As the prospects for a rising interest-rate environment grew over the second half of 2016, so too did the idea that sponsors of frozen pension plans may finally be able to think in earnest about terminating them. But Jeff Kletti, head of investments for Wells Fargo’s Institutional Retirement and Trust business, and Steve Guggenberger, senior portfolio manager with Wells Fargo Institutional Asset Advisors, argue that hibernation—continuing to manage a plan for an extended period of time pending termination later—may remain the more attractive alternative for many plans. CIO recently asked Kletti and Guggenberger what plan sponsors should be considering in the termination-versus-hibernation debate, and what role an outsourced chief investment officer (OCIO) like Wells Fargo can play in making a decision.
Q: Much of the pension community is focused on what rising interest rates will mean for frozen defined benefit plans. What do you expect?
Jeff Kletti: We think we’re in a period where rates could be going higher over the next several years, but we think the impact on the funded status of individual pension plans may not be as significant as some are expecting. Consider a plan where the portfolio is split 60/40 between equities and fixed-income, with the fixed-income portfolio having roughly a five-year duration and the plan’s liabilities a 12-year duration. Under that scenario, a 100-basis-point rise in interest rates might translate to only a 2.5% to 3% increase in the funded ratio. And if your portfolio is heavily immunized, rates rising or falling really won’t matter much.
Q: It sounds like termination may not be the slam dunk some are anticipating.
Steve Guggenberger: It will make sense for some plans, especially those that achieve fully funded status and have most of their assets in a liability-driven investment strategy. But plan sponsors need to know they’ll pay a premium to get their pension plan off their balance sheets. Termination typically involves transferring a plan’s liabilities to an insurance company, which in turn provides annuities for each plan participant. There is no contractual obligation that says an annuity provider has to take on a plan’s liabilities. Annuity providers will look at them, they’ll value them—really honing in on your participant base and the actuarial data—and then they may give you a bid, often valuing your liabilities differently than you have and necessarily including some profit for themselves. The net result is that you might write a check somewhere in the range of 112% to 120% of your plan’s funded status to terminate it. For a lot of companies, that’s an issue.
Q: Are there any other caveats plan sponsors should consider?
Kletti: Implementation time. Your plan assets will remain exposed to market risk while you’re working to close the termination, which can take 12 to 18 months. If interest rates drop substantially during that time, your plan could see a significant reduction in its funded status. So getting yourself to fully funded is just the first step on the path to termination. The second is matching your assets to your liabilities so you have the money you need to continue sending out those pension benefits. There’s also the issue of communicating with your workforce. There will be many questions about why you’re doing what you’re doing, and about what happens if there’s a problem with the insurance company. Again, there are some plans where working through that will make sense. Others will find it daunting.
NOTE: Terminating a plan involves legal, audit, and administrative processes that are not discussed in this article. For additional information refer to Internal Revenue Service, IRM 7.12.1 Plan Terminations and the Pension Benefit Guaranty Corporation’s Standard Termination Filing Instructions.
Q: How can companies put hard numbers to the terminate-versus-hibernate decision?
Guggenberger: At a very basic level, you want to compare the net present value of all the hibernation costs—ongoing management of the plan, any future contributions to it, PGBC premiums—with the cost of terminating. But the size of your plan relative to your balance sheet and your business goals can come into play, too. If you have to write a check for $30 million and it keeps you from launching a new product line or investing in something that has, say, a 10-year return above the cost of termination, you have to ask if writing that check is the best use of your cash.
Q: Suppose a plan sponsor decides termination doesn’t make sense now. With hibernation, how much does that sponsor have to worry about ongoing market risk and the cost of future contributions to their plan?
Guggenberger: A compelling part of the hibernation strategy is that you’re investing the plan in long-term bonds where you’re trying to match the payout and interest-rate sensitivity from those bonds to the payout owed retirees. If you have a plan that’s 100% funded, we can help minimize the volatility of your funded ratio. Keeping the plan running won’t be free—you’ve still got to pay for services—but that funding volatility and the big unexpected contributions are all minimized. We have found that package very compelling for many of our OCIO clients. That said, we’re not advocating for one strategy—hibernation or termination—over the other. We are advocating for plan sponsors to look at their choices, do the analysis, and think about who they should be working with to develop their strategy. We also point out that if they choose hibernation, it’s not an irrevocable decision. You could hibernate for a number of years until you got through a project that you want to fund, and then terminate. It’s a process of continuous evaluation.
Q: Interest rates have just started to edge higher. How soon should plan sponsors start thinking about this?
Guggenberger: The termination versus hibernation decision may be down the road a bit for many plan sponsors, even if interest rates move higher. For one thing, the path to getting fully funded tends to be bumpier and harder than plan sponsors expect. Still, they need to begin planning now. Why wait for rising rates to move your funded ratio up, then take six to eight weeks to do the termination-versus-hibernation analysis? You could give back all your gains while making a decision.
Kletti: Most organizations with large pension plans are already doing this analysis. The market that’s underserved is pension plans in the $50 million to $400 million range. Their pension committees don’t do pension management full time. This is where an OCIO can help. An OCIO can bundle investment management, actuarial and administrative functions, act as a fiduciary, and really enhance a plan’s ability to manage through volatile financial markets without jeopardizing its glide path. It also can be cost effective.
Q: What should plans look for if they go the OCIO route?
Kletti: You want an OCIO with an experienced, dedicated team that understands the investment management, actuarial and administrative functions of pension management, and has a story and a process that’s been repeated hundreds of times—not just new ideas they’re going to test on you. You want products and solutions that have been around for decades, not months. You want someone who can provide fiduciary coverage. Lastly, I think you want a provider that offers full fee transparency and complete objectivity when making decisions on your behalf. At Wells Fargo, we partner with internal and external professionals to provide investment, actuarial, accounting expertise, and what we consider the best investment-risk analytics in the industry, to the table. That combination has helped us grow our business significantly the last few years, making us one of the largest OCIO providers in the industry.
Examples are for illustration purposes only. Estimates are based on the assumptions noted, do not guarantee or imply a projection of actual results, and do not include the effect of taxes.
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