How to tackle pension underfunding issues Featured

11:50pm EDT March 31, 2012

Although the stock market has rebounded, most defined benefit pension plans are still facing difficult decisions related to their retirement philosophy and related workforce strategy. General Motors, Sears and Bank of America are a few of the companies that have recently announced major plan changes, but even small and mid-size companies are reviewing their retirement strategy.

The underfunding and asset-liability mismatch continues to challenge plan sponsors. According to the 2012 MetLife U.S. Pension Risk Behavior Index Study, plan sponsors no longer believe they can rely on traditional portfolio diversification alone to meet future obligations; many are considering changes.

“Despite on-going cash funding of pension plans over the past 10 years, many plan sponsors still find their plans underfunded due to market volatility and low interest rates,” says Steve Parsons, FCA, MAAA, and principal with Findley Davies, Inc. “This situation has resulted in employers reevaluating their pension strategies. This evaluation process includes a review of potential changes to plan design, funding, and asset allocation strategies. Several have reduced their commitment via plan changes, plan freezing, or terminating a defined benefit pension plan.”

Smart Business spoke with Parsons about the current pension underfunding crisis and the possible solutions for plan sponsors.

Why has pension underfunding reached a crisis point?

Although pension portfolios took a hit during the 2008 market correction, the current crisis has really been brewing over the last 10 years. Marketplace volatility, low interest rates and changes in accounting procedures and cash funding rules have converged and boosted the number of companies with underfunded plans by 20 to 30 percent. The Pension Protection Act of 2006 reduced the opportunity for employers to have funding strategy options and now requires them to fund shortfalls over a seven-year period. The bottom line is that companies have taken this opportunity to reevaluate their retirement strategy and philosophy. As a result, employers tended to elect one of three paths: maintain their commitment to the current plan, keep their current plan with a reduced formula, or freeze their pension plan and shift to a 401(k) strategy.

When is freezing a plan a viable solution?

Defining options and strategy can empower an employer to properly align market competitiveness, cash funding strategies, and strategic work force plan. When evaluating a freeze to the pension plan, an employer should consider how the decision to freeze its defined benefit pension plan will impact talent acquisition, morale and retention down the road.

Freezing the pension plan can be accomplished several ways, including closing the plan to new participants, partially freezing the plan that protects older participants, or a hard freeze impacting all participants.

A soft freeze allows companies to grandfather the current plan for older employees based on age and/or service and move everyone else to a 401(k) plan. A hard freeze shifts the risk to all employees via a defined contribution plan from the plan freeze date forward. The transition may cost the employer more to shift to a 401(k) plan in the interim years as the employer continues to fund the pension plan while contributing to the new 401(k) strategy.

What are employers doing to target plan termination in the future?

Terminating the plan and providing a lump-sum payment or purchasing annuities with the proceeds is certainly an option for participants. But given today’s low interest rates, most companies need to provide additional funding to purchase annuities that fulfill their long-term pension obligations. The key is connecting your actuary, financial staff, and investment advisors, defining the glide path and seeing when it might be advantageous to pull the trigger. We could see higher interest rates or get regulatory relief down the road, impacting the timing of the decision. As of now, about a third of our clients are committed to their current plans, a third have frozen their plans and shifted the risk of retirement planning to employees, and a third are still considering whether to freeze or terminate their defined benefit plan in the future.

Should employers be considering other solutions?

Employers should redefine their pension strategy in relation to total rewards and how they want to allocate internal resources in the future. For example, administrating a frozen plan may not be the optimal use of internal staff and resources. They will also need a comprehensive communications plan to explain pension plan changes to current staff and retirees. If stakeholders will be assuming responsibility for selecting investments and planning for retirement, they should be given the opportunity to provide feedback through a compression planning process. All of these issues must be considered and addressed before a company decides to freeze or terminate their defined benefit pension plan.

What’s the best way to evaluate the various options and select the right solution?

Consider how each option will impact the company and employees both short-term and down the road, because among other things, companies may no longer be able to control turnover or the timing of employee retirements if they switch to a defined contribution plan. Examine the impact of the change on administrative policies and procedures to determine the cost benefit of internal versus external management to minimize cost and liability. For a frozen or terminated plan, allow sufficient time for the transition, because employees will need considerable education before they’re ready to take the reigns of their retirement planning process. Finally, don’t be hasty. The solution to the pension plan crisis is different for everyone and changes can be reevaluated down the road if the pension plan is maintained in either an active or frozen state.  This will give employers options for future work force issues and strategies.

Steve Parsons, FCA, MAAA, is a principal with Findley Davies, Inc. Reach him at (216) 875-1924 or SParsons@findleydavies.com

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