De-risking your pension plan
With private sector pension plans at their healthiest level in over a decade, now could be the right time to consider de-risking your pension plan (defined benefit). Four in 10 defined benefit pension plans – 40 per cent – reached fully funded status at the close of 2013, according to pension consulting firm Mercer. What a difference 12 months makes – at the start of 2013 less than one in 10 pension plans – six per cent – were fully funded.
If the financial crisis in 2008 – that left many pension plans severely underfunded – has taught us anything, it’s that that plan sponsors need to do a better job of protecting themselves from the many risks inherent in offering a defined benefit pension plan. We only touched on de-risking your pension plan last month, so let’s take an in-depth look at some strategies you can undertake to de-risk your pension plan.
With many pension plans at or near fully funded status, it’s a lot less costly today to de-risk your pension plan. When de-risking is discussed, the first strategy that typically comes to mind is a plan redesign. There’s a good reason why final average earnings plans, which used to be a dime a dozen, are becoming scare in the private sector. Not only do plan sponsors bear the full investment risk, final average earnings plan are an open-ended liability waiting to happen, since it’s difficult to predict what an employee’s salary will be when they retire or terminate employment.
Plan redesigns can take many forms besides simply switching to defined contribution. Among the options to consider are: closing the plan to new hires, freezing current pension benefits and switching to defined contribution for future services, and switching to a less generous plan formula for future service (e.g. final average earnings to career average earnings). Each option has its pros and cons, so it’s important to carefully weight your options before undertaking a plan redesign.
If you’re a big employer with many different pension plans, it might be worthwhile to consolidate your pension plans. Not only can having too many pension plans be an administrative nightmare, it can very costly for administer and maintain. It’s important to think long-term – although there will be upfront costs, the savings in the long-run could easily pay for itself.
Furthermore, it can be risky for plan sponsors when knowledge about different pension plans is spread across an organization. As the saying goes, “knowledge is power.” What if your lead pension benefits administrator decides to retire or leave the organization? It can be difficult and time-consuming to piece together the plan history and continue with day to day operations. By consolidating your plans, it can make them a lot easier to administer.
If your plan’s investment returns are underperforming its targeted benchmarks, a change in investment strategy may be warranted. Liability Driven Investing (LDI) has become a popular investment strategy with many plan sponsors, who have seen their investment returns drop and their liabilities increase in recent years. Although few things are guaranteed in life, the traditional defined benefit pension plan continues to guarantees members a monthly pension in retired based on their earnings and years of credited service, regardless of how investments perform – LDI can help protect against investment risk. LDI can take many forms, but it typically involves hedging a plan’s exposure to changes in inflation and interest rates.
Why bear all the risk of sponsoring a defined benefit pension plan when you don’t have it? An annuity buy-in involves transferring the risk of your pension plan to an insurance company. Although Canadian plan sponsors haven’t fully embraced this approach yet, it’s become a popular option in the U.S. and the U.K. Annuity buy-ins can be a costly option and might not be up to snuff with current legislative requirements, so a full cost-benefit analysis should be undertaken with your pension consulting firm before deciding to go this route.
These are only a few of the many de-risking strategies plan sponsors have at their disposal. The window of opportunity to de-risk could close if interest rates suddenly fall and equity markets have a less than spectacular year in 2014. It’s a good idea to do a careful review of each de-risking strategy to see which makes the most sense for your organization to help maintain your pension plan for the years to come.