Plain Talk about Risk — To the Company

By sponsoring a retirement plan, a company may assume a variety of risks in exchange for benefits it hopes to gain for its business, such as a more productive workforce. For purposes of this discussion, a “risk” is the potential that an outcome will be different from its “expected” value and have negative consequences. Differences that might be favorable over the long-term might nevertheless produce short-term adverse consequences.

The nature and extent of retirement-related risks depend on the type of plan – defined benefit (DB), defined contribution (DC) or something else – and on one’s point of view – employer-sponsor, employee-participant or shareholder.

In this article we focus on the two key risks that employers sponsoring traditional defined benefit (TDB) plans face: interest rate risk and investment risk. For many TDB plan sponsors, those two risks are the source of a lot of pension “pain” right now.

Interest rate risk

Interest rate changes present one of the chief risks to a TDB sponsor. When rates go down, pension liabilities and (cash and accounting) costs go up; when rates go up, liabilities and costs go down.

If you look at recent history, interest rate changes have contributed more to retirement plan volatility than any other factor. In our Pension Finance Update we discuss the impact of the nearly 100 basis point drop in interest rates in 2011 on the financial statements of a typical TDB plan sponsor. For the corporate, single-employer pension universe in the US, we estimate the decline in rates during 2011 increased reported obligations by $150 billion. For some TDB sponsors interest rate performance has had near catastrophic consequences.

But this “interest rate problem” is to a large degree artificial. It only exists because TDBs promise to make specific, defined-dollar benefit payments (based on a formula, typically defined as a percent of pay) far into the future. The TDB commitment is analogous to the obligations of issuers of long-term bonds with fixed interest and redemption payments. To determine the value of a TDB promise today, the accounting and funding rules require that future benefit payments be discounted to their current value. And to do that you must use an interest rate assumption.

In the past, employers were allowed to use various smoothing formulas to reduce the impact of period-to-period interest rate volatility. But the worldwide movement towards greater transparency, combined with concerns over funding adequacy in the US, has forced a move towards “mark-to-market” valuations, which means less smoothing. That trend is not likely to reverse itself.

Combine the increased volatility of interest rates with the move towards mark-to-market and the result has been an explosive increase in the volatility of TDB-related costs over the past several years.

There are situations where this pension problem does not cause a problem for the total enterprise. For some employers, pension liabilities, no matter how volatile, are simply not material relative to a company’s business operations. And in other cases, the interest rate impact on the TDB may actually work to hedge a company’s other obligations. But for many, perhaps most, TDB sponsors, interest rate volatility has been a significant source of financial pain.

Under a DC plan, the interest rate risk problem does not exist, at least from the employer’s perspective. As we discuss in another article, interest rate risk may be less significant to employees, and they may be in a stronger position to absorb and manage it.

Investment risk

In contrast to interest rate risk, investment risk is “real” for any retirement plan that pre-funds benefits, including all tax-qualified DB and DC plans in the U.S. Money has to be saved now and invested. If investments do well, then less will have to be saved; if investments do poorly, then more will have to be saved or something else will have to give. That risk – investment risk – must be borne by someone. In a TDB plan, this risk is borne by the employer-sponsor whereas in a DC plan, it is borne by the employee.

Does it make sense to ask employees to bear this risk? In one sense, yes. Employees know their own situations best and, therefore, should be in better positions to judge how much investment risk they want to take on at different stages of their lives.

In addition, like interest rate risk, the investment risk problem presents less flexibility to TDB sponsors. Above we say: “if investments do poorly, more will have to be saved or something else will have to give.” Well, for most TDB sponsors, there is no ‘or’. Movement toward “mark-to-market” funding rules exposes employers to increased year-to-year pension funding volatility due to investment fluctuations. A poor investment year, like a year of declining interest rates, translates to higher funding requirements the following year, period.

But investment risk is problematic for employees too. For one thing, they don’t have access to the tools, the expertise, or even the asset classes available to employers, who can exploit scale advantages by pooling retirement investments.

Some employees are simply ill-equipped to execute a sound retirement investment strategy. And most employees face a variety of behavioral hurdles, such as “loss aversion” — the tendency to attach greater weight to, say, a 5% loss than to an equivalent 5% gain — that can lead to undisciplined and suboptimal investment decisions.

DC sponsors recognize the difficulties employees face in managing retirement assets; in recent years, many have devoted considerable time and effort to employee investment education and advice. However, studies show, even looking at the most recent years, that on average DC investments continue to underperform DB investments, particularly among larger employers. At this point, it is not clear how effective the “employee education and advice” effort might prove to be.

Lower average returns from DC plans translate to some combination of higher company costs and lower employee benefits. An additional 0.5% or 1.0% per year can have a dramatic impact on the cost of financing retirement, particularly in an environment of modest expected investment returns.

But averages don’t tell the whole story. As the saying goes, a man can drown in a pool of water that is, on average, only an inch deep. And so it is in DC plans, where average investment performance masks a wide dispersion of outcomes – with lucky or skillful investors “winning” while unlucky or less skilled investors end up “losing.”

Thus, in many respects, employees are in a worse position to manage retirement investment risk than employers. Moving from a TDB plan to a DC plan may in some cases involve a gain to the company (the reduction in its risk) that is more than offset by the loss to employees (the increase in their risk).

The ReDB® solution

Regardless of any new design, TDB sponsors face “legacy” risks related to benefits already earned. Some have adopted a “freeze, de-risk, DC” strategy as a way of dealing with both interest rate and investment risks. Under that approach, the TDB benefits are frozen, DB investments are shifted primarily to long-term bonds and future benefits are provided in a DC plan. We understand the logic behind these decisions, but, as we discuss in another article, we believe this strategy may be a mistake and a missed opportunity for many employers.

At October Three we believe that a better approach to managing retirement risk for a company with a long term commitment to its employees is one where risks are shared, what we call a ReDefined Benefit Plan® (ReDB®.) In our view, it is essential that the problems that are driving companies away from TDB plans are not replaced by the same, or even worse, problems for employees under DC plans.

We understand the importance to many employers of stable and predictable retirement plan costs. At the same time, a wholesale shifting of risks to employees (the DC “solution”) ignores opportunities employers have to provide value to their employees in financing retirement.

We discuss the ReDB® solution further in our article The ReDefined Benefit Plan.