Uncertainty, rising administrative costs and budget constraints are driving plan sponsors to revisit derisking strategies.
Temporary lump sum windows can be an effective cost reduction strategy for plans that aren’t yet fully funded.
Plan termination and buyout strategies are becoming more prevalent for plans of all sizes, and an annuity buy-in is a possible bridge strategy available to plan sponsors.
Our recent white paper discussed investment-related challenges Defined Benefit (DB) pension plan sponsors are facing in 2020. Our guidance focused on investment strategies, such as Liability Driven Investing (LDI), that we believe plan sponsors should be considering in light of today’s uncertain economic environment. While having a sound investment strategy is an integral part of any overall DB plan strategy, it is just one aspect. A holistic approach considering various strategies is necessary to effectively mitigate risks and manage administrative costs.
Derisking trends
Derisking is not a new concept, but the difficult economic conditions companies are dealing with in 2020 magnify the importance of reducing pension plan risk. Whether a company offers a lump sum window or an annuity carve-out for retirees, pursues a buy-in, or purchases annuities for all participants, these actions continue to be an effective way of:
reducing a DB plan’s overall risk
driving down administrative costs
limiting the plan’s impact on financials
managing cash flow
Derisking has been especially widespread due to skyrocketing Pension Benefit Guaranty Corporation (PBGC) premiums. The PBGC is a federal agency that was established to protect participants’ DB plan benefits. It can be thought of as insurance for pension plans: Plan sponsors pay premiums each year, and in return, the PBGC will cover any benefit shortfalls (up to a limit) resulting from the sponsor’s bankruptcy.
Since 2012, flat-rate premiums have nearly tripled while variable-rate premiums (VRPs) have risen fivefold. Additionally, PBGC premiums are subject to indexing after 2020.
Temporary lump sum windows
Offering a temporary lump sum window for terminated vested participants can be an economical way of reducing both flat-rate and VRPs. Unlike plan terminations, plans do not have to be fully funded in order to pursue this approach.
The interest rate and mortality basis used in determining minimum lump sums are defined under Internal Revenue Code Section 417(e)(3) and should be considered when reviewing the effectiveness of such a program.
For example, if the plan document indicates a two-month lookback with a one-year stability period for a calendar year plan, then all lump sums paid in 2020 would be based on the November 2019 interest rates. If interest rates decline throughout the year (as they have been as of July 31 of this year), then the interest rates used to determine the lump sum amounts would be higher than the interest rates used to measure the obligations. Given the inverse relationship of interest rates and obligations, under this scenario the lump sums paid in 2020 would be less than the accounting liability being released and result in a net gain for the plan.
For a majority of plans that means a 2020 lump sum window will not only result in PBGC premium savings, but also an improvement in its funded status on an accounting basis. Plan sponsors should still consider:
Possible one-time accounting charges to Profit and Loss statements
Impact to contributions
Cost of the lump sum project
Temporary lump sum windows are generally limited to deferred participants; however, IRS provided guidance in 2019 indicating lump sum offerings to retirees were no longer prohibited. As outlined in guidance we issued in 2019, we generally do not recommend this approach for several reasons.
Pension buyout landscape
Pension buyouts remain prevalent despite a low interest rate environment and the financial difficulties of 2020.
The first quarter of 2020 saw sales of $4.5 billion, which was second only to the record-setting first quarter of 2019. The average annuity buyout in the first quarter of 2020 was just shy of $58 million, and collectively over 60,000 participants were covered — meaning pension buyouts are not just driven by jumbo deals.
The COVID-19 pandemic is expected to decrease buyouts in the second quarter, but most experts agree we can expect a resurgence later this year or in early 2021. Many of the reasons that have made pension buyouts popular still remain valid today, and buyout activity should pick up as companies begin to resume normal operations and focus on pension plan risk.
Buy-ins could also be an option for plan sponsors looking to terminate their pension plans. Buy-ins shift interest rate and longevity risk to an insurance company; however, plan sponsors maintain contractual obligations and continue to pay benefits to participants.
Key buy-in features:
Assets and liabilities for the plan stay with the plan sponsor
No settlement of obligations
Buy-in contract serves as an asset of the plan, and the insurance company reimburses the plan for benefits paid
Plan sponsor continues to pay all administrative fees and PBGC premiums
Can typically be converted to a buyout at plan termination with no additional premium due to the insurer
Buy-ins have been around for several years, increased popularity can be attributed to plan sponsors using the buy-in as a bridge to plan termination and the ability to convert to a buyout after the plan sponsor completes the formal plan termination process with the IRS and PBGC. This tactic can allow plan spoonsors to “lock-in” plan termination cost before receiving all IRS and PBGC approvals.
If a plan termination is not possible due to the plan’s funding level, a retiree carve-out could also be an option if the plan has a large number of retirees with small monthly benefits. Given the rise in PBGC premiums and administrative costs, a retiree’s benefit could potentially be less than the cost to administer the participant. Plan sponsors will want to consider the appropriate population for the carve-out, impact on funding level, and impact on future derisking activities.
Managing administrative costs & efficiencies
Many DB plan sponsors are facing the new reality that they will need to maintain their plan for several more years before reaching a termination point. Therefore, companies should aggressively review ways to minimize their plan’s drain on valuable internal resources and ensure they are not overpaying for its required services. An in-depth review of plan fees and service providers (i.e. actuary, trustee/custodian, recordkeeper, investment manager) is part of a plan sponsor’s fiduciary responsibilities and can lead to significant cost savings. Consolidating service providers can streamline the plan’s administration, reduce its cost structure and improve its participants’ experience.
The COVID-19 pandemic has created significant headwinds for DB plan sponsors. Now is the time for companies to aggressively reduce the risk and costs associated with maintaining their plan for years to come.
Investment advisory services offered through Lockton Investment Advisors, LLC, a SEC registered investment advisor.
Nothing in this message should be construed as legal advice. Lockton may not be considered your legal counsel and communications with Lockton’s compliance services group are not privileged under the attorney-client privilege.
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