Employee retirement plans have some hidden risks that aren’t always obvious. Did you know that certain required pension insurance costs regulated by the Pension Benefit Guaranty Corporation (PBGC) have increased nearly 400 percent in the last six years for the variable rate portion of the premium? You probably know that life expectancy is improving as well. In fact, according to the Society of Actuaries, there’s now a 50 percent chance that at least one member of a married couple currently age 65 or older could live to age 95? That’s longevity risk, and if your company still sponsors a defined benefit pension plan, that risk recently hit your balance sheet, and you probably didn’t anticipate it.
Defined benefit pension plans have long been a staple in the menu of employee benefit plans. But thanks to the Pension Protection Act of 2006, what was once a footnote on your financial statements is now a real liability on your balance sheet. Come this October, if your pension plan is underfunded (and most are), you’re going to pay a hefty 3 percent of that underfunded balance to the PBGC—and that’s just one cost that’s creating financial risk for your company. Assuming you implemented the new Society of Actuaries mortality table (RP 2014) your pension plan liability may have increased by 5percent or more. Combine these with low interest rates and volatile equity markets and you may just be reaching for that air-sick bag the next time you’re flying the friendly skies.
Investment risk you can hedge. Liquidity risk you can plan for. But, when plan expenses increase by 400 percent and you have to increase your pension liability on your balance sheet by 5 to 10 percent, you’ve got problems. So what’s a CFO or treasurer to do?
Managing pension risk
The insurance industry has been busy developing strategies that can help you manage these pension risks. There are buy-in, insured liability-driven investing, and buy-out solutions available from insurance companies that have considerable experience in these pension risk-transfer issues.
Let’s discuss the buy-in first. Your pension retirees have now put you in the insurance business. The annuity stream you owe to those retirees is set in stone. Whether you’re paying a life-only annuity to a single participant or a 100 percent joint and survivor annuity to a married couple, you’re now acting just like an insurance company. So, do you have the right asset in your pension trust to absolutely address the risks that you face with these pension obligations? Not likely. The buy-in is a group annuity contract that will pay out the scheduled benefits you owe month by month, year by year—whether that retiree lives to age 80, 85, etc. The point is, you’ve been managing that pension plan to make sure you have enough money to pay those benefits—and now those benefits are due.
The buy-in allows you to purchase an asset that truly matches your pension liability, and once the buy-In annuity is in place, you’ve addressed several of those financial risks we mentioned earlier. Therefore investment risk, liquidity risk and longevity risk are no longer an issue. Expense risk remains if you decide to keep these participants in your plan. If you’re worried about settlement costs, then you’ll likely hold onto the buy-in annuity for a year or two. And, when you’re ready to accept those potential settlement costs, it may be as simple as writing the insurance company a letter and asking it to convert the buy-in contract to a buy-out contract and you’re done. The conversion process is simple, and once you convert to a buy-out annuity, those retirees are completely off your balance sheet.
How about something that simply hedges your interest-rate risk? Have you ever heard of liability-driven investing (LDI)? Most of you with defined benefit pension plans have probably explored this concept with your investment advisers. Yet, your investment advisers have always “hedged” themselves a little, too. They may tell you things like, “You can’t buy the curve” [that would be the Citigroup Pension Discount Curve (CPDC) that you use to measure the liability for purposes of generally accepted accounting principles]. So, if you can’t “buy the curve,” what do you do? You’ll likely employ a “best efforts” LDI strategy and call it a day. But, what if you could actually “buy the curve”?
An insured LDI solution allows you to “buy the curve”. It is a group annuity contract that matches the same interest rates that are contained in the Citigroup Pension Discount Curve. And guess what? The insurer can actually use the word “guaranteed” and tell you that the insured LDI contract value will match your liability based on the CPDC and the projected benefit payment you provide. You can actually “buy the curve.”
Marty Menin is Director-Retirement Solutions Division, Pacific Life Insurance Company and a speaker at the upcoming AFP Annual Conference. Russ Proctor, FSA, CFA, EA is Director-Retirement Solutions Division, Pacific Life Insurance Company.