In the wake of the severe losses in plan asset values and the pronounced volatility in interest rates in late 2008, the damage to company-sponsored pension plans from the meltdown in global financial markets is enough to give any CFO sleepless nights.
While results vary significantly from one company to the next, the overall picture is clearly unsettling. In February 2009, the funding level for the Towers Watson benchmark pension plan fell to 60.2%, the lowest recorded since the data series began in December 1998.
Little relief from PPA pension funding rules
Probably the most immediate problem for many plan sponsors is a large increase in required contributions in order to meet funding requirements set by the Pension Protection Act (PPA) of 2006. Substantial increases in required funding remain, despite the modest relief provided by the Worker, Retiree and Employer Recovery Act (WRERA) of 2008.
Companies that fail to meet key funded status thresholds must comply with restrictions on lump sum payouts and other benefits. For calendar-year plans, the benefit restrictions can take effect as early as April 1, 2009, although for many companies the effective date will be when the actuarial valuation is completed (however, not later than October 1, 2009).
Companies whose funding levels fell below 75% in 2009 may also be considered "at risk" for 2010 and will have higher required contribution levels. They must also pay higher variable premiums to the Pension Benefit Guaranty Corporation. In addition, companies that sponsor at-risk plans face significant penalties for funding any nonqualified deferred compensation arrangements.
Webcast on options for managing pension plans
In a webcast on March 5, 2009, three Towers Watson consultants discussed the actions sponsors should consider in light of the impact of the capital market results on their pension plans. They reviewed the new benefit restrictions faced by plan sponsors in 2009 and offered a number of recommendations companies might take to avoid them or, if not, prepare for their onset. The financial management decisions an organization makes in response will impact not only plan benefits and funding levels, but cash flow and other critical financial variables.
"The restrictions are new and unfamiliar, and employers need to take action now," said Mike Archer, Towers Watson's chief actuary. Archer was joined by Kathy FitzPatrick, Principal, and Randy Cusick, Asset Consulting Services practice leader.
In a pulse survey of webcast participants, approximately 35% indicated that they expected to be subject to lump sum restrictions in 2009 unless they increased plan funding levels. Of these companies, about two-thirds said they planned to make contributions to avoid the restrictions.
In addition to increasing contributions to mitigate the impact of capital market results on benefit restrictions, employers can:
Adopt asset smoothing as allowed under WRERA
Move from a 24-month average-interest basis for calculating liabilities to a one-month average
Revise other assumptions used to calculate plan liabilities, consistent with changing expectations of future experience in light of the economic environment (such as later retirement expectations)
Forfeit credit balances, some of which might be mandatory
Post a surety bond, which would be counted as an asset for 2010
Managing cash flow
Webcast participants were also advised about ways cash flow could be managed in the post-PPA world. Many of the same techniques that can avoid benefit restrictions could be used to reduce contribution requirements. Archer cautioned about potential traps in the funding rules that could cause plan sponsors to be forced to forfeit credit balances and thus have to make much larger contributions.
FitzPatrick gave the example of one large employer that was facing a requirement to forfeit $222 million of its accumulated credit balance from prior years in order to be at least 80% funded and avoid benefit restrictions.
However, she explained, the company was able to lower its required minimum contribution by smoothing the value of plan assets under WRERA, which in turn delayed recognition of a large amount of losses in 2008. This raised its reported funding level to 95% and enabled it to keep its entire credit balance of $428 million.
Other potential actions that could help company cash flow and manage cost include changes in benefit design. These run a familiar gamut and include a plan freeze (temporary or permanent), closing the plan and a suspension of 401(k) matches. Strong companies with a stock that the organization's executives believe is undervalued may wish to consider contributing stock or property, provided there is fiduciary compliance.
More exotic approaches may also be worth evaluating, such as amending the plan to advance accruals or increasing pension plan benefits while reducing other benefits that require immediate cash flow. For example, a company could provide enhanced pension benefits in lieu of severance benefits.
FitzPatrick suggested companies may also be interested in cash balance plans, which could take on greater appeal to employees given the losses many have experienced with their 401(k) plans. Obviously, any of these changes require serious consideration of both the financial impact and the potential impact on workforce attitudes.
Investment implications for pension plan managers
Plan sponsors and their investment advisors have had to face a number of tough issues if they engaged in active management of pension plans. "Between illiquidity and the lack of safe havens for investment managers, many plans continued to substantially underperform passive indices," said Cusick. "All these issues raise very pressing questions. Do I rebalance now? Can I rebalance now? Should I replace my underperforming managers? Should I change my strategic allocation or should I start hedging my liabilities?"
In a pulse survey of webcast participants, roughly two-thirds (63%) anticipated no change in their asset allocation. Most of the remainder said they were becoming more conservative, and only a few said they were becoming more aggressive.
"At a minimum, companies should start rebuilding their plans for investment strategy," Cusick said. Possible steps range from revisiting your strategic allocation to implementing strong, detailed and rigorous procedures to monitor and control plan performance.
Plans that experienced fixed-income returns far below their benchmarks because they were overweighted in mortgage-backed securities and certain other sectors may be well served by taking a critical look at their individual fixed-income manager performance, as well as at investment manager mandates, to assure that risk management allows sufficient diversification of investment styles.
No time like the future
Employers need to take stock of the damage and carefully plan out their future path. And, while doing so, they should realize that their pension plans often provide financial opportunities as well as challenges.
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