Plan Sponsors Plot Their ‘De-Risking’ of Defined Benefits

It appears that 2012 is going to be a rough year for defined benefit plan sponsors. High plan liabilities coupled with anemic returns in the market will make it tough to achieve funding requirements without large infusions of cash, experts agree.

With such a precarious future, plan sponsors are looking to create a much different strategy, one that aims to protect assets instead of pursuing high stock returns.

Financial executives “used to manage [pension] assets without looking at the movement on liabilities and the impact that had on funded status,” says Richard McEvoy, leader of Mercer consulting’s Dynamic De-risking Solution group in New York. Plan sponsors “are now clued in, more than ever before, on interest rates and plan costs.”

Here’s the math that is challenging plan sponsors: Liabilities are bounding over assets. An analysis from New York-based consulting firm Milliman showed market value assets for the 100 largest corporate defined benefit plans increased $12.3 billion to $1.22 trillion in 2011 from $1.21 trillion in 2010. Yet pension liabilities soared $248.7 billion to almost $1.7 trillion in 2011 from $1.4 trillion in 2010.

“There has been an asset-liability mismatch,” says Cynthia Mallett, vice president of product and market strategies in corporate benefit funding for MetLife Inc. “This is a wake-up call to the reality that there is a different way to manage your money.”

Besides dealing with market volatility, sponsors with plans that are less than 80 percent funded face strict multiyear funding requirements with the goal of becoming fully funded. Many companies have had to pour massive amounts of cash into their plans to meet the funding hurdles.

Plan sponsors are well-aware of the situation. According to a December 2011 study by Mercer and CFO Research Services, 59 percent of 192 senior-level financial executives surveyed say their defined benefit pension plan poses at least a moderate risk to their companies’ short-term financial performance.

Some take a look at the funding levels and are predicting the death of defined benefit plans.

“The traditional defined benefit plan as we know it is on life support,” says Sheldon Gamzon, principal at PricewaterhouseCoopers in New York. “The typical CFO is going to look at their situation and say enough is enough.”

But for those staying on target, Mercer’s McEvoy suggests plan sponsors create a formal de-risking strategy, designing a road map for the plan to gradually move to more conservative investments, protecting existing assets, as funded status improves.

“We are seeing a growing number of plan sponsors who are interested in dynamic de-risking strategies,” McEvoy says.

According to the Mercer/CFO survey, 21 percent of companies say they are matching the duration of fixed-income investments to plan liabilities. And, 50 percent surveyed say they are likely to adopt this strategy within the next two years. In protecting capital, 14 percent say they have a plan to increase fixed income, while 57 percent say they are likely to do the same.

But even with a strong de-risking strategy, other plans need to be in place, experts agree.

Some companies have reacted to their funding situation by freezing or closing plans. As of December 2011, 29 percent of the top 100 corporate defined benefit plans closed the program to new hires; the move still allowed existing participants to accrue benefits, data from Oaks, Pennsylvania-based investment management firm SEI shows. Meanwhile, 24 percent of plans were frozen, meaning no new entrants and no new benefit accruals for existing participants.

Freezing or closing a plan stems the growth of obligations (in terms of new hires), but the strategy doesn’t shrink what is currently there, experts agree. Plus, there are still many plan sponsors that don’t want to give up because they see the value of offering a defined benefit plan to attract and retain quality workers.

“Defined benefit plans are a great workforce management tool for maintaining the flow” of workers in and out of a company, MetLife’s Mallett says. “DB plan sponsors have a pretty good feel as to who is retiring. DC plan sponsors have no idea.”

That’s why plan sponsors need a two-pronged approach: high cash contributions complemented by a new de-risking strategy, experts say.

While the 2011 cash contribution figure is still being tallied, the top 100 companies contributed $59.4 billion in 2010, says John Ehrhardt, principal and consulting actuary at Milliman Inc. Plans contributed just under half that, or $29.8 billion in 2008.

Ehrhardt expects the 2011 contribution to be at about $80 billion, and thinks these companies will contribute more than $100 billion in 2012.

“It’s pretty clear, interest rates are at or near historic lows, so we’re going to see a record level of contributions in 2012,” Ehrhardt says. “Any company that isn’t aware of cash funding requirements has had their head in the sand.”

There are other ways to de-risk plans, like lump-sum cash-outs for terminated vested participants or annuity purchases, McEvoy says. These options can take away risk, but need to be analyzed to see whether they work for individual company situations.

“These are very effective means of risk reduction,” McEvoy says. “It’s a new realm of plan management that’s focused on funded status.”

Patty Kujawa is a freelance writer based in Milwaukee. To comment, email editors@workforce.com.