In my previous blog, I talked about risk as it relates to managing a defined benefit (DB) pension plan. The long and short of it is that risk is what happens when DB plan sponsors are busy making other assumptions.
Today, the combination of several factors—including market volatility, low interest rates and recent legislation—has created significant challenges for DB plan sponsors. Fortunately, the pension industry is helping plan sponsors manage these risks with a number of innovative approaches.
Plan design changes
I’ve had many conversations with plan sponsors who aren’t sure if their current plan design is as effective as it once was as a retirement benefit. Potential plan design changes include restructuring of benefits or a plan freeze.
Liability-driven investing (LDI) is an investment strategy that more closely matches the plan’s investments with the duration of its liabilities. It helps to reduce the interest rate/liability risk.
Instead of trying to just maximize the plan’s total return each year (most plans are heavily invested in equities), an LDI strategy involves investing primarily in bonds. The goal is to allow plan assets and liabilities to react similarly to interest rate changes.
Dynamic asset allocation
Dynamic asset allocation (DAA) is a form of LDI. It involves moving from a traditional total return investment strategy to one that more heavily uses long-term bonds over time.
As a DB plan becomes better funded each year (through additional employer contributions, investment performance and/or interest rate increases), the investment allocation is transitioned to an LDI strategy. This strategy is particularly effective for frozen DB plans.
Another way to manage the risks of a DB plan is to simply transfer it to someone else — either the plan participants or an insurance company.
- Transfer to plan participants. The most common way to transfer the risk is to terminate the DB plan or offer participants a lump sum payment. When that happens, the plan participant receives the benefit in the form of cash or an annuity.
- Transfer to an insurance company. There are two ways a plan sponsor can transfer risk to an insurance company: a pension buy-out or a pension buy-in. Both involve purchasing annuity products from an insurance company.
More to come!
I’ll take a deeper look at each of these options in future blogs. Until then, keep in mind that none of these risk reduction options should necessarily be considered cost reduction techniques. They are not one and the same.
Bottom line, there is no free lunch! Plan sponsors who are interested in managing their risks should carefully evaluate the different options available.
In addition to blogging here, I also tweet regularly about DB topics of interest. Click to follow me on Twitter- @scottruba.
Asset allocation/diversification does not guarantee a profit or protect against a loss. Use of DAA and/or any glide path does not guarantee improvement in plan funding status nor the timing of any improvement.
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.