Managing Pension Risk.

Author:Farnklin, cary
 
FREE EXCERPT

Traditional defined benefit (DB) plans in general, and multiemployer DB plans in particular, have faced criticism as being too risky to remain sustainable in the long term. This criticism began with the market downturn following the late 1990s bull market after many multiemployer plans needed to improve benefits to ensure the deductibility of employer contributions.

Several large multiemployer plans facing insolvency in the not-too-distant future have received much press and have motivated various legislative efforts. The benefit suspension provisions of the Multiemployer Pension Reform Act (MPRA), which were intended to save these severely troubled plans, have been ineffective at providing relief, since the available benefit reductions are often insufficient and few applications for suspensions have been approved.

At the same time, roughly two-thirds of the more than 1,300 U.S. multiemployer DB plans are in the green zone under the Pension Protection Act (PPA), (1) and many of the yellow and red zone plans are on their way to improved financial health and long-term sustainability. How have these plans weathered the various storms that have hit the multiemployer pension system over the past two decades? The short answer is that they have successfully managed their risks. This article explores the ways in which pension risk can be effectively managed through three key policies: benefit design policy, funding policy and investment policy.

Pension risk management seeks to increase the likelihood that plans will be sustainable over the long term, with a relatively stable balance between contributions and benefits. The more effectively each plan manages its risks, the more stable and sustainable the multiemployer system will be as a whole.

What do we mean by pension risk'? Traditionally, risk has been viewed solely as the volatility of investment returns. But plans face many different risks in addition to investment return volatility, including the following. * Contribution base risk: The contribution base (e.g., hours on which contributions are based) declines due to weakening work levels, competitive market conditions or employer withdrawals.

* Longevity risk: Participants live longer than assumed, with benefit liabilities becoming greater than assumed.

* Employer withdrawal liability risk: Employers withdraw and are assessed withdrawal liability (employer's risk perspective), or withdrawn employers do not pay their obligation (plan's risk perspective).

* Pension Benefit Guaranty Corporation (PBGC)-related risk: PBGC premiums increase significantly, or PBGC becomes insolvent.

* Benefit adequacy risk: Plan benefits do not meet participants' needs, causing them to seek employment elsewhere or to remain employed beyond the age that employers would prefer they retire. This includes the inflation risk, which is when benefits do not keep pace with cost-of-living increases.

* Excise tax risk: A red zone plan fails to make scheduled progress in its rehabilitation plan, exposing the employers to excise taxes on funding deficiencies.

Some of these risks fall primarily on the participants (e.g., benefit adequacy), and some fall primarily on the employers (e.g., withdrawal liability, excise tax), while others are shared by the employers and participants collectively as sponsors of multiemployer plans. (2) All of these risks are connected through the interaction of benefit design, investments and funding (Figure 1). Addressing one risk may aggravate a different risk. For example, reducing investment volatility by going to a more conservative asset allocation may increase the risk that benefits become unaffordable or inadequate. The challenge is to find the optimal risk balance.

Defining the Policies

Benefit design policy addresses these questions (among others):

* Are the promised benefits adequate to secure the participants' retirements?

* How are the benefits allocated among participants?

* Who has the investment risk under the benefit design?

* Are lifetime benefits available?

A funding policy establishes a formal connection between contributions and benefits.

* Under what favorable conditions may benefits be improved or contributions reduced?

* Under what unfavorable conditions must corrective action be taken--benefit reductions or contribution increases?

The Employee Retirement Income Security Act (ERISA) requires every plan to have a funding policy and to disclose it in the annual funding notice. However, in practice, funding policies tend to be minimally designed by most plans solely to comply with the ERISA rule--This minimal approach misses an opportunity to manage plan risks.

Investment policy is typically the policy that gets the most attention and covers: (3)

* How much investment risk is tolerable?

* What is the optimal asset allocation?

* Who controls the investments?

Too often, the investment policy is developed and adjusted without regard to the other two key policies; that is, the investments are viewed in a vacuum without regard to the impact on plan funding or benefit design.

None of the policies operates effectively independently of the other two. Here are two examples to illustrate this point:

* A more aggressive investment policy means greater investment return volatility and risk of underfunding, thus increasing the need for a prudent funding policy to absorb adverse experience without jeopardizing the plans stability. (4)

* A benefit design policy that aims to replace specified percentages of income at retirement needs appropriate funding and investment policies to help stabilize contributions.

Which Policy Comes First?

Ideally, the process of setting or adjusting the three policies would begin with the benefit design policy--What benefits does the plan want to provide to participants? In practice, most benefit designs have evolved without a well-thought-out process.

In a perfect world, boards of trustees (or bargaining parties) would begin by designing a plan that best meets the needs of the participants and then develop funding and investment policies to support the benefit design. They would make adjustments among the three policies to ultimately arrive at a benefit design that is affordable and well-coordinated with the funding and investment policies.

Strategic Approach to Benefit Design

Despite the wide variety of benefit designs, there are only two distinguishing factors:

* Who has the investment risk--the employer or the participant (or is it shared)?

* How are the benefits allocated among participants?

Investment Risk

Conventional wisdom says that in DB plans the investment risk is borne entirely by the employer, while the investment risk falls entirely on the participant in defined contribution (DC) plans. In practice, however, both employers and participants share the multiemployer DB plan investment risk: Employers often face contribution increases when investments do not perform as intended, but the shortfall also can be made up by participants allocating a portion of their negotiated wage package to the pension plan. Further, an investment loss may be addressed by reducing...

To continue reading

FREE SIGN UP