© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the November 2006 edition of BENEFITS CANADA magazine.
Pension planning: Tip of the iceberg
Frozen doesn’t necessarily mean frozen, at least when it comes to the management of defined benefit plans that are no longer active.
By Aleksander Weiler

THE PERFECT STORM OF DECLINING DISCOUNT RATES AND poor equity market returns over the past half decade has resulted in widespread underfunding of defined benefit(DB)pension plans and remedial corporate responses. Studies, from the Pension Benefit Guaranty Corporation in Washington, D.C., point to roughly 1-in-10 DB plans in the U.S. being hard frozen, a substantial increase from even a few years ago.

Companies’ interest in freezing their plans is understandable as the underfunding has now become a serious business issue, making an on impact both financial statements and actual cash flow in a material and negative fashion.

Because of the cost of closing the plan, most companies have opted for a “freeze,” a stopping of benefit accruals. Freezes can be of the hard variety where all benefits for current plan participants(active and retired)are frozen at current levels with no further accruals and no new participants allowed, or they can be of the soft variety whereby benefits continue to accrue for current plan participants but no new participants are accepted into the plan. There are, of course, many variations in between.

The hope underlying plan freezes is that by slowing or stopping the accrual of benefits, the plan has a chance to get back to fully funded status. Unfortunately for plan sponsors, the reality of pension mathematics means that this hope is largely destined to remain unfulfilled. Plan liabilities are a function of demographics(participant additions, aging and mortality), service accrual, salary increases and liability discount rates. Regardless of the nature of the freeze, the long duration liability still exists. In the extreme case of hard freezing, a plan removes any further demographic, accrual or inflation risks; however, the liability to current participants still exists and it remains as sensitive to discount rates as before. In the case of a soft freeze, demographic, accrual and inflation risks remain(though in a diminished fashion as no new participants are being added)as does the interest-rate sensitivity.

Not being aware of this, many companies are surprised to find that five or six years after freezing their DB plans, they remain underfunded and further contributions are required.

Before the freeze, with an active and aging plan population, pension plans are typically run more traditionally with an eye to maximizing return, subject to diversification and prudence requirements. Avoiding underfunding and any associated financial statement volatility are of paramount importance. This has mostly led to equity-heavy allocations to capture the historical risk premium in the asset class.

However, once a plan is frozen, it becomes much more of a game of liability matching in order to ensure participant obligations are met while avoiding any unnecessary capital calls on the sponsor. This would imply a fixed income-heavy book. Such an allocation, however, would be a mistake during the initial years after the freeze based on the reasons outlined earlier: the issue of underfunding remains and the liabilities are still fairly long-dated. The dual goal of liability matching and closing the funding gap/avoiding further capital calls can often be met by pursuing an innovative investment process such as those employed by U.S. university endowments, the results of which have been historically high real returns with limited volatility. They have achieved this by heavy use of alternative asset classes(such as private equity and real assets)and extensive use of active management(usually in the form of hedge funds).

After the initial years pass and the sinking-fund nature of a frozen DB plan begins to assert itself, asset allocation would begin migrating more towards the fixed income-heavy bias necessary to “annuitize” the remaining liability. Ultimately, the plan would likely have a greater chance of achieving the dual mandate of meeting the real obligations to the plan participants over the long-term and the avoidance of any unnecessary funding gaps.

Aleksander Weiler is an alternative investment strategist living in Greenwich, Conn.

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