Originality can be overrated, or perhaps more accurately the lack of originality can be underrated!
Take Star Wars: Episode VII – The Force Awakens for instance, a movie that has grossed approximately $1 billion even though it essentially rehashes the plot of the original Star Wars from 1977 scene by scene. Sure, Han Solo is way older, but many elements of Ep. VII feel incredibly familiar.
- Starkiller Base is just like Death Star, but…you know…BIGGER!
- We need that Force-kid from the desert planet to destroy it!
- Did we mention it has a built-in self-destruct button if you hit it just right?
Far be it from me to criticize incredible marketing and commercial success based on recycled material. On the contrary, I embrace it! Luckily, the issues facing plan sponsors in 2017 very closely resemble those of 2016, so I proudly present:
7 Habits of Highly Successful Plan Sponsors: The Sequel!
A year ago, the original “7 Habits” blog post generated rave reviews and a record box office. The 2017 edition includes many of the same characters and plot lines, but with some fresh new twists!
- Understand the impact of interest rates on your plan’s liabilities
If you read last year’s blog, you now know that pension liabilities move 10 to 15 percent – in the opposite direction — for each one percent change in the corporate bond rates used to value them.
Corporate bond rates went on a wild ride last year. They dropped steadily through July to a bottom about 80 basis points below January levels (pushing liabilities up 8 to 12 percent). Fortunately for sponsors, they have since recovered to just slightly below year-ago rates.
If you are using a liability driven investment (LDI) strategy, this wasn’t much of an event for you as your assets and liabilities would have moved consistently with one another. If you’re still traditionally invested in equities and core bonds, however, it was quite a funding-ratio roller coaster ride. Mercifully, we wound up back at the station with nothing but butterflies in our stomachs and a newfound appreciation of interest rate risk.
- Factor the plan’s funding ratio into asset allocation decisions
Say it with me, “The risk in my DB portfolio should be calibrated to the need to take it!” And the need to take it is tied directly to the market value funding ratio of your plan.
If your market value funding ratio is weak, then taking equity and interest rate risk is a logical action to help close the gap and minimize your cash requirement. If your market value is strong and you haven’t committed to an LDI strategy featuring duration-matched, high quality bonds, you may really want to reconsider (see Habit #1)!
- Consider a lump sum window
By now you know that I’m essentially neutral on the question of lump sum windows, but 2017 presents one last tactical opportunity for plan sponsors who are considering transferring risk to former employees through lump sums.
The mortality assumption used to convert pensions to lump sums is almost certain to change in 2018 (see Habit #4). This means that sponsors have one more year to pay out benefits before an estimated mortality-related cost increase of 3 to 5 percent.
Since rates ended 2016 in a favorable position, 2017 offers one final opportunity to transfer risk and shave down PBGC premiums at reasonable cost. (Though I’d be remiss if I didn’t mention that an additional increase in bond rates of about 30 basis points would offset the impact of the mortality increase.) If you’re interested, though, you’d best get moving; administration takes time!
- Ponder mortality
As mentioned above, the IRS finally committed to new mortality assumptions for minimum funding and PBGC premium purposes for 2018. So the 3 to 5 percent increase expected for lump sum payments will hit those calculations as well. Sponsors should take note of this change, though it’s impact comes in a distant third when compared to the potential effects of interest rates and investment returns.
The pension world thankfully seems to be moving into a period of general calm regarding mortality assumptions. For the next several years, most sponsors should see only very slight changes in liability due to periodic adjustments in mortality improvement scales as new data is released by the Social Security Administration.
One area that may cause some ripples is clarification of regulations for the use of customized mortality assumptions rather than IRS standards, but the costs associated with analyzing and constructing acceptable alternatives seem to outweigh any potential benefit for all but the largest plans.
- Reduce PBGC premiums
The only thing released more frequently than Star Wars sequels are PBGC premium increases. For 2017, the flat rate premium increases $5 to $69. The more impactful variable rate premium jumps from 3.0 to 3.4 percent of the plan’s unfunded liability (up to a maximum cap of $517 per person.)
Sadly, these will be at least $80 and 4.2 percent respectively by 2019. With inflation like this, sponsors are naturally pulling out all of the stops to minimize premiums by reducing plan headcount and/or unfunded liability. (Possible actions include: Contribution timing, lump sum windows, and review of filing method and assumptions.)
I strongly encourage sponsors to contact their actuaries to review options. The effectiveness of different measures varies from plan to plan, and they can also impact minimum funding and accounting results.
- Set a funding policy
A rational funding policy should consider the true objectives for the plan and the financial capabilities of the sponsor. Hopefully, sponsors have already implemented rational funding policies rather than blindly following the minimum contribution requirements under the Pension Protection Act.
If they haven’t, they may be in for a surprise this year due to the potential “Return of the Minimum Contribution” (I think that’s Episode III.) Three rounds of funding relief from 2012 through 2015 have extended the use of higher interest rates to calculate minimum contributions.
The effect of this relief is beginning to erode, however, and many plans will use effective interest rates at or below 6% for 2017. The structure of this relief rule ensures that the funding rate will likely continue to drop for at least several more years.
As a result, sponsors that were exempt from contributing when measured at forgiving interest rates may be put back onto a required schedule, regardless of what their current funding policy is. (And a number of them may be out of practice due to the relief-driven contribution holiday.)
- Search for administrative efficiencies
One thing that certainly hasn’t changed is that HR departments would much rather spend their time doing almost anything besides administering defined benefit plans. This goes double if those plans are already frozen.
Though it comes with costs, outsourcing of data maintenance and participant services is a logical consideration for employers looking to devote fewer internal resources (with associated soft dollar costs) running plans that may no longer be the primary retirement benefit for current employees.
Time to awaken!
If you missed the original blog, I encourage you to read it. (It has a satisfying nostalgic feel, though the special effects are beginning to feel a bit dated.)
If you did read the original but didn’t act, you lucked out. Fortunately, 2016 turned out to be somewhat of a free pass for plan sponsors. We were able to witness interest rate volatility without being significantly harmed by it, and we got a one year reprieve on mortality liability increases.
Like a familiar sequel, 2017 offers a fresh opportunity to enter into the story, and to apply the “7 Habits of Highly Successful Defined Benefit Plan Sponsors”.
Mike Clark is a fellow of the Society of Actuaries (SOA) a member of the American Academy of Actuaries (AAA), so the numerous nerdy Star Wars references pose little risk to his street cred.
The subject matter in this communication is educational only and provided with the understanding that 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® (Principal®), Des Moines, IA 50392.