Just when the value of pension assets has plummeted, the funding requirements for companies with defined benefit plans are scheduled to rise in 2009. Staying on top of the plan’s funded status, required contributions and financial statement impacts round out the daily to-do lists of plan sponsors.
“It’s not a time to panic, but it’s definitely a time to be vigilant. Plan sponsors are feeling bombarded now with the market swings, so you’ve got to stay on top of your risk position,” says Michael Ford, senior investment consultant with Watson Wyatt Worldwide.
“Make sure you understand your current situation and have the right planning processes in place to do accurate modeling and forecasting, because you really want to avoid surprises,” says Christine Tozzi, retirement practice leader at Watson Wyatt Worldwide.
Smart Business spoke with Ford and Tozzi about how companies should manage their plans in the current environment.
What risks does the current economic volatility pose for pension plans?
Tozzi: The falling asset values will cause the plan’s funded status to decline. This requires employers to infuse cash in order to comply with IRS pension plan requirements. The cash needs will be magnified in 2009 because of the investment losses. In addition, under the new Pension Protection Act if a plan is not funded to minimum thresholds under the law it may need to restrict lump sum payments or temporarily freeze plan accruals entirely until the plan’s funded status improves. Meeting those funding thresholds will be difficult in this current environment. In addition to cash, pension expense in the company’s P&L statement may increase significantly due to asset losses.
Ford: The current environment is different than the last major downturn in the equity market in 2000. This time corporate bond yields have risen as a result of weakness in credit markets and the liquidity crisis. Since pension liabilities are valued using the AA corporate bond yield curve, liabilities have decreased somewhat offering some relief. But, the drop in assets more than offsets the decrease in liabilities, which has led to large decreases in a typical plan’s funding ratio.
Are there other solutions for underfunded plans?
Tozzi: Companies may be able to find some small relief from the significant cash funding that will be required. Sponsors could use an asset averaging method, which would factor in years when asset balances were higher. Alternatively, if employers have made larger-than-required contributions in prior years, they may be able to apply those credit balances to help meet 2009 funding requirements. They also may be able to change to a spot interest rate basis for measuring liabilities to capture the fact that today’s bond yields are higher, which lowers costs. We may see some legislation that will provide temporary relief to plan sponsors to minimize the additional cash that could be required due to the events of 2008.
What are the best funding strategies?
Ford: It’s important to remember that the risk in your plan’s asset allocation model and risk profiles within various asset classes have changed. Review your investment strategy in light of both the increased economic risk and liquidity risk to see if the model will still deliver its intended results. Revisit your plan’s fundamentals and your company’s risk tolerance to see if your plans and strategies are still in line with those philosophies.
Tozzi: Run models to see how the plan’s assets and liabilities will fare under a variety of investment returns and bond yield swings and develop contingency plans to deal with each situation. Preview the numbers more frequently and ride out some of the market’s ups and downs until things stabilize. Continue to monitor your plan governance processes and hold additional meetings to review your programs and investment options.
How should sponsors manage the increased cost for retirement plans?
Tozzi: In addition to updating budgets, it’s important to remember the long-term objectives for offering retirement programs to employees and balance that with the short-term impacts. As long as the retirement program is aligned with the company’s objectives, it is best to be patient. A Watson Wyatt survey shows that very few employers have plans to actually freeze benefits.
Ford: Plan sponsors can also consider and outline alternative asset allocation strategies, which may reduce volatility and the need for cash infusions down the road.
What should plan sponsors communicate to participants?
Tozzi: If the company offers a pension plan, sponsors should reinforce that prior benefits that have been accrued are protected. Update participants about the plan’s funded status and tell them that the company intends to make its scheduled minimum contribution. Plan sponsors want to communicate the truth, but also allay the fears of participants as much as possible.
Ford: Sponsors of defined contribution plans, such as 401(k)s, should communicate the implications of what’s going on in the market in a transparent and empathetic way, but making sure not to offer explicit advice. Remind participants that retirement investing is a long-term proposition and cite prior bear markets as proof that the current situation is not unprecedented. <<
MICHAEL FORD is a senior investment consultant with Watson Wyatt Worldwide. Reach him at firstname.lastname@example.org or (818) 623-4754.
CHRISTINE TOZZI is a retirement practice leader at Watson Wyatt Worldwide, San Francisco office. Reach her at email@example.com or (415) 733-4346.