The 5 Myths: Executive Summary
The 5 Myths Holding Back Plan Sponsors
The Need for Pension Risk Transfer
A number of respondents to a recent survey sponsored by Prudential and conducted by CFO Research said that obligations from their companies’ defined benefit (DB) plans are placing constraints on their companies’ performance. In fact, the survey found that:
43% of finance executives are concerned that obligations from their companies’ DB plans constrain cash flow
39% of finance executives feel that pension obligations restrict their ability to invest in growth opportunities
Prudential and CFO Research, “Managing Financial Risk in Retirement and Benefits Programs,” July 2014.
Despite an increasing interest in and awareness of risk management alternatives, the market has yet to see more large companies implement de-risking, and in particular, risk transfer solutions.
Plan Sponsors Missing Out Due to Myths About Pension Risk
While several plan sponsors are currently evaluating their de-risking options, a gap clearly exists between the intentions and actions of some companies with respect to DB risk reduction. The following are five myths that are contributing to this gap:
- Myth It is possible to significantly reduce risk with just a partial Liability Driven Investing (LDI) strategy.
- Fact Even the best case scenario with a partial LDI strategy is only modest risk reduction.
- Reallocating assets towards an LDI strategy not only limits potential investing opportunities, but also does not provide much of a safeguard from the impact on plan contribution obligations from poor market performance.
- Myth Companies are better off delaying the implementation of DB risk management solutions to benefit from further improvements in the financial markets.
- Fact There is no major benefit to increasing funded status compared to the potential risks associated with market volatility.
- After a certain funding status is reached, there is very little economic benefit to be gained through market improvements – however, there is a lot to lose.
- Myth Risk transfer solutions can only be executed once a company reaches or exceeds full funding.
- Fact Pension Buy-In and Longevity Insurance can be used to transfer risk regardless of funding status.
- While many people think of a pension “Buy-Out” as the only PRT solution, there are many options available regardless of funded status.
- Myth Transferring DB risk to an insurer is cost prohibitive.
- Fact Transferring DB risk can actually mitigate expenses.
- Aside from just looking at potential risk, taking into account asset management fees, changing mortality tables, potential credit downgrades, and administrative expenses – transferring your risk to an insurer can actually be a cheaper option.
- Myth Reducing DB risk reduces shareholder value.
- Fact Reducing DB risk can increase shareholder value.
- The stabilization of assets through pension risk reduction can act favorably on a company’s valuation through narrowing the company’s projected range of DB plan contributions and lowering their Weighted Average Cost of Capital (WACC).
Invalidating the five myths discussed in this publication helps to broaden the range of options that DB plan sponsors are willing to evaluate when formulating their long-term pension strategies. A wider range of options is essential to providing sponsors with the flexibility they need to achieve their long-term DB objectives.
It is also critical that plan sponsors begin evaluating these solutions as soon as practical, as executing many of these solutions— such as a buy-in or a buy-out—requires significant lead time. Proactive evaluation of these solutions will enable plan sponsors to successfully execute DB risk reduction strategies at the timing of their choice.
Of course, the decision to transfer pension risk is based on the specific nuances and demographics of each particular plan. To determine which solution is appropriate for their companies, plan sponsors should work with their actuaries and advisors to:
- Examine the health of their plans
- Consider how plan management impacts the company
- Explore the available pension risk transfer solutions
Forward-thinking plan sponsors that make time today to reexamine the assumptions surrounding their pension plan obligations will be able to confidently chart the right course for their pension and their company—and they will be at an advantage relative to those who don’t.