How to Avoid Freezing Your Defined Benefit Pension Plan
It seems as if everybody is freezing their pension plans. Suppose you take a contrarian view. Does it make sense for you to continue your pension plan? If a plan is desirable, how should you make it manageable for the long haul and avoid a freeze?
Employers have been freezing their pension plans for two main reasons, namely a) rising plan costs and b) volatility/unpredictably of plan costs. "Cost" has two meanings for employers. It may involve the actual cash required to meet the Internal Revenue Code minimum funding requirements, or the annual accounting expense determined under the Financial Accounting Standards Board financial rules.
During the 1990s extravagant returns on pension plan assets allowed many employers to reduce or eliminate contributions. Two major market declines, in 2000 through 2002 and in 2008, coupled with more stringent funding rules under the Pension Protection Act, reversed that trend. Many employers saw plan funding requirements and accounting expense and liabilities rise sharply. Furthermore, with expense and cash determinations now linked to bond market rates, gyrations in the credit markets can cause pain and confusion to pension plan sponsors.
Under Pension Protection Act rules, if plan assets fall below 60 percent of the plan’s funding liability, an employer is forced to freeze the pension plan, until the assets exceed the 60 percent threshold. Setting aside such involuntary freezes, how can an employer who wants to continue his plan cope with higher, unpredictable costs? Consider the reasons to continue a defined benefit pension plan. The first test for any employee benefit is whether it is preferable to cash in the paycheck. In general, non-cash benefits confer two potential advantages, either by providing favorable tax treatment, or through economies due to group purchase of benefits.
Employers commonly provide retirement plans. At the very least they may offer a defined contribution plan, such as a 401k or 403b plan that gives employees the advantage of tax-deferred build up of a nest-egg. Employers may make contributions matching those of the employee in whole or part, or may pay contributions independent of employee contributions. Clearly there is a demand for and appreciation by employees of employer-sponsored retirement plans. The real question is whether the defined benefit form is the appropriate one. Defined contribution plans have overtaken defined benefit plans in popularity because they are portable and easier to understand. On the other hand, many employees who are not comfortable with making their own investments have been unnerved when their accounts nosedived twice this decade. They might be attracted to a plan with guaranteed returns and professional investment, such as a cash balance plan, which is a DB plan. But even if you can find a plan that appeals to employees, the cost/volatility problem still remains.
Volatility in contributions and expense arises from both fluctuations in the investment returns of plan assets and fluctuations in plan liabilities. Plan liabilities can vary due to the nature of the plan design and changes in employee demographics. The value of plan liabilities is based (among other things) on certain assumptions about future employee pay, length of service, or longevity and is subject to change if the future is different than assumed. For example, if your plan uses a traditional final average pay formula, deviations in actual salary increases from those assumed can drive your liabilities up and down. With the move to market-based liability measurements, changes in credit markets subject your plan to even greater variation. One method for handling the volatility arising from this source is by so-called liability driven investing or LDI.
Traditional pension plan investments have aimed at the greatest return for a given level of risk (read volatility) or the lowest volatility for a given return. Under that approach, plan assets were locked in a race with liabilities in which assets could suddenly surge ahead, as the late 1990s, or unexpectedly fall behind, as has happened more recently. The surging and fading induced dizziness in plan sponsors. Under LDI, assets and liabilities are considered together. Managers select assets that behave in coordination with liabilities, so that mismatches are reduced. In many cases, LDI leads to more investments in fixed income securities that are similar to those used to set discount rates for liabilities. The downside of this approach is that fixed income investments typically produce lower returns than equities over the long haul, so a plan may be more costly. Some sponsors have employed derivatives and other hedging strategies to compensate for the lower expected return from fixed income instruments.
If you do adopt an effective LDI strategy that reduces volatility, you can tackle the level of cost. Assume, for example, you have moved to more fixed income investments. If the cost of your plan is now higher than you can afford, you can reduce it by altering your plan’s formula. For instance, you might increase the averaging period for final average plans, or change the basic accrual rates under the plan. A more radical approach is to change the final average plan to a cash balance plan. That mimics a defined contribution plan, with annual additions to the account based on compensation, and an "investment" return tied to an index. The cost of a cash balance plan can be adjusted to an acceptable level simply by changing either of these two features.
There is no reason for an employer to freeze a defined benefit plan that it is otherwise inclined to continue. The key to long-term viability lies in a mixture of plan design and an appropriate investment strategy.