Mercer's Argument for Lump Sum De-Risking

(May 19, 2014) — Now may be an opportune time for pensions to offer lump sum payouts as a form of pension risk transfer, according to Mercer.

The consulting firm argued that predicted rising interest rate levels and last year’s improvements in corporate pension funded status point to a suitable environment for cashing out one member at a time.

“Among the attractions to the plan sponsor are reduced pension liability, leading to lower plan financial risk and volatility,” said Matt McDaniel, senior consultant at Mercer. “Other advantages include eliminating Pension Benefit Guaranty Corporation premiums, investment and administrative costs, and making payments before updated mortality tables come into effect.”

However, certain misconceptions may stand in the way of plan sponsors taking advantage of lump sum payments, Mercer said.

Plan sponsors could be deterred by low interest rates, waiting for higher rates to reduce payout values. The report pointed out the upside potential built into many cash out rate agreements. Often, contracts will lock in a “lookback” interest rate for a full year, during which the plan sponsor would earn a spread on the lump sum payouts if rates fell further. Still, Mercer acknowledged that rates “remain low relative to historic norms.”

For plan sponsors concerned with losing the opportunity to generate returns above their liability growth rate, Mercer suggested paying the lump sum out of their bond portfolio.

“This trades out a fixed-income asset for a fixed-income liability, leaving the plan roughly neutral on a risk basis and preserving the level of growth assets,” the report said. “If you were to consider the cash out as an asset class, cashing out the obligation from fixed-income assets effectively ‘immunizes’ the portion of the portfolio from risk.”

Large payouts may be of concern to plan sponsors with underfunded plans, the consulting firm noted. However, funding and reporting implications of lump sum payments arguably reduce assets and liabilities in concert, resulting in an unchanged funded status.

“Plan termination is a lengthy process than can take 12 to 24 months or longer,” Mercer said. “Paying out lump sums now reduces risk and carrying costs over this period, and it ensures that payment occurs before the new (more expensive) mortality tables take effect for lump sums.”