Navigating a Frozen Plan to Termination
Pension plan terminations are on the rise. Strong portfolio performance, strong corporate balance sheets and rising interest rates have contributed to many plan sponsors of frozen pension plans to either consider or implement a full termination.
Through our experience working with plan sponsors in this situation, we have developed some best practices and creative ideas in managing a frozen plan to and through a successful termination. The following are key aspects in developing an optimal plan termination strategy:
- Have a comprehensive, strategic plan
- Be able to navigate within your strategic plan quickly when opportunities arise
- Make sure you define risk appropriately and not de-risk inappropriately
Crafting a Strategic Plan
A well thought out strategic plan involves managing multiple components in sync with each other. In order for a pilot to smoothly land a plane, the pilot has to successfully navigate many gauges. Similarly, in order for a plan sponsor to smoothly terminate a frozen pension plan there are several gauges to navigate:
- Contribution policy (i.e., cash contributions)
- Investment policy (i.e., risk/return)
- Liability management (i.e., risk transfers)
Upon plan termination, we see each policy dial going to zero.
The main goal in navigating these gauges simultaneously is to strike the balance between timing, costs, and risk. The longer a frozen pension plan takes to terminate the more costs (and risk) the sponsor takes on.
Therefore, a strategic plan needs to be developed that is customized to the plan sponsor and is flexible in changing over time.
A strategic plan should take into account how a plan sponsor desires to achieve fully funded status. Will it get there through investment performance, higher interest rates, future plan sponsor contributions or a combination of the above? The strategic plan should be developed around these expectations.
To further illustrate the point, if the plan sponsor is planning on higher future discount rates to improve their funded status, having a knowledge of how much higher interest rates need to be should be known and quantified. Or said another way, if the sponsor believes rates will increase by 0.50% over the next few years, then the strategic plan should reflect that belief and be built around that expectation – along with analysis of what will happen if that economic result isn’t achieved.
Another input to the strategic plan should be the financial health of the plan sponsor. Many strategic plans don’t factor in a sponsor’s enterprise risk and thus a potential exists for a mismatch between risk taken in the pension plan and risk to the organization. How the sponsor’s business results change in different economic environments should be a factor. Finally, the size of a pension plan in relation to the sponsor should be taken into context.
For example, if a pension plan is small in relation to the plan sponsor’s bottom line, more risk can be taken within the strategic plan, or accelerating contributions should be analyzed if cash flow is available. Likewise, if a plan sponsor’s financial resources are impacted by a recession, then any strategic plan should be designed such that the pension plan doesn’t negatively impact the sponsor during that period of time.
With the passage of the recent funding relief legislation, plan sponsors have a tremendous amount of flexibility in funding their pension plan going forward. Shorter term, minimum required contribution levels typically dropped as a result for many plan sponsors, thus allowing sponsors to have more control over how much to contribute to the pension plan and when.
In developing a contribution policy, a plan sponsor should account for a number of factors including other corporate alternatives for cash, tax rates and the funded status of the plan. While mostly true that a dollar contributed to an ERISA plan provides the sponsor less flexibility to use that dollar later, the same is true for expenses paid by the plan sponsor to manage the plan. There needs to be a balance between keeping the plan financially healthy, the use of cash to fund the plan, and the expected ongoing expenses that will continue until the plan is terminated.
To illustrate the point further, consider a pension plan that is approximately 90% funded, has reduced the expected return of the investment portfolio by de-risking, and has chosen to eliminate contributions going into the pension fund in the short term. In this example, they will be extending the life of the pension plan by not making contributions. The investment return may not be able to “close the gap” and the amount of contributions needed to get the plan fully funded will typically not change going forward. Thus, by deferring contributions, they may have simply increased costs to the company by having more years of pension plan related expenses.
Adding to the tools available to plan sponsors, the current low interest rate environment allows plan sponsors to be able to borrow money to fund pensions at low interest rates. Borrowing money to fund pensions can be thought of as an interest rate swap by exchanging a variable form of debt (pensions) for a fixed form of debt (bank loan). This can ultimately lead to a plan termination in the short term and effectively eliminate all of the risks inherent in sponsoring a pension plan (i.e., investment, PBGC expenses, plan administration).
Setting the investment policy may be the most critical step in developing a strategic plan for pension plan termination. Balancing expected investment return and investment risk is a difficult decision. Typically, the lower the investment risk, the lower the expected return and as a result, the longer the life of the pension plan (and higher total expenses).
As noted earlier, factors such as the size of the pension plan relative to the plan sponsor, the plan sponsor’s enterprise risk and the sponsor’s ability to withstand short term volatility all need to be factored into the investment policy.
One situation that we commonly see that ignores this point are plan sponsors on a traditional investment glidepath. Many glidepaths de-risk a plan based on funded status or interest rate levels, but don’t take into account the risk tolerance of the company. If a pension plan is relatively small in size vs. the corporate balance sheet, the pension plan can take on more risk to accelerate the expected termination date. Or, if the pension plan has de-risked through lump sum offerings or annuity placements, the glidepath needs to be reevaluated given the smaller size of the plan to potentially allow for more growth assets.
Many plan sponsors don’t take into account all the investment tools available to an investor either. This typically leaves them in a situation to have to choose between how much interest rate risk to hedge versus how much expected return to generate to be able to close the funding shortfall. Introducing tools like derivatives can separate this decision to help a plan sponsor independently choose the levels of risk (equity and interest rate) and how much expected return they desire. By separating these decisions plan sponsors can have more control over the timing and ability to “land their plane” and can customize their strategy to their specific circumstances.
One item we see commonly mismanaged is related to the risk prior to a lump sum offering. Since many plan sponsors base the amount of a lump sum offering on interest rates from the beginning of the year (or a few months prior) these amounts are fixed once the plan year starts. Thus, these assets are best hedged with cash holdings during the expected year of payout. To play out the example, if a sponsor chooses to offer a lump sum window and rates were to rise during the year, there is a potential loss to the pension plan if the assets used to pay for the lump sum were held in liability matching assets.
Finally, any investment policy needs to be consistent with the plan sponsor’s investment view. Earlier we noted that a strategic plan should factor in how a plan sponsor desires to reach full funding (rates, returns, and/or contributions).
The third factor in building a strategic plan is liability management. This typically involves either offering one-time lump sum windows or buying annuities from an insurance provider for a portion of the retirees.
Risk transfers are integral to controlling expenses, especially if the pension plan is paying variable-rate PBGC premiums at the premium cap. Offering lump sums or purchasing annuities for these pension plans will help reduce potentially significant administrative expenses while also offloading the liabilities from the company’s balance sheet, and therefore reducing risk.
In addition to offering lump sums and purchasing annuities, there are other creative solutions available to manage liability risk in the pension plan. One such solution that is particularly effective at targeting active participants is to spin off a portion of the pension plan population into another (new) plan and then terminate the old plan. The decision on which participants to spin off to a new plan is made based on what the plan sponsor is trying to achieve - reduction in headcount and thus, reducing PBGC premiums or offering lump sums to active plan participants that would not otherwise have that option available to them. This is particularly attractive to plan sponsors who may have many active participants with small frozen benefits.
As we noted in the beginning of the article, having the ability to review and alter your strategic plan quickly is critical. Many plan sponsors will meet once a quarter to review the plan’s investment results. That timing is inefficient as circumstances change more frequently. As an example as to why this is important, some of our clients decided to increase their equity allocations in April 2020 right after markets had fallen. This proved to be very beneficial versus other clients that didn’t meet or didn’t decide on changing their allocations until weeks later, when some of the opportunity was already lost.
Investment committee meetings should be focused on “what should we do, if …” versus the traditional “how did we do” conversation. By instituting this one change, committees can develop strategic action plans to be able to actually act when market conditions are right. The status quo generally results in missed opportunities that could have had significant effects on a plan’s funded status.
Many pension plan sponsors and their service providers may feel that glidepaths accomplish this, especially for frozen plans. However, as noted earlier, events can happen that should cause glidepaths to be re-evaluated.
Finally, we noted risk should be defined properly. We discussed some points around this earlier in this article. Risk needs to be defined at the enterprise level first and then translated to the pension plan level. For example, if cash flow is the main risk to the organization, especially during a recession, then the pension plan strategy should be developed with this in mind. Similarly, if the pension plan is relatively small to the organization, what risk does it really represent to the organization and how should that be best managed?
Defining risk properly will result in better decision making and a better overall strategic plan. This can result in a paradigm shift for many pension plan sponsors that have traditionally looked at their pension plan risk in isolation. This leads to poor decision making related to de-risking (or re-risking), contribution policy, investment allocation, and risk transfers.
For plan sponsors with frozen pension plans to successfully navigate to plan termination, careful thought needs to go into a comprehensive strategic plan. Crafting a strategic plan that takes into consideration contribution policy, investment policy, and liability management is key to ensuring that the process is smooth and that all aspects and their interactions are factored into the decisions made. That includes the flexibility to act quickly when opportunities present themselves and to be able to view the pension plan risk in the proper context of the overall organization.
In the pension plan service provider space, there are many consultants that understand one or two aspects of managing a pension plan to termination, however there are only a few that have the skills and resources to be able to analyze and address all aspects and can help to effectively and efficiently implement a strategic plan to get a plan sponsor to their ultimate goal.
SECURITY INDICES: This presentation includes data related to the performance of various securities indices. The performance of securities indices is not subject to fees and expenses associated. Investments cannot be made directly in the indices. The information provided herein has been obtained from sources which River and Mercantile LLC believes to be reasonably reliable but cannot guarantee its accuracy or completeness.
CONFIDENTIAL: For addressee use only, not to be disclosed to any other person without express consent from River and Mercantile LLC. Past performance cannot be relied upon to predict future results. River and Mercantile LLC is an investment advisor registered with the US Securities and Exchange Commission.
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