be well compensated by exploring all their options before embarking on a “one size fits all” de-risking strategy.