10 De-Risking Resolutions for the New Year

(December 20, 2013) — Investment consultancy Mercer has collated its top 10 tips for de-risking pension plans in 2014.

Double-digit equity returns and rising interest rates during 2013 have resulted in significant improvements in funded status for a majority of pension plans. The aggregate funded status of defined benefit plans sponsored by companies in the US’s S&P1500 was at 93%, with around a quarter more than 100% funded.

With this in mind, Mercer anticipates many more funds in the US will seek to accelerate their de-risking plans and has therefore come up with its top 10 pension risk management priorities to consider in 2014.

They are:

1) Consider taking your de-risking glide-path to the next level with interest triggers as well as funded status triggers

Today, the majority of glide-paths have triggers based on funded status, with some plans also adopting interest rate triggers. Mercer said it anticipates plan sponsors will continue to use a two-pronged approach, with an increased emphasis on interest rate triggers given expectations of tapering by the Federal Reserve in 2014, and the potential for an increase in interest rate volatility.

Also, a number of plan sponsors who are looking to terminate their plan within a specific time frame are introducing time-based triggers. Mercer said it expected to see greater interest in these types of triggers.

In Europe, the situation is the opposite—top investors are moving away from triggers in favour of a shift towards affordability or funding.

2) Review the best liability-driven investment (LDI) benchmarks for liabilities

Pension plans that have a substantial allocation to liability-hedging assets in their portfolios should ensure that the choice of bond benchmarks fits the liability characteristics. This will be an important theme in 2014, and Mercer said it believes an increasing number of plans will explicitly set the benchmark to the plan liabilities.

3) Don’t forget about derivatives
Pension plans using LDI have increased their exposure to liability-hedging assets as funded statuses have improved. However, physical securities may not be sufficient to manage interest rate risk, or may be an inefficient use of capital, and Mercer thinks more plan sponsors will follow the European example and deploy the use of derivatives.

4) Optimize growth assets
De-risking glide-paths are intended to reduce risk as the funded status improves, but this can lead to a reduction in growth assets that limits the expected returns. Another way to reduce risk without necessarily reducing returns is to add new asset classes and investments other than equities, Mercer said.

5) Evaluate whether a completion manager is right for the plan
The use of a completion manager to assist with sophisticated LDI techniques is set to develop further in 2014, according to the consultant. Pension plans will move from using standard long bond benchmarks to a measure that is tailored to its own liabilities. This can involve specifying interest rate durations to more closely match the liability cash flows and therefore fill in any potential gaps that are generally not addressed by duration matching strategies.

6) Consider accelerating contributions
Many plan sponsors are making discretionary contributions to improve the funded status of their pension plan, especially plans that are on a de-risking glide-path but have a funded status that is much lower than the first trigger point, Mercer said.

Accelerating contributions has the added benefit of reducing Pension Benefit Guarantee Corporation variable rate premiums, which gives an effective “free” return of nearly 2% to these assets.

7) Pension surplus planning is on the rise
Unthinkable a year ago, today many plans are having to face the reality of an over-funded pension plan in 2014, Mercer said. Surpluses in pension plans can potentially be managed by merging underfunded plans into overfunded plans arising, for example, from M&A acquisitions, paying for retiree medical costs, and shifting other types of benefits into the overfunded plan.

8) Check on governance needs
A glide-path approach or LDI strategy need integrated governance structures to ensure they meet the implementation objectives of the program, the consultant said.

Many plan sponsors, especially those with limited internal resources, have decided to delegate these functions to focus on their core business, and Mercer believes this trend will continue at an increased pace in 2014.

9) Analyse the cost advantages of a cashout
Mercer anticipates a significant increase in cashout programs in 2014, which will generally be directed towards former employees with vested pension benefits (“terminated vesteds”).

PBGC premiums are expected to increase dramatically in 2015 and thereafter, and this coupled with rising interest rates makes 2014 a very good time to cash out terminated vested participants and avoid paying these annual premiums for the rest of these participants’ lives, Mercer said.

Furthermore, the introduction of new mortality tables in the US is expected to increase liabilities by 2%-3% by 2016. Cashing out participants before the tables are implemented can result in further significant cost savings.

To get ready, sponsors should be looking now at the legal, administrative, and financial implications of such a program to ensure optimal results, Mercer advised.

10) Annuity purchase may be a viable option

Transferring retiree liabilities to an insurer removes considerable volatility from the balance sheet and income statement. The improvement in funded status has resulted in annuity purchases being much more attractive, Mercer said.