Reducing Pension Plan Risk – Updated to Reflect IRS Notice 2019-18

Mar 10, 2019 | Defined Benefit Plans, Pension Risk

Reducing Pension Plan Risk – Updated to Reflect IRS Notice 2019-18 | Watkins Ross

RISK IN PENSION PLANS

Risk is often associated with the opportunity for great gain at the cost of opportunity for great loss. Risk exists in a pension plan because the annual and ultimate cost of the plan is sensitive to factors such as market swings, life expectancy improvements, PBGC premiums, pension legislative changes, changes in tax code, and other uncontrollables. Some of these factors affect legally required minimum funding, some affect the real cost of the plan (the real cost of paying all benefits due and administrative expenses over the life of the plan), and most affect both. Most of the risk in a pension plan offers little opportunity for gain, so a plan sponsor should annually consider whether there are risk elements in the plan that can be eliminated.

APPROACHES TO REDUCING PENSION PLAN RISK

In very general terms, there are four approaches to de-risking:

  • Allow lump sum payments from the pension plan to individuals who have terminated employment
    This strategy removes risk of future mortality improvements and interest rate fluctuation with regard to the future benefit streams that are instead paid as a lump sum. There are varying degrees of offering lump sums:  to all terminated employees, at retirement age only, up to a stated threshold, or as a “window” opportunity for terminated employees. In early 2019 the IRS and Treasury issued Notice 2019-18, opening up an opportunity that may allow plans to offer lump sums to retirees in pay status in lieu of the continuation of the monthly benefit (they had removed this option in 2015 via Notice 2015-49). When individuals are paid their benefit as a lump sum, they are removed from the plan, thus reducing per-participant PBGC premiums and alleviating the administrative cost of tracking these former employees.
  • Use a Liability Driven Investment (LDI) asset management approach
    This strategy involves investing pension assets in vehicles that match the future pension plan cash flow needs. As a plan matures and has greater cash outflows and a shorter time horizon, a larger portion of investments under this approach will be directed to fixed income vehicles to preserve capital and reduce the impact of market swings.
  • Transfer longevity risk via use of insurance company products
    Purchasing annuities for retirees in pay status provides a secure vehicle outside the pension plan to continue the retirees’ lifelong benefit payments. Although this approach may be expensive to complete, there are creative options that can be employed when teaming up with experienced pension risk transfer professionals to hedge costs, such as buying into a group annuity contract rather than purchasing individual annuities. This approach will reduce per-participant PBGC premiums and alleviate administrative cost of tracking retirees. Your retirees will experience easy transition with no disruption to their monthly benefit payments.
  • Plan termination 
    The ultimate de-risking action is to terminate the pension plan and pay out all benefits to participants via annuity purchases and/or lump sum payments. If your plan is frozen, plan termination is probably your goal as soon as feasible. Sponsors may want to consider financing the cost of plan termination if the interest cost would be less than the expected future administrative costs. Plan termination is a lengthy and costly process, but if it will be done eventually, the decision is mostly about timing.
  • Combination of Actions
    Finally, there may be a combination of the actions mentioned above that would meet the objectives of the plan sponsor.  As one example, spinning off a portion of the pension plan into a new continuing plan and terminating the remaining plan may present de-risking opportunities that are not available with the whole plan intact.  That’s just one example of a creative combination of actions.

THE NEXT STEP

Each approach to decreasing risk requires careful consideration of the benefits and trade-offs such as cost, tax advantages, philosophical positions, administration, time horizon, etc. with regard to the particular pension plan and its company sponsor. Watkins Ross has the expertise and resources to assist you and your advisors in exploring how these opportunities would best suit your specific circumstances. Please contact us to begin a discussion!

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