The Case for Freezing Pension
Plans
March 22, 2006 (PLANSPONSOR.com) - New
research from Towers Perrin looks into the challenges presented to
employers by defined benefit pension plan risk, why employers are
freezing plans and the unmet need for solutions to manage the
risk.
The Case for Freezing Pension Plans
Interviews with over 100
senior and finance executives across various industries found that
57% of companies considered pension-related risk significant
relative to other financial and operational risks they
faced. Though companies with plans that are well
funded or whose cash contributions have minimal effect on earnings
or cash flow view the risk as being manageable over the short term,
most senior executives voiced concern for the potential effect of
the plan on company credit ratings and cash flow.
The Case for Freezing
Pension Plans
Many employers have responded
to this risk threat by freezing their pension
plans. Thirty-two percent of the companies
interviewed by Towers Perrin had closed their plans to new
entrants. However, freezing plans may not be
desired by companies who still consider their DB plan a valuable
employee recruiting and retention tool, and, as a recent study from
SEI concluded, it does not alleviate all risks (See Study Warns DB Plan Freezing Doesn't
Mitigate All Risks). Towers Perrin said in its report,
"Freezing defined benefit plans, though popular, is a half-measure
that slows the growth of the plan, but does little to alleviate the
market and mortality risk associated with the legacy pension
plan."
Other than company-specific
factors such as the size of the pension deficit, maturity of the
plan or overall company finances, companies are also freezing DB
plans or considering freezing them due to recent and pending
regulatory changes (See Plan Sponsors Not Waiting for Reform to
Consider Pension Options and Poll: Pension Reform Will Contribute to
Plan Terminations).
In the Towers Perrin research,
72% of executives with active plans said they would consider
freezing their plan if the Financial Accounting Standards Board
(FASB) were to eliminate accounting smoothing mechanisms, while 62%
of respondents said they would consider freezing if tighter funding
requirements were enforced.
The Towers Perrin study also
indicated that employers choose to freeze their DB plans because
they are generally dissatisfied with other options available to
them. Terminating the plan entirely through
annuitization represents a cost-prohibitive option for even the
best-funded plans due to the conservative market return and risk
assumptions insurance companies use to price pension termination
annuities. Other options companies might
consider, and their downside, include, according to Towers
Perrin:
-
Altering Asset
Allocation: Due to the volatility
of the stock market, some companies have been tweaking their
portfolios to include a higher percentage of assets in alternative
vehicles such as hedge funds and property
investments. While altering the asset
allocation mix can help decrease a funding gap by generating
higher returns, focusing on the asset side can only go so far in
addressing risk because returns are volatile and are often not in
line with liability payments.
-
Cutting Operational
Costs: While DB administration
costs are often overshadowed by the costs of the liabilities, some
companies have turned to cutting cost by outsourcing
administrative parts of the plan and combining multiple services,
such as actuarial and investment management consulting, under a
single provider. And although some companies
have realized some efficiencies and cost savings from doing so,
these operational solutions haven't captured much traction in the
marketplace, primarily because they fail to adequately address the
greater financial risks that are top-of-mind among
executives.
Senior financial executives
feel the current choice of DB plan solutions are either too
expensive or ineffective at managing risk.
Other
Options
As part of Towers Perrin's
research, the executives were asked to evaluate several potential
solutions, some which are not widely available on the market
today. Their reactions demonstrate that an unmet
need does indeed exist in the marketplace, as does a willingness to
adopt new solutions, provided they have been validated and tested,
Towers Perrin said.
Suggested possible solutions,
and respondents reactions, were:
-
Third-Party Plan Transfer: This
type of risk transfer entails "spinning off" the plan to a third
party, likely a large investment or commercial bank, which would
take responsibility for managing risk and meeting
liabilities. Executives found this option
compelling, especially those who have explored annuitization but
found it to be cost-prohibitive. Executives
indicated that their key concerns about this solution would be
long-term feasibility, potential conflicts of interest with
counterparties, and the cost of the
transaction.
-
Pension
Insurance: As a way to
protect pension plans from downside risk in the market, purchasing
pension insurance is an option that is not readily available in
the market, largely because the insurer would be required to cover
any portfolio losses if the market were to fall below a certain
percentage point. Many considered insurance a feasible
alternative to more sophisticated financial instruments if the
pricing was attractive.
-
Liability-Based Asset
Management: An increasingly well-known method of
matching market returns more closely to liabilities,
liability-based asset management - which involves reducing risk by
lengthening the duration of a plan's bond portfolio -i s already
being considered by several corporate pension
committees. More than half (52%) of executives
said that using sophisticated financial instruments would be the
most interesting solution given their companiesEsituation, and
many companies are already using this method of asset
allocation.
-
Captive-Based
Solution: One of the more innovative solutions
tested in Towers Perrin research, the use of a pension captive,
which would reinsure pension liabilities, generated some interest
as an innovative solution to mitigating risk.
Key benefits of this solution include: Access to surplus
assets - Companies are able to access and use any surplus
assets generated by the plan in excess of those required to meet
annuity obligation; Secure plan benefits - EmployeesE
benefits are insured by a highly rated commercial insurer;
and Active asset management - Because the plan
is backed by an annuity, companies are able to undertake more
aggressive investment strategies. Executives who currently use
captives in their organizations and have a general familiarity
with them, as well as companies with fully funded pension plans,
were the most interested in the captive
approach. Nearly one-quarter
(23%) of respondents said they use captives to
protect against risks in other areas of their
organization. However, those who are less
familiar with captive insurance models or whose defined benefit
plans are far from being fully funded felt the solution was less
appropriate for their situations.
More information can be obtained by
emailing Matt Herrmann at Towers Perrin, matt.herrmann@towersperrin.com.
Rebecca
Moore editors@plansponsor.com |