The average funded status for pension plans was 92 percent to 95 percent in early 2014, according to research by Towers Watson. That’s good news for defined benefit plan sponsors, but now is the time for employers to give some serious thought to the future of their plans, according to Paul Bosse, Kimberly Stockton and Nathan Zahm, defined benefit retirement plan experts at Vanguard.
The biggest thing plan sponsors need to do in light of the increase in funded status is to take action to retain their robust funding, while at the same time recognizing that funded status is a key influencer in decision-making going forward, Vanguard said.
Zahm, senior investment actuary for Vanguard, said that a good starting point for employers is to know their plan’s maximum funding level. The maximum funding level is different from a full-funding target, where plan assets meet 100 percent of liabilities. It is the funding level where a plan sponsor will want to be in a very low risk, well-matched portfolio.
"Depending on a plan’s status and the sponsor's objectives, maximum funding levels vary," Zahm said. "For instance, the starting point for an open plan (one that expects to continue indefinitely) would be excess assets about equal to ten times the normal cost of the plan," he said. This equates to a plan sponsor expectation that benefits will continue to accrue for about ten years out.
"A closed plan rule of thumb starts at about five times the plan's normal cost — less, if the plan is considering freezing or termination," he said. "And if a plan is frozen, a maximum funding level of about 105 percent of the liability would be appropriate. Anything more could risk stranding assets in the plan."
The next step is finding a glide path to achieve your maximum funding level, said Stockton, an investment analyst with Vanguard.
"It's better for sponsors to think about the low-risk portfolio they want to have in place when their plan's maximum funding level has been determined. Once this is known, they can map a glide path from the current funding level and asset allocation to the maximum funding level, identifying triggers that change asset allocation and shed risk as funded status improves. In this way, sponsors can achieve the right balance between a plan's risk and return at all levels of funding," she said.
It is one thing to develop a glide path and another to execute it in a timely manner, said Bosse, a principal at Vanguard. Problems can be averted if the plan adopts a dynamic investment policy statement, he said.
“When funding-level triggers are reached, asset allocation can automatically shift in a timely manner, helping to lock in funded status gains and control risk and financial-statement volatility. What's more, plans without an automatic asset-shift not only miss de-risking opportunities—they also run the risk of losing funded-status gains,” he said.
Now that your plan’s funded status is in a good position, the next step is to consider immunization or termination. Immunization means maintaining a stable funded status with as little volatility as possible. That is achieved through a combination of corporate and Treasury fixed income assets. The other option is to terminate the plan. The cost of terminating a plan can be just as much as maintaining the plan so the defined benefit plan’s investment committee needs to determine which path is right for their plan.
One way plan sponsors can reduce the amount of pension liability and its risks and volatility is to offer terminated vested participants a lump-sum distribution instead of an annuity.