Managing pension risk in 2021
Every pension plan has risks. There are many risks but they tend to fall under three distinct groups: governance risks, funded status risks, and legal and compliance risks. Plan sponsors need to understand the various risks that their pension plan poses to their organization and then decide how to manage those risks. They can choose to minimize, eliminate, or fully take on the various risks and there are many different tools available to plan sponsors to help them handle a given risk. What risks are most prevalent in 2021 and what are some ideas plan sponsors should be thinking about to optimize their risk management this year?
First let’s define what we mean by “risk”. In general terms, risk is the exposure to the chance of injury or loss, or in the investment sense it’s negative volatility. Defining the three categories of risk:
- Governance risk - The risk that the inherent structure for making decisions regarding the plan is ineffective, leading to missed opportunities and/or imbalance of the level of risks within the plan and organization.
- Funded status risk - Chance that a plan’s funded status deteriorates to a point where the levels of cash contributions (or balance sheet liabilities/income statement expense) become detrimental to the sponsoring entity.
- Legal/compliance risk - Chance that upon inspection, issues are uncovered that point to deficiencies in how the plan has been operated that are in violation of rules and regulations the consequence of which could end in disqualification, penalties or delayed decision making upon plan termination.
Many plan sponsors grapple with how to structure the oversight for their pension plan. Having the right structure in place will allow the plan to make effective decisions in a timely manner. Some committees decide to have certain functions automated (e.g. automatic glidepath triggers, outsourced investment management). For a more hands-on committee with pension plan expertise that can schedule ad hoc meetings when things come up, they may prefer to hold on to the decision-making process for each decision. One pitfall for governance committees to avoid is not being able to come to a consensus soon enough to take effective action resulting in missed opportunities.
Each plan sponsor is different and each one will need to decide how decisions are made including which decisions are retained versus outsourced. The importance of having a good structure in place was amplified in 2020 as companies dealt with a myriad of difficult issues, and decisions around pension plans still needed to be made. For example, those committees that rebalanced their asset allocation to adhere to their investment policy (or made proactive decisions to re-risk), most likely had superior returns in 2020 versus those that didn’t. Those with organization appropriate structures fared well while those without were exposed.
Funded Status Risk
The two most common ways that plan sponsors look to address funded status risk are through their asset allocation and pension risk transfer strategies.
With the funding relief provisions in the March stimulus bill, plan sponsors with underfunded plans will see their required contributions shrink and the volatility around future contributions diminish as well. Unless a plan sponsor has a deliberate plan to contribute more than the minimum, they should reassess their strategic asset allocation considering the reduced cash flow risk. The funding relief provisions could open the door for plan sponsors to take more investment risk in their pension portfolio with the hopes of out earning the liability growth over time.
In addition, plan sponsors that have adopted liability driven investment strategies may want to also revisit any glidepath parameters and decide if they are better off re-risking (i.e. change the glidepath trigger points) to take advantage of rising rates. If plan sponsors do decide to invest more in return seeking assets, they will also want to assess whether or not a strategy that limits their downside exposure would help them avoid severe setbacks in funded status if there is a market correction. One such way that still allows for equity growth and/or interest rate growth is through the use of derivatives. Interest rates and likely funded status are up significantly for most pension plans during 2021. Derivatives such as zero premium swaption collars and/or shaped equity can efficiently help to protect a plan’s increased funded status position against potential future rate or equity declines.
Pension Risk Transfer
There are two primary pension risk transfer strategies that have been commonplace over the last ten years that have been used to eliminate funded status risk as opposed to mitigating the risk: lump sum cashout windows and annuity buyouts.
Lump sum cashout windows can be advantageous to shrink the overall vested terminated participant population. With the SECURE Act in 2019, there is also the possibility to open up this type of strategy to active participants over age 59 ½. Timing a lump sum strategy is critical for plan sponsors, as not every year produces the economic environment that can be beneficial to plan sponsors. In general, in years with an increasing interest rate environment (e.g. 2021), plan sponsors may find that the lump sum payments paid out are more than the economic liability they are releasing from the plan, thus deteriorating the funded status. There still may be advantages if the plan is subject to the PBGC variable rate premium cap, especially if the lump sums are related to small benefits.
Annuity buyouts have seen steady growth over the last decade and the market was only slightly stymied with the pandemic. We continue to see favorable pricing for plan sponsors on both in-pay and deferred annuities. The big question when evaluating an annuity buyout will be around which assets to sell to cover the premium. This isn’t always an easy decision and will be highly dependent on a plan sponsor’s view on future interest rates, equity markets and cost savings resulting from the annuity placement.
The increase in interest rates combined with strong equity returns over the last year have most plans in a stronger funded position than in many years and likely ever. That well-funded status combined with reduced funding requirement will likely result in increased appetites for sponsors to execute annuity purchases during 2021.
The legal and compliance risk that a plan sponsor faces can sometimes be overlooked. Too often we’ve seen a reliance on a third party who doesn’t carefully address plan documentation, distribution procedures, and plan level data that results in operational failures. These failures left unchecked can result in costly fixes and a substantial time commitment from the plan sponsor.
For plan sponsors that have outsourced the plan administration function, they still need to ensure that the plan administration is correct. Our experience has been that almost every plan has some issue that needs to be remedied – some more severe than others. Having an independent plan review by a qualified provider can be one way to mitigate this risk. Even though plans are audited each year, that is usually for financial reporting purposes and the goal is to ensure that processes are in place and not that the processes are correct. For example, are the forms of payment are offered to participants in election packages the same as what the plan document allows? What about the allowance for non-spouse beneficiaries? Are election forms properly filled out and notarized where necessary? These might seem obvious, but we’re always surprised by how many times we come across a plan that has issues with those specific items.
Identifying and fixing operational issues can be more cost and time effective if addressed now rather than finding out there are problems when you’re ready to implement a big project (e.g. pension risk transfer or plan termination).
The best way for a plan sponsor to manage pension risk in 2021 is to take on a review of the risks inherent in their plan and articulate how they are owning, mitigating, or eliminating those specific risks.
Special for 2021 will be a number of opportunities: funding relief legislation decreasing contribution risk, all time high equity markets with a rising interest rate environment, and continued increase in PBGC premiums.
We believe prudent management will lead to better outcomes for plan sponsors to help them accomplish their overall goals and objectives with their plan. Every pension plan has risks, it’s how they are managed that will determine how successful the plan sponsor is with respect to how those risks affect the company.
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