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The US de-risking environment – and the importance of effective navigation

01 May 2018

Publication: Pensions & Investments magazine

Author: Matthew Seymour


The de-risking journey — are we all heading to the same place?

An increasing number of U.S. pension plans are on one of two routes: to hibernation or to termination.

Hibernation comes through creating a low-risk liability-driven investment portfolio; termination takes all the risk off the table through a combination of retiree annuity buyouts to a third-party insurer and bulk lump-sum offerings to terminated vested participants. But what is the difference between these two strategies in reality?

A considerable number of U.S. defined benefit plans ultimately are heading to the same place; even those pursuing a route to hibernation will find the opportunity or the need to transfer the residual liabilities at some point. When you look at it this way, it becomes not a question of if a plan should transfer risk, but when.

U.S. pension plans should therefore plan their strategy with a medium-term mind set — not "is my goal hibernation in 15 or more years?" but rather "am I likely to transfer risk over the next five years or so, or do I plan to retain the assets for the foreseeable future?" This is not a one-time decision, but like any strategy needs to be revisited every few years and be capable of adapting to meet changing circumstances and requirements. Indeed, it is not about committing to one or the other, but committing to the right one at the right time. The hibernation vs. termination decision is therefore a journey — and for most plans it is to a similar destination.

 The question is: how best to get there?

 

Effective navigation

In order to stay on course, readily available critical information is key: you could not navigate a boat optimally without regular updates on exactly where you are in the ocean, and on what risks might lie ahead. Similarly, pension plans need to know their position (assets, liabilities and risk) regularly, not just annually.

Plan executives also need to be able to assess the potential consequences of taking certain actions and of market developments — this becomes even more important as you near your destination, when going off course can be costly. By carrying out efficient, effective, detailed analysis and scenario testing on plan assets and liabilities, pension plan executives can gain insights into risk — both short and long term, enhance their understanding of the trajectory of their plan, and make informed decisions on the best actions to take. Indeed, plans require the flexibility to capture opportunities to reduce risk as they arise.

During the journey a plan takes to hibernation, opportunities for de-risking will crop up. As the chart below illustrates, a combination of accurate daily funded ratio monitoring, and the ability to quickly implement changes to the portfolio, meant that these opportunities were seized in a timely manner, with the shrinking size of the value-at-risk bar illustrating the various stages of de-risking that have been put in place over the three-year period.

 

Time to act?

With a better ability to understand their current position and regular updates on how the position is changing, plan executives can then seize opportunities to derisk.

With deficits of U.S. plans falling (decreasing to $375 billion from $408 billion in 2016) and funded ratios improving (the estimated aggregate funded ratio of pension plans sponsored by S&P 1500 companies increased to 84% from 82% year-on-year as of Dec. 31), there is incentive for plans to "strike while the iron is hot."

Combine this with recent changes to U.S. accounting standards introduced by the Financial Accounting Standards Board, which could play a role in helping to lower the barrier to de-risking, and we can expect a significant impact on risk-transfer behavior and appetite in the foreseeable future.

Under the new accounting rules, organizations are required to separate the service cost component from the other financial components of net benefit cost for presentation purposes; thereby altering where different components of pension income and costs appear in accounting disclosures. The standard takes effect for public business entities for annual periods beginning after Dec. 15, 2017. For other entities, the amendments take effect for annual periods beginning after Dec. 15, 2018.

Such changes to the accounting model — i.e., the movement (aside from service cost) of pension assets and liabilities away from operations reporting — could impact the way in which plan sponsors view their investment strategy, including their approach to de-risking. With expected return on assets income no longer being included in operating earnings, this could act as a catalyst for sponsors to reassess their hibernation vs. termination strategy — and potentially result in a more significant shift toward de-risking and moving assets into longer-term fixed-income holdings.

Although these accounting changes might not remove the barrier to de-risking for some companies, it should lower the barrier and result in more opportunities to reduce or transfer risk. Add to that the fact that some sponsors might also choose to accelerate plan funding, in order to take advantage of tax relief at current rates, this may further reduce the funding gap in the short-term and add to the impetus to derisk.

Certainly, the developments in the pension market and accounting and reporting space are putting the possibility of de-risking in the spotlight, and pension plans should re-examine when termination might become the desired path for them. Indeed, there will come a point when, no matter your size, eventually you will need to transfer the residual.

For many plans the journey remains the same, but there may now be a better route to optimizing long-term risk and costs. By harnessing tools that enable insight into accurate, up-to-date data, pension plans can optimize their de-risking strategy — making informed decisions about the right time to derisk — and stay on course to smoothly touch down at their intended destination.

 

(This article was originally published by Pensions & Investments)

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