AUGUST 20, 2015 treasuryandrisk.com
Managing a Frozen Pension Plan
When a pension plan is frozen, its time horizon and risk profile shift
substantially. Here are some considerations that should be front and
center in decision-making for a frozen plan.
By Bob Collie, James Gannon, Justin Owens
I
n just a few years, the frozen pension plan
sector has moved from being a footnote in the
institutional investment story to a central plot
point—a billion-dollar segment of the market in
which some of the most rapid strategic development is
occurring.
Every defined-benefit (DB) pension plan exists in one
of three states. If it’s an open plan, it continues to enroll new participants and benefits continue to accrue.
If it’s a closed plan, it is not enrolling new participants,
but already-enrolled participants continue to accrue
benefits. And if it’s a frozen plan, not only does it not
accept new participants, but no new benefits accrue.
Figure 1, below, shows the proportion of U.S.-based
defined-benefit pension plans that fall into each category; it’s based on the latest reports available from the
Pension Benefit Guaranty Corporation (PBGC), along
with our estimate of pension plans’ current position.
It’s worth noting that there is some minor variation
in how the concepts of open, closed, and frozen pension plans are applied in practice. The PBGC data
shown in Figure 1, for example, defines a “closed plan”
as either a plan that is closed to new entrants but continuing accruals, or else a plan in which benefit accruals are partially frozen.
As Figure 1 illustrates, the proportion of U.S.-based
plans that are frozen has grown dramatically over the
past decade, and around 10 percent of all U.S.-based
plans have been closed since 2008. This growth in
popularity for closing and freezing pension plans has
happened because many American corporations have
chosen to move away from a defined-benefit plan toward the easier, more predictable defined-contribution
model. As they have done so, their DB plans have not
gone away—these plans will continue to exist for as
long as there are assets to manage and benefits to be
paid—but they have changed.
A frozen plan is different from an open plan, and
it needs to be managed differently. One key difference is that a frozen plan has a finite life span. Even
though that life span may be decades long, once a
plan is frozen the plan sponsor should start working
almost immediately toward the new end game. Freezing a plan shortens its investment time horizon, and
the sponsor of a frozen plan should increase focus on
marked-to-market asset and liability values, as well as
on risk management. The longer a plan is frozen, the
greater the distance between the sponsor’s ongoing
business operations and decisions
around investing
plan assets.
This is a rapidly
changing sector
of the investment
world. In 2013
Russell Investments produced a
handbook called
“The Investment
and Management of Frozen Pension Plans.” Within
18 months, we already needed to update it to capture
some important new developments: the emergence of
the concept of hibernation, the growth in popularity
of risk transfer, and the growing importance of PBGC
premiums in plan decision-making.
Pension Plan Hibernation as a Strategy
Once a pension plan has been closed to new entrants
or benefit accruals have been frozen, the plan starts to
change. The typical lifecycle of a frozen plan is illustrated in Figure 2, below.
“Since termination costs vary over time,
one benefit of hibernation is that it gives the
plan sponsor control over the timing of the
termination decision and the ability to wait
for favorable market conditions.”
A frozen pension plan will go through a number of
stages before it ceases to exist. For this reason, any risk
transfer decision—whether to pay lump sums to plan
participants, offer an annuity-based buyout, or (ultimately) completely terminate the plan—is in effect a
decision about timing. Will the liabilities be met one
monthly pension check at a time, or will they be met
more quickly via a risk transfer? And if the plan does
transfer risk, should it do so now or is it better to wait?
This is the context in which plan sponsors have
started to use the word “hibernation” to refer to the decision to delay termination and keep running the plan
within the corporate structure. In a loose sense, every
frozen plan that has not been terminated is in hibernation. But in practice, hibernation really becomes significant when a plan sponsor makes a conscious decision
to delay termination beyond the point at which it first
becomes feasible. The plan sponsor weighs the costs
and risks of terminating sooner versus those of terminating later and decides whether or not to hibernate,
for now. Since termination costs vary over time, one
benefit of hibernation is that it gives the plan sponsor
control over the timing of the termination decision
and the ability to wait for potentially favorable market
conditions.
Risk Transfer Has Become Common
Pension plan risk transfer takes two primary forms.
The plan may make lump-sum payments either to terminated vested plan participants—i.e., those who have
left the company but have not yet started to receive a
pension—or, less commonly, to current retirees. Alternatively, the plan may purchase annuity contracts from
insurance companies, so that retirees receive their pension benefits in the form of ongoing annuity payments
from the insurer.
Pension benefits can be paid as a lump sum only
when the plan participant chooses (except in the case
of de minimis benefits—if the lump sum benefit is
below $1,000, the plan can cash out a participant
without his or her consent). Since 2012, hundreds
of U.S.-based companies’ pension plans have undertaken programs to offer lump-sum cash-outs; typically
between 30 percent and 70 percent of participants
who are offered a lump sum take the offer. The total
amount of money involved runs into the tens of billions of dollars.
Meanwhile, the market for annuity buyouts—which
ran at around $1 billion a year from 2009 to 2011—
exploded in 2012. First, GM announced a $26 billion
deal, then Verizon Communications followed up with
a $7.5 billion announcement. According to LIMRA,
activity in 2013 totaled $3.8 billion, which would have
made it seem a strong year prior to 2012. Then 2014
came in at $8.5 billion.
The incidence of risk transfer activity can be expected to
ebb and flow as market conditions shift and change the
attractiveness of both lump-sum programs and annuity
purchases. Risk transfer compresses the lifecycle of a frozen plan, reducing the size of both assets and liabilities,
decreasing the plan’s footprint on the corporation, and
bringing the plan one step closer to eventual termination.
How PBGC Premiums Affect Funding and Risk
Transfer Decisions
Until recently, PBGC premiums were an unwelcome
cost, but they were marginal. They were not a significant consideration in funding or risk transfer decisions. But both the Moving Ahead for Progress in the
21st Century Act of 2012 (MAP-21) and the Bipartisan
Budget Act of 2013 increased PBGC premiums substantially (see Figure 3). As a result, PBGC premiums
are now hard to ignore for plan sponsors making decisions about how much risk to retain.
The increase in variable-rate premiums creates an
incentive for plan sponsors to accelerate contributions
in order to pay down a shortfall. In effect, for as long as
the shortfall exists in the plan, each marginal dollar that
is retained in the corporate account suffers a penalty
of almost 3 percent a year. Most CFOs like to have dry
powder on their balance sheet, but 3 percent a year is a
high price to pay for holding cash rather than improving
the pension’s funded status. In fact, even if a company
does not have the requisite cash at hand, it may find
that it would be cost-effective to borrow money in the
capital markets in order to fund the pension plan.
The increased fixed-rate premium may likewise factor into some plan sponsors’ decisions about pension
plan management. Specifically, the potential savings
of $64 a year per participant adds to the attractiveness of both lump sum payouts to participants and the
purchase of annuity contracts.
From 2016 forward, the variable-rate PBGC premium
will be capped at $500 per participant. For plans that
are affected by this cap, the dynamics of the incentives
created by PBGC premiums change significantly. In
that case, the savings from reducing headcount within
the plan would no longer be $64 a year per participant,
but rather $564 a year. That’s enough to demand atten-
tion from just about
any CFO.
The Frozen Plan
Segment Continues
to Evolve
The number of
U.S.-based pension
plans that are frozen
can be expected to
continue growing. At
the same time, the
age of participants in plans that have been frozen in the
past 20 years will also rise, and frozen plans will become
ever more separate from the corporations that sponsor
them. In light of these trends, we expect to see continued innovation and development in strategy and in best
practices for managing frozen pension plans. These developments will be shaped by market conditions, changing attitudes, regulation, and competitive pressure.
The story of frozen pension plans is only just beginning.
is chief research strategist in Russell
Investments’ Americas institutional business. Collie
is responsible for the strategic advice delivered to the
various parts of Russell Investments’ institutional
client base, as well as for working with the manager
research team, product groups, and other research
efforts across the company. He is also the lead author
of the Fiduciary Matters blog.
BOB COLLIE
is managing director, asset
allocation and risk management in Russell
Investments’ Americas institutional business.
Gannon oversees the examination of pension
plans from an actuarial perspective, and helps
advisory and investment outsourcing clients reach
an effective asset allocation decision by bringing
together actuarial liabilities and available asset
classes in a risk-reward framework.
JAMES GANNON
is a senior asset allocation strategist
for Russell Investments’ Americas institutional
business. As a subject matter expert on defined-benefit
plans, Owens regularly publishes research covering
a variety of topics related to risk management and
investment strategy for DB plan sponsors.
JUSTIN OWENS
(#87260) Adapted with permission from TreasuryandRisk.com. Copyright 2015 by The National Underwriter Company doing business as Summit Professional Networks.
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