Is Your Defined Benefit Plan Ready for Termination? Part III
Part 3 – Funded Status Risk
This post is the third in a series on plan termination readiness. Last week, we discussed the plan’s funded status. This week, we’ll be focusing on the risk of changes in funded status.
A plan’s funded status is subject to interest rate, investment, and regulatory risks. Understanding and appropriately mitigating these risks is important as the plan progresses toward termination. A fully funded plan with an inappropriate asset allocation can quickly find itself in a poorly funded position due to changes in interest rates or a fall in the investment markets.
Most funded status risk is associated with the pension plan’s asset allocation. Assets can be thought of as being in one of two buckets: liability-matching and return-seeking. Liability-matching assets are a mix of fixed income securities that closely match the duration and cash flow characteristics of the plan’s liabilities, so when interest rates change, the liabilities and assets change in sync. All other plan investments are return-seeking assets, which are intended to outperform the liability growth and offset the contributions that would otherwise be necessary to improve or maintain the plan’s funded status. Return-seeking assets take on risks to accomplish this outperformance. Additionally, every dollar allocated to return-seeking assets is a dollar that is not matching the plan’s liabilities; as a result, a greater allocation to return-seeking assets will generally increase the plan’s exposure to interest rate risk.
The plan’s funded status and the plan sponsor’s funding policy and risk appetite should be taken into account when determining the allocation between liability-matching and return-seeking assets. For example, as the plan’s funded status improves, most sponsors no longer want to take on as much risk. Once the plan is fully funded on a plan termination basis, there is very little benefit from investment risk in the plan’s portfolio (i.e. close to 100% of the plan’s portfolio should be allocated to liability-matching assets). Note that the correct liability-matching portfolio is likely to change significantly in the final 12-18 months of a plan’s existence, and it takes an investment advisor with an in-depth knowledge of the plan termination process to understand how to navigate this period appropriately.
To understand their exposure to funded status risk, plan sponsors should measure their plan’s sensitivities to specific economic risks by analyzing the investment portfolio in tandem with plan liabilities. Only by measuring those risks can plan sponsors make informed decision about how much risk they can bear.
Sponsors should also continue to review economic and regulatory environments to reduce their liability risks. Risk transfer strategies (i.e. lump sum offerings and annuity purchases) can be implemented in the years leading up to plan termination to lower ongoing costs and reduce overall risks. These should be prudently considered as interim steps toward an eventual plan termination.
Changes to the investment allocation can be implemented and risk transfer strategies considered immediately. Risks should continue to be monitored going forward as changes in funded status and market conditions may necessitate future changes.
Action items: Plan sponsors should measure the risks they have in the plan and be able to answer some important questions:
• How sensitive is my funded status to changes in interest rates?
• What would happen to my plan under various economic conditions (e.g. “flight to safety”, stagflation, bull market)?
• How will my asset allocation change as funded status improves?
• How will plan contributions be invested?
• What risk transfer strategies should I implement and when?
• How should my assets be managed differently in the final year of the plan’s existence?
Next week, we’ll be shifting our discussion away from funded status. Instead, we’ll be looking at plan administration, and how sponsors can take action in advance of termination to avoid headaches later on.
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