For a variety of reasons, many sponsors of defined benefit (DB) plans have decided to freeze their plans in favor of new or expanded defined contribution (DC) plans. Others are considering this strategy. One of the common causes for going this route has been rising and volatile cash and accounting costs and liabilities. The hope is that eventually the DB plan will be terminated – when interest rates rise sufficiently so that the cost of paying lump sums and purchasing annuities will become more favorable.
In the meantime (which, given the Federal Reserve moves to keep interest rates low, could be a long time), the employer has two major issues to deal with regarding the frozen DB plan: (1) how to invest the plan’s assets, and (2) how much (and when) to contribute to reduce any unfunded liability.
If the DB plan’s funded status is near or over 100%, one popular strategy is to invest the plan assets in a portfolio of bonds that essentially protect the plan from interest rate risk. For a traditional DB plan (TDB), which defines benefits as annuities payable (typically) at age 65, the “duration” of the bond portfolio will need to be quite long to match the corresponding long duration of the plan’s benefit obligations.
If interest rates rise, the bond portfolio value will fall and so will the present value of the plan’s benefit obligations – by similar amounts. Conversely, if rates fall, the bond portfolio value and the present value of the plan’s benefit obligations will both rise by about the same magnitude. (If the plan is overfunded, some or all of the excess assets might be invested in equities; our analysis here focuses on the assets needed to match the benefit obligations.)
This approach, a variety of “liability driven investing” (LDI), while mitigating interest rate and investment risk, comes with a price. By foregoing any growth oriented investments (e.g., equities), the employer is locking-in costs to provide the frozen benefits at a higher level than likely would have been the case had a more balanced portfolio been continued. That price could turn out to be substantial given that interest rates have recently been at historic lows. Once the Fed eases off on its “highly accommodative” stance on monetary policy, higher interest rates may ensue. And in that event, the value of the plan’s bond portfolio will suffer. The value of the plan’s frozen benefits will decline as well, but the employer will have given up a likely improvement in the plan’s funded status by switching to long-duration bonds.
Foregoing the upside may be justified by the fact that in a frozen plan, any overfunding – excess of assets over the value of the frozen benefits – has very little use to the employer. Those excess assets can’t be used to fund the DC plan accruals while they remain in the plan. And if the plan is terminated, much or all of the excess will likely disappear because annuity purchases are expensive and due to the heavy taxation of any residual assets (income tax and potentially excise tax).
Many frozen plans are underfunded. In those cases, the bond-matching LDI strategy seems to provide little or no benefit. Interest rate risk cannot be adequately hedged by a matching bond portfolio. Yet maintaining a more traditional portfolio does not reduce the volatility in costs that the employer hoped for when freezing the plan. That “relief” could take a long time to achieve. This problem can be “solved” by funding up the plan to 100% and then shifting to the bond portfolio. Again, the cost of this strategy is to lock-in higher costs based on the current funded status of the plan.
There are variations on LDI that attempt to address underfunding issues. Under a “dynamic” or “glidepath” strategy, plan assets are shifted increasingly into bonds as the plan’s funded status approaches 100%. This approach might work but it also might fail. It is premised on a combination of contributions and asset returns (on a portfolio that continues to include equities) moving the plan’s funded status toward 100%. As we have seen, this is by no means an ironclad strategy given the equity market plunge in 2008 or the drop in interest rates in 2011.
Under another LDI variation, the “overlay” strategy, the plan enters into an arrangement, such as interest rate swaps, to hedge away most or all of the interest rate risk. Plan investment policy is unaffected by this strategy, thereby retaining the potential upside returns from equities. This strategy can temper but surely not eliminate volatility of funded status and costs that many employers are seeking when they freeze their DB plans. And, it leaves the risk of overfunding and “trapped surplus” with the sponsor of the frozen plan. As we see it, freezing a DB plan comes with costs and, short of plan termination, continuing risks.
Fortunately, there is an approach that provides the relief sponsors are looking for without the costs that a “freeze, LDI, DC” approach entails. Even better, our approach provides a framework that will deliver more secure benefits to employees than a DC plan can deliver. We call this approach a ReDefined Benefit Plan® (ReDB®). A ReDB® turns LDI on its head – it is more like an IDL – an Investment Driven Liability strategy. Thus, rather than fixating on how to match plan investments to frozen pension benefits, it defines ongoing benefits that are aligned with the plan’s investments, while eliminating the issue of overfunding risk that constrains, and drives, retirement investment decisions for many frozen plans. More details on how a ReDB® works can be found under The ReDB® Solution.