Getting your pension plan off autopilot
Take a look at any pension funded status index over the last two decades and you’ll see plenty of ups and downs, but not much overall progress. The volatility that many pension plan sponsors have experienced over the last twenty years has plenty of consequences: increased contributions, hits to the P&L and balance sheet, reporting to government agencies, etc. But does it have to be this way? Too often pension plan sponsors have resigned themselves to thinking that there is no other way – they’re on autopilot. And while it’s true that there will always be some variability in a pension plan’s funded status, managing it appropriately can help avoid nasty surprises and unwelcomed outcomes that could have been prevented and ultimately get plan sponsors to their desired destination. This article looks at how plan sponsors can turn off autopilot and successfully navigate their pension journey by letting rate increases and equity returns help them along the way.
What drives funded status
There are five fundamental drivers of pension plan funded status. These drivers can generally be put into one of two buckets: liability drivers and asset drivers.
Liability drivers include interest rates, demographics, and risk transfers. Asset drivers include interest rates, returns, and contributions. Interest rates show up in both buckets because they can affect both sides of the funded status equation. As interest rates used for measuring pension liabilities change they can have substantial effects on the size of the liability. On a mark-to-market basis, a 1% change in interest rates can cause pension liabilities to change anywhere from 8% to 18%. If a plan’s assets don’t change in a similar way there is going to be some serious funded status volatility. An ideal strategy for pension plan sponsors would be to protect funded status against rate declines and allow rate increases to improve funded status. We have been helping plan sponsors implement and maintain efficient liability driven investment strategies to help protect against interest rate declines while maintaining or even increasing equity exposure through derivatives.
Pension risk transfers have been a staple of funded status risk management over the past decade. These come primarily in two forms: lump sum windows and annuity buy-outs. There have been several opportunities, during the last ten years especially, for plan sponsors to implement one or both of these strategies that could have actually improved funded status. 2020 was one of those years. For companies that offered a voluntary lump sum window in 2020 for calendar year plans, they likely saw improvements in funding shortfalls (on a mark-to-market basis). If a plan sponsor didn’t take advantage of the right timing, they probably left some funded status gains on the table along with an opportunity to reduce the overall size and cost of the plan. During 2020, a number of River and Mercantile (R&M) clients implemented a pension risk transfer. Of those that did, all of them saw an improvement in funded status as a result of implementing the strategy. Those that implemented a lump sum window saw by far the biggest gains.
We all know that contributions can solve any funded status problem (just contribute more, right?). But most plan sponsors don’t have the cash to make their pension woes disappear or they would rather invest more in their core business to generate more revenue. With pension funding relief set to begin phasing out in 2021, if plan sponsors don’t have an eye on this driver they could be left with bigger and bigger bills to pay in the years to come. The interest rates used for contribution determinations are expected to drop 1.25% - 1.50% over the next 3-4 years which would cause many sponsors to see very large increases in required contributions (absent any additional funding relief). For our clients where this matters, we routinely provide contribution projections to help them understand what contributions may be in the short-to-medium term.
Why autopilot doesn't get you to your destination
For pension plan sponsors whose annual pension routine involves reluctantly paying required contributions when due and shrugging their shoulders with no idea what they can do about it, they need to realize that there are other options for managing a pension plan.
Most plan sponsors fall into one of two camps as it relates to their ultimate pension funded status goals:
- Frozen plans – looking to eventually terminate the plan and offload all benefit liabilities to participants via lump sum payouts and/or annuities purchased from an insurance company.
- Ongoing plans – wanting predictability year over year on the company’s financials (cash, balance sheet, and income statement).
Being on autopilot rarely has helped a plan sponsor get to where they want to go. In fact, the way that some pension rules work make it nearly impossible. As an example, only paying the minimum required contribution each year when a plan is underfunded will almost certainly not get the plan sponsor to their desired destination. Having a strategy that looks at a potential destination and how to most effectively get there can pay huge dividends in time and money over the long haul. And, if a plan sponsor is cash constrained? There are still other strategies to pursue that can look at growing pension assets more effectively (while controlling interest rate risk) or shrinking the overall size of a plan so that any volatility becomes less harmful when it goes against the plan sponsor.
What it means to turn off autopilot
For plan sponsors that want to turn off autopilot and take control, they need service providers like R&M that can help them navigate the pension funded status map to plot a course to get them to their desired destination. This will mean looking at strategies from a liability perspective, an asset perspective, and most importantly an integrated asset/liability perspective.
What this looks like is a comprehensive strategy that identifies plan sponsor goals and objectives, constraints, risk tolerance, and timeline. Taken together a course can be mapped out. From there the person at the helm is empowered to guide the plan to successful outcomes. That might mean strategies like:
- Pension risk transfers – these are typically time sensitive in that there are times when they are more economically advantageous than others. Understanding the economics as well as the potential cost savings can help plan sponsors implement these strategies to their benefit.
- Liability driven investing – having an asset allocation strategy that is relative to the plan’s liabilities is imperative. This is a key to managing the interest rate risk that exists within a plan and can be one of the biggest causes of funded status volatility and risk. A fresh look at all the tools in the pension investment toolbox can also help plan sponsors be setup to generate the returns they need with the right amount of risk exposure (e.g. high yield bonds, long credit fixed income, derivatives, hedge funds, and other alternatives).
- Contribution planning – understanding what cash calls are up ahead will allow for plan sponsors to effectively plan for and hopefully mitigate unnecessary contribution spikes over the coming years.
The end goal is achievable
For plan sponsors that have taken off the autopilot approach, they have seen meaningful progress in how they manage their pension funded status risk. For some that has meant more predictability in their contribution requirements; for others it has meant shrinking the size of their plan and therefore reducing their overall risk profile; and for some it has meant the arrival at their desired destination.
During 2020, R&M pension plan clients saw an average increase in funded status in terms of actual dollars from the start of the year. This came about from our proactive approach with our clients on all three fronts listed above.
Plan sponsors do not have to deal with the status quo. There are ways to intentionally deal with pension funded status risk that lead to positive progress. In order to get there, however, you’ll need to ensure you’re working with providers that can safely take you off of autopilot and help guide you in the right direction. R&M is that firm.
R&M pension plan services
Through a variety of strategies, we can help defined benefit plan sponsors solve some of their most acute challenges.