Yes, there are still many companies that maintain defined benefit plans, but most ceased crediting benefits years ago to stop the pension liability growth. However, even though the majority of Fortune 100 and 500 companies have frozen their plans, they often still have contributions due for what participants have already accrued, as plans typically aren’t 100 percent funded at the time they are frozen. If a company hasn’t settled its obligation or transferred the risk, then it still owns it.
Rich McCleary, Director, Actuarial Service, at Tegrit Group, says, “It’s a popular discussion topic. Our firm has over 300 defined benefit plan clients with whom we work, and many traditional plan sponsors we talk to want to find a way to terminate their plan.”
Smart Business spoke with McCleary about how business owners can mitigate their defined benefit plan risk.
How do defined benefit plans differ from other retirement plans?
A defined benefit plan promises a certain amount of benefits, typically in an annuity form, at retirement to plan participants. The company contributes to the plan and maintains the obligation to provide those benefits once they are earned or accrued. Much like the Social Security system, promises to plan participants are virtually irrevocable. If a company can’t fulfill them, the Pension Benefit Guaranty Corporation (PBGC), the governmental agency that insures pension plans, will step in.
What’s the current situation for defined benefit plans?
On the investment side, pension plan performance has been lackluster over the last decade, remaining steady or decreasing slightly against expectations. In addition, in this severely declining interest rate environment, liabilities have consistently gone up. Along with that, the federal government has continually passed regulations to make the funding requirements more stringent.
Companies maintain this liability and risk on their balance sheets, and the liability remains until the last participant or contingent beneficiary is paid out. Manufacturing in particular has been hit hard, as the industry often used these plans to meet union benefit demands. Also, the liabilities on the balance sheet don’t truly reflect the entire economic cost of the plan. There are numerous administrative expenses, such as fees for investment management, actuarial, legal and accounting, as well as PBGC premiums, which can add 3 to 5 percent to the liabilities.
What are some strategies for plan sponsors to mitigate risk?
Liability-driven investments are a popular way to drive down the risk. Investment managers can help with transferring the risk into fixed income investments that closely match the duration of the pension liabilities.
In order to reduce their pension risk, some large companies have offered lump sum payments to retirees and beneficiaries. Although there might be a higher initial cost, the pension liability is transferred either directly to the participant or an insurance company, which improves the stability of the balance sheet and ultimately, shareholder value. Amazingly, some companies have pension plans with liabilities that approach or exceed the total market capitalization of the company, creating volatility and jeopardizing profits.
Although a smaller company may not be publicly traded, it can find ways to get the necessary cash from other sources besides loan covenants or issuing bonds. As an example, one business took out a second mortgage on its building because it happened to be cheaper at the current mortgage interest rates and loan period than paying down the pension plan liability. However, there are accounting and tax implications that occur when transferring risk, so use expert advisers to carefully review the balance sheet and make sure the risk transfer makes sense.
Rich McCleary is Director, Actuarial Service at Tegrit Group. Reach him at (330) 983-0539 or firstname.lastname@example.org.
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