Ever since I began writing the Principal Financial Group® defined benefit (DB) blog in June 2014, our well-meaning and extremely patient communications team (affectionately known as “my handlers”) have implored me to write in a style better suited for the Internet age.
It seems you can’t get readers to read blogs until you get search engines to read them first. With each blog submission, my handlers grit their teeth and make some polite suggestions:
- “Put a number in the title!”
- “You have to use lists!”
- “People want bullet points!” (See what I just did there?)
As a reward for my handlers’ perseverance, and as a service to plan fiduciaries everywhere, I am pleased to present:
7 Habits of Highly Successful Defined Benefit Plan Sponsors!
Thoughtfully delivered in convenient list format. Perfectly designed to rise to the top of web searches so you can secretly read them off your smart phone during your next DB planning meeting!
1. Understand the impact of interest rates on your plan’s liabilities
The liabilities of a typical DB plan move inversely by 10 to 15 percent for each one percent change in the interest rate used to discount future benefit payments. Corporate bond rates have been low for a long time now, but measurable rate increases would reduce plan liabilities significantly. This would introduce valuable opportunities to hedge [through liability driven investment (LDI) strategies] or transfer (through annuity purchases or lump sums) your plan’s pension risk.
The sensitivity of a specific plan’s liabilities to interest rate movement depends on the design and demographics of the plan:
- Longer duration plans — those with younger populations and traditional monthly paid benefits — are more sensitive to interest rate movements.
- Older populations and cash balance plans tend to have shorter durations and react less to rate changes.
Note that different types of benefits with different durations can exist within a single plan as well.
2. Factor the plan’s funding ratio into asset allocation decisions
The lower the market value funding ratio, the more logical it is to take additional risk to generate returns. But as a plan approaches full funding on a market value basis (particularly frozen plans looking to terminate), hedging against downside risk becomes more important than chasing overall returns.
The only way to know your plan’s position is to get periodic reporting of liabilities at current interest rates vs. the market value of plan assets. Many plan sponsors have adopted dynamic asset allocation (DAA) strategies that formally adjust the plan allocation based on the funding ratio:
- More return focused at lower ratios
- Greater emphasis on LDI hedging at higher ratios.
3. Consider a lump sum window
Offering a temporary lump sum “window” to terminated vested employees (no longer employed but not yet receiving a pension) has been gaining popularity for several years now. This approach offers a way to transfer risk directly to individuals without adding an expensive, permanent feature to the plan.
The impending adoption of longer mortality assumptions by the Internal Revenue Service (IRS) in 2017 for the calculation of minimum lump sums has added additional urgency. That’s because paying out in 2016 could save five to 10 percent of the overall cost. (Though future interest rate movement should also be considered.) Aggressive Pension Benefit Guaranty Corporation (PBGC) premium increases have added additional fuel to the lump sum window fire.
No two plans are the same, so analysis of a lump sum window’s impact on plan funding, accounting, and PBGC premium levels should be done before proceeding. You better get moving quickly though if you want to get the payouts administered by year-end!
4. Ponder mortality
You don’t have to go all Hamlet, but it is important to understand the impact that mortality (or more specifically, less of it) has on your plan.
The Society of Actuaries released their new generational mortality assumptions in 2014, and they updated the improvement scales last year. Generally, longer assumed lives mean more benefit payments and higher liabilities. Although the precise impact of the change varies greatly based on the demographic makeup of your plan.
You’ve probably already booked a significant accounting liability for this change. But the impact to minimum plan funding, lump sum conversions and PBGC premiums won’t occur until 2017. We still don’t know exactly which tables the IRS will use, but you may want to request estimates from your actuary now.
5. Reduce PBGC premiums
The Bipartisan Budget Act of 2015 included the third major increase to PBGC premiums in three years. Since premiums paid to the PBGC have no benefit to your plan (unless you’re going to declare bankruptcy) you should do everything in your power to minimize your assessment.
Each plan is different, but there are ways to potentially reduce premiums that you should discuss with your actuary if you haven’t already:
- Making additional contributions
- Assigning contributions as “receivables” to the prior plan year
- Switching from the “alternative” to “standard” filing method
- Offering a lump sum window to reduce head count
6. Set a funding policy
Many plan sponsors have historically used the ERISA minimum contribution requirement as a default funding policy. But three rounds of pension funding relief laws have reduced minimum contributions almost to the point of insignificance, forcing plan sponsors to consider what funding is actually appropriate rather than just required.
Before blindly accepting government-offered funding holidays (which they consider tax revenue generators) you should consider the long-term objectives of your plan. Market value (or termination) liabilities are significantly higher than the liability used in the minimum funding calculation, so minimum funding may not get you where you want to go. Keep your eye on the appropriate target when planning your annual contribution.
7. Search for administrative efficiencies
A significant number of DB plans still have “in-house” staff provide many plan services, absorbing large chunks of valuable Human Resources time and exposing plan sponsors to risk of miscalculation and non-compliance. Plan sponsors should consider the benefits of outsourcing DB plan administrative services to improve both the employee and plan sponsor experience. After all, that decision was probably made years ago regarding the defined contribution (DC) plan.
Outsourcing to a provider with strong DB expertise may increase hard dollar costs, but the addition of call centers, web access and education resources can provide significant value. Soft-dollar costs of freeing up internal staff time should also be taken into account.
You know, maybe my handlers have had it right all along. With these seven easy habits, you will surely be the smartest one in the room at your next retirement committee meeting and well on your way to being a highly effective DB plan sponsor!
But more importantly, we are going to get a ton of hits on this post!
Mike Clark’s 2 Top Actuarial Certifications!
- Fellow of the Society of Actuaries (SOA)
- Member of the American Academy of Actuaries (AAA)
The subject matter in this communication is provided with the understanding that The Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
No investment strategy, such as diversification or asset allocation, can guarantee a profit or protect against loss in periods of declining value.
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.