In our prior article, we discussed the basic factors in a standard plan termination analysis: taking as a baseline the plan’s PBO, we considered the key variables of the present value of future administrative costs (including PBGC premiums) and the annuity purchase premium. In this article we will consider a factor that is left out of that analysis – the equity risk premium.
Our prior article took as a given a plan liability value based on accounting rules. Those rules provide for the valuation of plan liabilities using a high-quality-corporate-bond yield curve. It’s no surprise that those liabilities are similar to the cost of an annuity, because the underlying investment that supports an annuity contract is typically a portfolio with a heavy bond allocation. For both plan sponsors and insurers, such a portfolio can essentially ‘immunize’ the liability.
In a sense, in doing that sort of termination analysis you are comparing the costs of (1) managing a bond portfolio plus insurance company administrative and regulatory overhead vs. (2) managing a bond portfolio plus pension plan administrative and regulatory overhead. Insurance companies can bring scale to this challenge that is not available to plan sponsors.
One advantage (at least in the view of many pension sponsors) of employer sponsored defined benefit plans – going back to the 1960s – is the ability to finance benefits by investing in a more diverse portfolio – more diverse than the bond portfolio that supports the insurance company’s annuity promise and that is the premise of PBO-based valuations. Unlike the insurance company’s portfolio, an employer-sponsored pension plan may invest in, e.g., equity securities, real estate, and alternatives. If all you were trying to do with a pension plan was finance benefits with bonds, why not just buy annuities in the first place? That, indeed, was what pension plan sponsors did before the employer plan ‘revolution.’
The equity risk premium and frozen plans
The underlying premise of the employer plan strategy – the reason sponsors began setting up their own trusts to manage plan investments – was that, given the long-term investment horizon for assets set aside to pay (long-term) plan liabilities, it was reasonable to invest some portion of the plan’s portfolio in, e.g., equities. And that such equity investments would carry with them a premium over the return on bonds.
In this regard, frozen plans are a little unusual. They often have a very mature participant base, especially if the sponsor has aggressively ‘de-risked’ (lump summed out) benefits. And thus they typically have a much shorter investment horizon than a plan with ongoing accruals for active participants. Basic investment theory holds that as the investment horizon shortens, the ability to take on investment risk goes down, because there is less time to smooth out the volatility of riskier markets.
We’re not going to try to put a value on the equity risk premium. But we do regard the following statements as axiomatic: to the extent that a plan (even a mature, frozen plan) can take on some investment risk in excess of the amount of risk implicit in annuity pricing, continuing the plan will, at the margin, be cheaper than terminating-and-paying-out-annuities. How much risk a plan can reasonably take on will be a function of the plan’s investment horizon, the sponsor’s view of the equity risk premium, and the sponsor’s tolerance for equity risk.
The problem, of course, is interest rates
Uncertainty around the equity risk premium, and equity market volatility generally, have been a source of pain for CFOs this century. Bear markets in 2000-2002 and again in 2008 were disruptive, but the overall return (just 4% per year on the S&P 500 this century) is the real source of equity market pain.
But even this pales in comparison with the pension pain felt by CFOs due to lower interest rates, which, all by themselves, have more than doubled the value of pension liabilities compared to 1999.
If you assume a ‘going concern,’ with all benefits ‘internally financed’ by returns on plan investments, then ‘in real life’ the plan never has to reckon with interest rates. So long as returns are in line with assumptions, the actual cost of benefits can be determined based on those expected return assumptions.
But, sponsors (at least, sponsors subject to Financial Accounting Standards Board rules) must still reckon with reporting based on market interest rates. In this regard, a sponsor considering continuing its frozen pension plan may want to consider an LDI (liability driven investment) overlay strategy. Such a strategy generally will not compromise the plan’s portfolio strategy but will ‘immunize’ the sponsor’s financials to the effects of interest rates.
Of course, with interest rates currently near historic lows, many sponsors perceive little risk of rates falling further and, consequently, may have little appetite for such an immunization strategy right now.
The issue of the equity risk premium – available under the plan but not available with an annuity purchase – is sometimes left out of that analysis. Leaving it out may make sense, e.g., where the plan’s population is very mature (and the plan’s investment horizon is ‘short’) or where the sponsor has a preference for certainty. If it is reasonable to consider the equity risk premium, however, continuing the plan may in many cases be cheaper – a better financial deal – than terminating it.