Financial Accounting Standard 158 made pension underfunding more obvious and introduced a "mark-to-market" approach to pension accounting. In addition, the Financial Accounting Standards Board is contemplating moving closer to the International Accounting Standards Board's more transparent standards.
The Pension Protection Act of 2006 increased funding requirements, among numerous other changes. Discount rate relief, resulting from MAP-21 legislation (Moving Ahead for Progress in the 21st Century Act), has improved regulatory funding levels, and decreased contributions, but the result is a reprieve, not a pardon.
PBGC premiums have increased and will continue to climb as they are indexed to wage inflation.
Interest rates are at near-historic lows. As a result, liability discount rates based on an AA bond portfolio are down significantly. The impact of falling rates on the liability is leveraged by the duration of the liability.
Asset returns have been moderate at best (and volatile since the start of the financial crisis) and have been overwhelmed by liability growth. The S&P's returns have averaged a tolerable 8.21% over the past 10 years. *Fixed income investments have benefited from falling rates, but with a relatively short duration, that hasn't begun to offset the liability's climb.
Funded status is defined as Assets minus the GAAP Liability. Currently, the vast majority of DB plans are underfunded. Declining funding leads to increasing contributions and, as losses are amortized, higher pension expense which lowers earnings per share (EPS).
Underfunding can be viewed as another type of debt owed to employees. Like any form of debt, excessive pension debt may lead to a higher cost of capital.
DB Plan sponsors have used various approaches to reduce plan risks. Benefit design (freezing the plan to new benefit accruals) has been popular for years, but is only the beginning. Overall plan risk is virtually unaffected, however this may be changed with additional steps.
The use of liability driven investing (LDI) is a popular step, which at its simplest is moving the assets towards a portfolio that reacts to changes in rates as does the liability. It can provide good, though limited, protection against interest rate risk. However, it provides no actuarial risk protection, and funded status and earnings volatility remain. At its simplest, this may entail just moving to a longer bond portfolio, one with an interest rate sensitivity or duration similar to a plan's liabilities.
Offering lump sums to terminated vested participants is sometimes the next step. The value of the lump sum is about the value of the GAAP liability, making this a cost effective solution - especially if the plan is well funded. However, this approach is counter to the basic reason for a DB plan, which is to provide a lifetime income stream. A buy-in, which uses an annuity as a DB plan asset, can generally be more effective by removing more risks, and therefore limiting overall plan risks. In addition to interest rate risk, actuarial risks like longevity and early retirement for a specific group of participants are eliminated.
Annuitizing retirees and plan termination (the ultimate risk reduction) is considered the end game for most plan sponsors, especially those of frozen plans.
For overfunded frozen plans, termination is the next logical step. Termination has two non-recurring impacts:
A non-cash charge on earnings, as accumulated gains or losses are recognized.
A cash requirement, assuming a final contribution is needed to fully fund the benefits.
The outcome is significant since it completely eliminates the plan and all of its risks.
Sponsors of active plans (those with participants still accruing benefits) can substantially shrink the plan by settling inactive participants liabilities through annuity purchases. The cost of annuities for retirees can be 10% above the GAAP liability, due to insurer's expenses, profits and assets, and liability risk charges. The premium to annuitize participants who have left the plan sponsor but not yet retired are slightly higher, due to early retirement risk and increased investment and mortality risk over a longer horizon. Some plan sponsors offer participants a lump sum. However, this approach is counter to the basic reason for a DB plan, which is to provide a lifetime income stream.
In summary, there is an array of de-risking strategies that can be employed over time - either alone or in combination with other strategies. Plan sponsors should do a cost benefit analysis to understand their risks and costs. Then, they can decide the appropriate levels for which to take action, and prepare to implement that strategy.
If a plan sponsor's ultimate goal is to shrink or terminate a DB plan, estimating the plan's economic or termination liability, or a subset of the liability, is an essential step. MetLife can prepare a reasonable estimate after reviewing the plan's actuarial valuation reports, though a more accurate cost would require individual participant data.
Like most group annuity contracts, MetLife group annuities contain certain exclusions, limitations, reductions of benefits and terms for keeping them in force. A MetLife group representative can provide costs and complete details.
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