Managing Risk in an Era of Defined Pensions
Kevin House, Towers Watson

Hundreds of organizations have closed their pension plans to new employees or frozen benefits altogether, but limiting future benefits does nothing to mitigate the continuing financial exposure for benefits that have already been promised.  Managing these risks takes planning and preparedness.  The key is to be ready to take advantage of opportunities as funded status improves -- and be equally ready if conditions worsen.

Almost half of U.S. corporations that sponsor defined pension plans today still have them open and about 80 percent of the liabilities in corporate pension plans are associated with participants who are not continuing to earn benefits.  In the automotive industry, OEMs and tier 1 suppliers have nearly a quarter trillion dollars of obligations for more than one million retirees.  Financial market conditions can cause these obligations to change quickly, and large funding shortfalls could emerge. 

In order to reduce risk, plan sponsors will need to assess what options are feasible.  One option getting significant attention today from many plan sponsors is the use of lump sums.

Why Now?
There are continuing regulatory requirements about how well funded a plan must be to offer lump-sum payments, but as programs become better funded, it is an increasingly attractive option.  The Pension Protection Act describes the basis upon which lump payments may be made.  Prior rules required lump sums be calculated with a premium because the present value of these payments were determined using treasury yields.  By 2012, the new law will permit companies to use corporate bond rates for these lump sum present value calculations, which is the same basis used to calculate program funding levels.

The elimination of this lump sum premium will allow more plan sponsors to provide the option to participants in a cost-neutral way.  As an example, an organization can offer a 40-year-old employee who leaves the company a one-time payment in exchange for decades of future benefits.  This ends years of future operating costs for the company, and it gives the former employee the power to manage his or her own portfolio.

Taking Action
The recent prolonged economic upheaval has made it very difficult.  Stocks were strong four years ago and approximately half of pension programs were overfunded.  Since then, economic conditions worsened and the risk of sponsoring defined benefit retirement plans became very apparent.  The desire to do something to manage these risks grew significantly, but the ability of organizations to act fell.  When retirement programs become poorly funded, there are regulatory and financial limits to taking significant action.

However, funded status is slowly improving and sponsors may soon be in a position to start making changes.  It is for this reason that plan sponsors should start preparing today.  Different options require different levels of preparation and those that are ready will be most able to act when conditions improve.

The first step is for management to achieve consensus about the approach it intends to use to respond to certain funding levels, which will typically be to establish objectives and triggers as part of a pension risk management plan.  The next step is to determine the services required by that approach, set the investment, funding and settlement strategies and align them with the triggers and objectives determined in the first step.

Organizations need to understand the pieces of their program, work with stakeholders to gain consensus around objectives and create steps to monitor and execute the plan.  There are no cookie-cutter solutions. 

We expect to see considerable activity in the area over the next 12 months.  Those who start the process now could have an advantage.

Kevin House, Towers Watson's Michigan offices retirement leader, can be contacted at 248.936.7420 or kevin.house@towerswatson.com