As pension plan administrators wrestled with the new funding mandates and the mark-to-market requirements imposed by the Pension Protection Act (PPA), the bottom dropped out of the financial markets, pummeling asset returns. As a result, many employers froze existing plans and adjusted asset allocations on the fly.
Now that officials have granted employers a brief reprieve from PPA funding mandates and the financial markets have rebounded from their 2008 lows, embattled plan administrators have a brief window of opportunity to revisit the fundamentals and craft a comprehensive pension strategy that reduces volatility and risk and increases asset levels to meet future funding targets.
“Although the calamity has abated to some degree, the risk of market volatility persists, the government has not backed away from its original funding targets and current investment strategies may not be appropriate for a post-PPA world,” says Pete Neuwirth, senior consultant for the retirement practice at Watson Wyatt Worldwide. “Employers should use this time to prepare for future crises.”
Smart Business spoke to Neuwirth about the challenges facing employers offering defined benefit pension plans and the elements they should revisit during this brief respite.
How can employers mitigate escalating pension costs?
Many employers have opted to pay the least amount possible into their plans, without considering how those decisions might impact required contributions down the road. This strategy may ease short-term cash flow, but even companies with currently well funded or frozen plans need to manage their risks. If assets are currently sufficient, plan liabilities will still likely grow faster than assets as future benefits accrue, and even for frozen plans, the value of accrued benefits will continue to grow as employees near retirement. Since the ultimate cost of a pension plan is the cost of benefits paid minus investment income and contributions, the best ways to mitigate increasing costs are through plan redesign and improved asset performance. Employers should use this breathing space to reassess their liabilities and asset allocations to reduce income volatility and control costs.
How has PPA impacted funding policies?
PPA drives employers toward 100 percent funding for pension liabilities and most have been well below that target. This means that many employers will have to pay normal costs plus a seven-year amortization payment on any unfunded liability. Additionally, PPA curtails an employer’s ability to pay more in good years and draw against those credit balances in bad times. When reviewing existing funding policies, employers need to know their funding target date and be cognizant of credit balances, so they can make informed decisions on whether and when to use or give them up. On the positive side, PPA gives employers some limited flexibility to use spot market rates or 24 month average rates in their funding assumptions, but those decisions need to be calibrated with the company’s investment strategy, because each option has advantages and disadvantages and one solution will not fit all.
Should employers review plan design?
Roughly one-third of the Fortune 1,000 offering defined benefit pension plans have now frozen those plans. Others have changed to a hybrid model, and 55 percent of the Fortune 100 now put new hires into a defined contribution plan. Employers need to reassess these decisions to see if this is the right strategy going forward, especially now that assets have rebounded. A recent Watson Wyatt survey reveals that traditional pension plans are highly valued by employees, so employers must consider the impact of changes on other HR objectives as well as the financial risks associated with interest rates, asset returns, longevity and inflation. If an employer is committed to a defined plan, sharing the risk with employees through a lump sum option, cash balance or a hybrid plan or moving the benefit calculation from a final average to a career average can help to mitigate the risks.
How can employers manage the volatility in asset returns?
Many employers were caught off guard by the quick drop in the market and were then reluctant to sell devalued equities for fear of missing the rebound. Given the improvement in equities, now may be a good time to revisit your company’s risk position in light of future funding requirements. Traditionally, many administrators favored high-risk positions offering higher long-term returns. Those positions no longer make as much sense because under PPA the risk is asymmetrical, meaning that the possible downside from high-risk investments exceeds the possible upside. In a recent survey conducted among 80 financial executives, two-thirds have made or are planning to make policy changes in 2009 and 2010 to asset allocations, while more than half have already made changes or are planning to make changes to investment lineups.
How has PPA impacted the assumptions and methods for calculating pension expense?
Key assumptions such as the discount rate, salary scale and long-term rate of return can impact the pension expenses reflected on a company’s financial statements, so it’s important to forecast cash and expense using a range of assumptions. For example, simply changing asset allocations from equities to a more conservative mix of bonds may cause auditors to reduce the expected rate of return in the assumptions. Since this can have a broad impact on company finances, including the interest rate paid on borrowed funds, it’s important to consider how an investment strategy integrates with funding and accounting strategy. Despite an anticipated adjustment in the accounting rules, for now, a holistic management strategy remains the best way to avoid the impact of the next crisis.
Pete Neuwirth is a senior consultant for the retirement practice at Watson Wyatt Worldwide. Reach him at (415) 733-4139 or Peter.Neuwirth@watsonwyatt.com.