Recalculating Pension Risk Following Health Reform

By Gordon Fletcher

Aug. 2, 2010

The short- and long-term implications of U.S. health care reform are vast—and they can be difficult to calculate. Consider, for example, one scenario for sponsors of defined- benefit pension plans. Many of them have realized that, in order to manage their pension risks, they may have to close the plans to new members and even take the next step of stopping the accrual of new benefits to all participants—in other words, they must “freeze” their plans. But will their plans’ depressed funding levels also suffer the burden of rising life expectancy for the portion of the population that may now benefit from improved access to health care?

In managing a pension plan, the basic goal is to set aside sufficient funds to pay beneficiaries for the remainder of their lives. And the simple fact is that an improvement in life expectancy will result in the sponsor having to write checks for a longer time. Since frozen plans are not accumulating new liabilities, they are in the “endgame” phase of gradually running off their current liabilities to zero over a period of decades. These plans have a finite lifespan and sponsors are now keen to realistically reserve for the cost and not get stung in the future because of any miscalculation of such a key parameter as life expectancy.

But isn’t it fanciful to imagine that health care reform could impinge on pension costs in the short term? Surely life expectancy creeps up too slowly to matter in this regard, doesn’t it? In fact, some startling research from the Max Planck Institute for Demographic Research raises fresh doubts about those assumptions. Researchers Rembrandt Scholz and Heiner Maier investigated the change in death rates of the East and West German populations before and after the fall of the Berlin Wall in 1989. They noted that before unification, East German mortality rates were materially higher than their compatriots in the West, but these differences had largely vanished within a decade of German unification.

Especially noteworthy was the change in female death rates for those over age 80. It might be thought that by this stage in life the die has been cast and life expectancy is immutable. However, the researchers found that the mortality of these individuals was extremely amenable to intervention, as these women in particular clearly profited from the medical, social and economic improvements associated with unification.

Could a similar effect happen in the U.S. and have a meaningful effect on the funding of public and private pension provisions? Indeed, the “plasticity” of mortality rates is a widely researched area of demographics, and the German unification study provides a stark example. So there seems no reason why there might not be an observed change in the United States. Whether this could be detrimental to pension provision will depend upon whether these plans have any substantial weighting of liability to the blue-collar workers who are likely to most benefit from any health care changes.

This risk of increased pension costs from the new health care legislation is simply an example of another risk outside a sponsor’s control. How many CFOs across the country have felt that the orderly runoff of their pension programs has been blown off course by the recent economic turbulence and fiscal stimulus activity? Surely they are not at fault, and could not have foreseen this? Yes and no. The risks we have described certainly come out of left field, but there are now techniques and tools for managing and insulating a pension plan from the worst effects. These new developments are forcing those managing pension plans to step up a gear and become risk managers.

One approach would be to adopt a liability-driven investment (LDI) strategy with interest rate swaps, as this can help mitigate large mismatching movements in assets and liabilities. This may also be accompanied by reducing a plan’s exposure to risky assets and diversifying the remainder. Plan managers may also consider transferring and spreading the pension risk through annuitization to an insurer. Alternatively, unanticipated improvements in life expectancy can be mitigated through longevity swaps. The spreading and pooling of risk to market providers is common in areas such as hurricane risk, and is now growing as a method to manage pension-related risk.

Deciding which of these methods to adopt, and when, should form part of a coherent risk management program. When should this be done? CFOs would do well to consider John F. Kennedy’s words: “There are risks and costs to a program of action. But they are far less than the long-range risks and costs of comfortable inaction.”

Workforce Management Online, August 2010Register Now!

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