Unfunded pension liabilities forcing companies to get creative in managing their risk

Unfunded pension liabilities are forcing many pension plan sponsors to look for alternative ways to manage their pension risk.

New industry regulations require companies to show their pension liabilities on their balance sheet. They also must contribute to their pension plans every year, which takes away money from their core businesses. This has forced many companies to look at different options to manage their risk and eventually terminate their defined benefit pension plans.

Prior to the Pension Protection Act of 2006, companies that terminated their pension plans did so because they were going through a merger or acquisition or were filing for bankruptcy. Now, “companies are looking to terminate their pension plans as a strategic risk management decision,” said Jay Dinunzio, a senior consultant at Dietrich & Associates, a pension risk transfer firm.

It isn’t that most companies intend to go out of business, but “we are going to see more companies proactively jettison their pension liabilities when they can afford to as opposed to in the past where specific business circumstances drove plan terminations.”

In the past, companies trying to terminate a plan would buy an annuity for the full amount of the pension’s liabilities to get the plan off their books, but still keep their promise of secure funding in retirement to their pension holders.

Twenty years ago, plan sponsors could use smoothing techniques to eradicate some of the volatility of their pension assets because pension liabilities didn’t have to be recorded on a plan sponsor’s financial statement, said Russ Proctor, director of PacificLife’s Retirement Solutions Division. “As the regulations changed, it has pushed companies to move away from defined benefit plans.”

Proctor added that the industry has seen a lot of plan terminations in the past 10 years and a lot more will terminate in the next 10 years.

“I think a lot of plans out there would like to terminate and get out of their defined benefit plans. …What is holding them back is a lot of plans are underfunded. They have to come up with the cash to terminate it, and also interest rates and yield rates are low, so it is more costly to terminate now,” Proctor said.

Some companies are borrowing money to pay off their plan’s pension liabilities because it is easier to account for a loan on their balance sheet than volatile pension liabilities.

Insurance companies have come up with some new products to help plan sponsors manage their pension risk, including an insured liability driven investment strategy.

“Insured LDI, one of the new solutions, helps a plan stabilize its funded status. It gives them the opportunity to get their plans fully funded,” Proctor said. Once their pensions are fully funded, a corporation can decide if it wants to fully terminate the plan or keep it going.

According to a recent Dietrich & Associates report on pension risk transfer, an LDI investment contract “guarantees that a plan’s expected cash flows will be valued equal to the prevailing rate of the same pension discount curve the plan uses to value its liabilities. This approach essentially allows a plan sponsor to invest in a contract (asset) whose value is equal to the liability. That is a powerful proposition for sponsors interested in de-risking their plan and increasing allocations to fixed income to protect their funded status.”

Dietrich & Associates also believes that plan sponsors don’t need to annuitize their whole plan immediately. “For plans funded in excess of 90 percent it is likely that they may be able to comfortably afford to annuitize some portion of their plan liabilities. This strategy concentrates on annuitizing retiree liabilities which can be most efficiently priced by insurers and reduce the plan cash flow/benefit payment expense burden.”

The report added that, “for plans that may be waiting for rates to eventually rise, this approach may be value-added over an alternative settlement approach of issuing voluntary lump sums to terminated vested participants, in that a future rise in interest rates will have a more dramatic liability reduction impact on long duration liabilities associated with younger terminated vested participants.”

Interest rates have been falling for 30 years, Dinunzio said, and “low interest rates are bad for pension liabilities. When the rates go up there will be huge activity in LDI and pension activity.”

Every year it gets harder to manage pension risk, Dinunzio said. “Lots of people are thinking of injecting cash than ever before. It is still a challenge from a CFO perspective, but if you are credit worthy, have access to credit and financing, with interest rates low, some plan sponsors may see value in borrowing the funds to fully terminate. Get rid of the unpredictable debt and replace it with fixed rate debt they can plan around.”

Proctor agreed, saying the new regulatory climate will force a lot of companies to move to defined contribution plans in the future because they can make predictable contributions to those plans.

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