Sponsors of defined benefit (DB) plans face big challenges. These challenges usually happen when business (like life) doesn’t quite go as planned.
Here’s an example. To make sure there’s enough money in the DB plan to cover future payments to participants, the plan sponsor funds the plan over time. To do that, certain assumptions are made over the life of the plan, usually relating to:
- Investment performance. How will the investments (including stocks, bonds and other investments) in the plan perform?
- Plan cost. What is the cost of the plan in order to meet the promises the plan sponsor has made to the participants? This is referred to as the plan’s liability and is calculated assuming specific interest rates. Because there’s an inverse relationship between interest rates and plan liabilities (as interest rates go down, plan liabilities go up, and vice-versa), changes in interest rates can have big impacts on the plan’s liability.
- Longevity. Will there be enough plan assets to last the lifetime of all plan participants once they retire and start receiving pension payments?
So what’s the problem? Well, nobody can predict the future (sorry, my Actuarial friends). And the assumptions discussed above often differ from what actually happens.
In the end, it all boils down to this. No matter what assumptions were made, the plan sponsor is on the hook to make the pension payments that have been promised. That presents a lot of risk for plan sponsors.
Over the past five years, we’ve seen especially volatile market performance (remember 2008, anyone?). We’ve also seen historically low interest rates. Both of these factors have led to significant volatility in DB plans. This volatility has wreaked havoc with DB plan sponsors and has driven their desire to reduce risk.
The silver lining in all of this is that the DB market has reacted with innovative products and services to address these risks. I look forward to introducing you to some of these innovative ideas in my future blogs.
In addition to blogging here, I also tweet regularly about DB topics of interest. Click to follow me on Twitter- @scottruba.
While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.